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Diversification in Down Markets: Is Now the Ideal Time to Consider a Crypto Index?

Posted by Samir Kerbage on Sep 23, 2022 10:30:00 AM

This content is shared by Samir Kerbage at Hashdex

Crypto investment products have come a long way. Just a few years ago, investors had limited options for regulated vehicles that met security and liquidity standards comparable to other types of investments. Today, new crypto investment products are being launched regularly as investor demand increases and the global regulatory environment improves. 

But what is the best way to get exposure to this emerging asset class? 

We believe investing in a basket of the most well-developed and promising crypto assets is an excellent long-term approach. 

For investors seeking this type of broad exposure, the current environment is providing an ideal opportunity. Of course, the devil is in the details. Not all crypto investment products are appropriate for all investors and there are many considerations to factor into deciding whether a product is right for your needs, including its fees, tax implications, and investment strategy. 

At Hashdex, we believe diversification is the best strategy for most crypto investors. And the current landscape of suppressed prices and strong ecosystem fundamentals is creating a highly attractive environment for long-term investors seeking this diversification. To that end, we believe the following three points are signals that this may be an ideal time for investors to broaden their crypto exposure.

Potential tax benefits.

Every investor has a different tax situation and needs. However, the crypto market drawdown that has occurred this year has left many investors that hold individual crypto assets—whether directly or via an exchange-traded product (ETP)—with significant losses. 

Arguably, the best time to consider shifting assets from one investment product to another is when an investor has experienced a loss, as they can liquidate their position without facing capital gains taxes. This is particularly relevant with crypto, an asset class that has experienced significant levels of volatility due to its status as an emerging, technology-driven industry. Crypto assets in general have experienced huge rises and falls in price. Bitcoin alone has experienced seven drawdowns of more than 50% in the last 10 years[1] as its price has increased 570,000% over the same period.    

For many tax-sensitive investors seeking broad crypto exposure, we believe taking the opportunity now to shift from single-asset exposure can be far more beneficial than making that decision after crypto’s next bull run.

Crypto may recover faster than other risk assets.

This year’s global risk-off environment has been driven by a combination of high inflation, tightening monetary policies, and geopolitical tensions. This scenario has impacted every type of risk asset. However, assets that derive their value from new innovations, such as tech stocks and crypto assets, have been particularly affected due to their long-term nature and value proposition. For example, as interest rates rise the discount factor of future value (or cash flow) for these assets also increases. 

This macro dynamic could flip within the coming year as central banks slow or stop the monetary tightening cycle. We believe as this scenario plays out, crypto has the potential to be one of the first asset classes to recover. Due to the speculation associated with crypto assets, they are more sensitive to the factors that impact risk assets, both on the upside and downside. So, as risk assets recover it's possible that crypto will outperform stocks and other risk assets.  

It’s also important to remember that when looking at current blockchain fundamental metrics, crypto is cheap compared to previous “crypto winters.” It has a stronger developers’ ecosystem, more venture capital investments, and higher total value locked (TVL) numbers[2]. These factors, independent from the current macroeconomic environment, are additional signs that these prices may be attractive buying opportunities and may result in a faster appreciation than other asset classes during the recovery. 

Diversification works.

Whether investing in stocks, bonds, or alternative asset classes like real estate, one thing has been proven true over the long term: diversification strengthens portfolios. Diversification is a time-tested investment approach that can help improve long-term investment outcomes by reducing idiosyncratic, geographic, and interest rate-related risks. It also helps ensure that our own qualitative biases toward one asset, sector, or region do not disproportionately impact our portfolios. 

“Diversification is a safety factor that is essential because we should be humble enough to admit we can be wrong.”

  • John Templeton, mutual fund pioneer considered one of the world’s greatest stock pickers[3]

We believe the benefits of diversification apply to crypto assets as well. We’ve seen this to an extent in the crypto markets recently, as there have been periods when the Nasdaq Crypto Index™ has recovered faster than individual crypto assets.

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It’s also important to remember that crypto is not a monolithic asset class. There are many different types of blockchains with different benefits and there are thousands of crypto assets focused on many applications: currencies, gaming, file storage, dApps, and DeFi to name a few. Crypto assets are competing for users in each of these segments, and only time will tell which assets—and segments—take off. 

As the crypto markets evolve, the dominance of the largest assets is likely to change over time. No one knows how or when this might happen, but as crypto becomes more mainstream there will be other assets that experience significant growth and potentially disrupt the market share of bitcoin, ether, and other assets that have dominated the crypto landscape to date. By diversifying into other assets, investors can position themselves to benefit from the growth of these other crypto assets, while still ensuring that they have exposure to the largest and most liquid players in the crypto markets. With asset prices well below all-time highs, now may be the ideal time to obtain this broader exposure within your crypto allocation. 

Getting the right exposure: Not all indices are the same.

Hashdex partnered with Nasdaq in 2020 to help solve a problem: investors looking for broad exposure to the crypto markets did not have access to an index appropriate for professional investors. This is why we co-developed the Nasdaq Crypto Index™ (NCI™). And it is why we again partnered with Nasdaq to create a benchmark to meet specific European eligibility requirements—the NCI Europe™.    

The ultimate goal of the NCIE™ is to provide investors exposure to the growth of the crypto ecosystem as a whole, through the most promising and mature crypto assets that are supported by institutional-grade service providers. This is done by setting strict eligibility criteria for any crypto asset that is included in the index, including that it must be eligible for listing in an ETP on specified European exchanges and must meet liquidity and market capitalization standards.

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This methodology is what separates the NCIE™ from other indices. By building a robust and stringent process around asset inclusion, the benchmark sets the bar for crypto basket investing. In fact, earlier this year Nasdaq compared the NCIE to other indices to better understand the crypto basket landscape. They found a number of key differences that we believe help make the NCIE™ a benchmark more suitable for investors, including:

  • The NCIE™ does not use capping or flooring to determine position sizes, which can distort the composition of the index and not accurately reflect market capitalization. Instead, the NCIE applies a free-float market cap weighted approach to ensure the size of each crypto asset’s exposure accurately reflects market performance;
  • The NCIE™ does not artificially limit the number of constituents. Instead, constituent assets fluctuate based on market conditions to better reflect the state of value concentration at any given time.  
  • The NCIE™ limits the qualitative discretion needed for implementation. Discretion is used by the NCI Oversight Committee for regulatory compliance and suitability, but never for sizing and/or portfolio construction. This helps ensure that an individual’s subjective views on a particular crypto asset do not override actual market conditions.      

These differentiators are some of the reasons why in the first half of 2022, Hashdex led all of our multi-asset crypto ETP peers in net new assets. While single-asset products will continue to play a role for some investors, we believe the inflows into diversified baskets are a clear sign that investor demand for broad crypto exposure remains, even in this most recent market downturn and uncertainty. 

In August, we shared with our clients five main reasons the current market is providing unprecedented opportunities for crypto investors. These potential catalysts for the next crypto bull market are a clear sign that opportunity abounds. For investors looking to make an opportunistic allocation to a broad set of crypto assets, we believe now is the time to consider a crypto basket strategy.   



[1] See www.visualcapitalist.com/bitcoin-historical-corrections-from-all-time-highs/.

[2] Total value locked (TVL) is a metric that measures the aggregate value of all crypto assets locked in decentralized finance (DeFi) protocols via smart contracts. Source: Cryptopedia, August 30, 2022.

[3] See web.archive.org/web/20170111160627/http://www.templeton.org/sir-john-templeton/life-story

 

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