Crypto index investing has seen a surge in passive investing strategies, following the trend set in traditional finance. But it’s important to engineer indexes that can grapple with the shortcomings and inefficiencies of the digital asset class. Market cap-weighted indexes have been considered the industry standard, but alternative weighting methodologies such as equal weighting, risk parity and maximum diversification have been introduced to exploit market inefficiencies. This has led to the development of the buzz term smart beta.
In the world of crypto indexing, benchmark creators have brought over market cap-weighting from traditional finance one-to-one. That approach, however, may not lead to optimal results, especially in the relatively nascent and evolving asset class of cryptocurrencies.
To address these issues, it is important to avoid the common pitfalls of market cap-weighted indexes and limit the investment universe to the top coins by market liquidity. One approach is to build an index based on a combination of risk parity and market capitalization. This aims to balance the risk contributions of index constituents, resulting in an index that over-weights smaller coins compared with a market cap-weighted one, achieving higher diversification.