Can DeFi indices finally make crypto-based passive investing worthwhile?

The concept of a DeFi ETF sounds promising, but it’s not without pitfalls.

Index investing in the stock market has become extremely popular thanks to the proliferation of exchange-traded funds, or ETFs, which often track popular market indices like the S&P 500 or the Nasdaq-100.

Investing in the entire market can be a simple, but effective, strategy. Instead of spending energy and time on trying to beat it — often unsuccessfully — investors are guaranteed average returns, which in the past 10 years have been more than respectable both in stocks and in crypto.

The rise of decentralized finance in the summer of 2020 seems to have reinvigorated the concept of passive investment in crypto. In addition to creating a new well-defined category of crypto assets, it has boosted the infrastructure required to create something analogous to a crypto-native ETF.

Several projects and platforms launched their own DeFi indices in 2020. Some, such as the FTX DeFi perpetual contract or Synthetix’s sDEFI, are derivatives products based on synthetic contracts. They simply track the price of a basket of assets, without owning the underlying tokens.

But DeFi grants the possibility of creating something much closer to an ETF. These types of funds always own the underlying basket of assets that they are supposed to track. At the end of each trading day, some large institutions have the privilege of creating or redeeming shares of the ETF for its net asset value. They create new shares and sell them if the ETF is more expensive than the assets it holds, and they redeem existing shares if it’s worth less.

A DeFi-based index allows for the same exact type of arbitrage mechanism, but it doesn’t need to be limited to a privileged set of maintainers.

Currently, there are three major ETF-like DeFi products: the DeFi Pulse Index, two different indices by PieDAO, and Power Index by PowerPool.

The indices differ primarily by the assets they consist of and how each token is weighted. DeFi Pulse and PieDAO use market-capitalization weighting, while PowerPool has a fixed quota for each token. The PieDAO and PowerPool indices can be changed by governance voting with Dough and CVP, respectively.

While DeFi Pulse and PieDAO closely emulate the features of a traditional ETF, PowerPool’s index construction highlights that DeFi indices may eventually grow beyond the possibilities offered by stock markets.

The index allows holders to vote in governance proposals for the underlying protocols without exiting from the index. This is part of the team’s vision of smart indices that maintain the utility offered by direct ownership of the underlying tokens. While this is likely dictated by the project’s strong focus on meta-governance, it suggests that the possibilities offered by DeFi composability are yet to be fully explored.

The DeFi Pulse index is currently the most popular, with a market capitalization of $36 million. The combined value of PieDAO’s two indices is valued at $3.7 million, while the Power Index maxed out its current cap of $500,000 in value.

While still small, these indices were launched relatively recently and are likely to be in the early stages of their growth cycle. However, some experts see strong limits to their maximum size.

A crypto product for crypto enthusiasts

Meltem Demirors, chief strategy officer of CoinShares, believes that using the term “ETF” for these redeemable index funds is not entirely correct, as the concept of an ETF is specific to traditional markets. She told Cointelegraph:

“An ETF is an investment product that combines the benefits of diversification with the ease of trading a single stock via a single ticker. Like many financial products, they rely on a manager, administrator, and a number of intermediaries, and have management costs, commission fees, restrictions on trading, and how easily you can buy or sell them, and differing grades of quality.”

While crypto indices capture many benefits of ETFs, they also “face the same challenges as buyers of traditional ETFs, without the benefit of regulatory oversight or standard documentation,” she added. “I’d call these types of products something very different in order to disambiguate what it is people are buying.”

The differences are crucial in determining crypto index adoption, in her view. “These products will initially attract crypto enthusiasts and proficient crypto users,” Demirors said, mentioning the difficulty of using DeFi interfaces for non-crypto users.

Demand for DeFi indices is likely to come from retail and crypto power users for now, while institutional investors will continue using the security and familiarity of their preferred brokerage accounts, Demirors concluded.

Joey Krug, co-founder of Augur and co-chief investment officer of Pantera Capital, shared the  same overall outlook. Though he is more positive about tokenized indices as “what a crypto native ETF would look like,” he said that “retail [will lead] in the beginning, although long term, I could see demand from institutional traders as well.”

Diversification has been problematic

The attractiveness of market index ETFs comes from the broad exposure they provide to holders. While single stocks may rise and fall due to specific and unforeseeable factors, a basket of them can smoothen these individual aberrations to provide a general picture of the market.

In crypto, diversification has been largely ineffective so far. “Historically, most crypto assets have traded with a beta of one to Bitcoin,” Demirors explained. “Beta” is a financial measurement defining how closely an asset tracks another — a beta of one indicates price movements that are correlated both in direction and in magnitude.

This has been a major issue for previous crypto index projects, which often suffered from excessive market-capitalization-based allocations to Bitcoin (BTC) and Ether (ETH) that compounded the lack of diversification, Demirors noted.

Liquidity in the underlying assets is the limiting factor for any index fund, as when their holdings become too large, “The tail begins to wag the dog,” she said. Market participants may start to trade against rebalances and overall flows into the fund, potentially distorting the prices of the underlying assets.

These market limitations pose severe restrictions on the viability of index funds, with Demirors noting that “It would be difficult to see crypto indices growing beyond the natural limits of these markets.”

DeFi or governance-centric funds may, nevertheless, help with diversification issues. Krug highlighted that DeFi tokens have recently moved independently or against BTC, suggesting that “Correlations are coming off a bit.” Over the long term, the presence of protocol revenue and cash flows may further help to break the correlation, he added.

Overall, thematic index funds like the DeFi baskets offered today are useful for certain niches of traders, both Demirors and Krug agreed. For example, they can be used to construct complex hedging strategies, Krug said.

But the prospects of mass adoption are somewhat cloudy, as these types of products will need to mature in lockstep with the wider crypto and DeFi markets to remain useful.