There are three primary weighting options when constructing a dynamic index. These three options are weighting by market, square root, and equal. To better understand each of these options, let’s break down how these different options work.
Market cap weighting is one which tracks the market caps of each asset in the dynamic index. The allocation assigned to each asset will be proportional to their market cap weighting compared to the other assets in the index. That means the assets with a larger market cap will consumer more of the portfolio than those which have a smaller market cap. This allows your portfolio to closely match the current state of the market, resulting in a performance which will be as close as possible to the market performance of all cryptocurrencies.
For example, if you have an index of two assets and the first asset is BTC and the second asset is ETH.
- BTC Market Cap: $137,008,021,275
- ETH Market Cap: $26,081,172,184
Calculating the weightings in the portfolio.
- BTC weighting: 137,008,021,275 / (137,008,021,275 + 26,081,172,184) = 84%
- ETH weighting: 26,081,172,184 / (137,008,021,275 + 26,081,172,184) = 16%
Therefore, the allocations in this example portfolio would be 84% BTC and 16% ETH.
Square Root Market Cap
A square root market cap distribution will take the square root of each of the market caps to dampen the affect an individual asset has on the portfolio. As we saw in the last example, Bitcoin held 84% of the value in the portfolio. Some people may consider this risky since most of the portfolio value is held in a single asset. To more evenly distribute the funds in the index, we can use a square root market cap.
Let’s examine how this will change the resulting allocations.
- BTC weighting: 137,008,021,275^(1/2) / (137,008,021,275^(1/2) + 26,081,172,184^(1/2)) = 69.62%
- ETH weighting: 26,081,172,184^(1/2) / (137,008,021,275^(1/2) + 26,081,172,184^(1/2)) = 30.38%
We see the result of taking the square root of the market cap is a distribution that is more evenly dispersed among the available assets.
An equally weighted index is one which allocates an even percent across all assets. If there are 5 assets in the portfolio, that means each will receive 20% of the value for the portfolio. If there are 10 assets, each will receive 10% of the total value of the portfolio.