Crypto Index Fund Construction - Part 2
Smart contracts allow different approaches to index fund construction that are not practicable in Traditional Finance.
This was initial published in my old blog in October 2020
Part 1 can be found here
Fixed Weight funds
In TradFi constant weight funds are generally not used as they require constant trades to maintain the weights. However, in Defi we have AMM protocols that automatically do this.
The widest used is a UNISWAP liquidity pool. However, this is always maintained in the 50:50 weight with two tokens so it a little pointless. Of more use for index funds are Balancer pools .
Containing the fund in a Balancer pool has the advantage that it will reblance constantly as it interacts with traders / arbitrators. Any change in the underlying token prices will result in the pool containing more of that token than is required. This allows arbitrators to purchase the higher value token using the other tokens i.e, providing A, C or D to remove B from the pool in our example in part 2. Most DeFi investors would recognise the above process as “Divergent loss” as the tokens that are pumping are sold to buy more of the others. However, as explained in Part 2, such rebalancing strategies may result in long term gains compared to a market cap weighing. One man’s divergence loss is another man’s rebalancing strategy!
In the case of a balancer pool, the Liquidity Pool (PL) token, is the fund token as this represents a proportion of the total pool value and so the ownership of the underlying tokens. As with Figure 1 above, Unit tokens / LP tokens are issued and redeemed using a smart contract to ensure they are done in the correct (preset) weighs.
A single pool can contain upto 8 tokens at weights selected by the contract writer. Finalised pools have static parameters and so do not allow changes to the weights etc While this may be useful for a single token pricing pool it is less useful for indexes where changes to the weighing, additions etc can be expected over time. Of more interest for index funds are smart pools, these have some parameters fixed and others controlled by a separate smart contract. This lets the creator for the pool adjust selected parameters over the life of a fund or even pause it in times of market volatility.
The best known example of the use of balancer pools as an investment funds are those provided by PieDAO (PieDAO was the first to launch smart balancer pool). PieDAO launched with two DeFI index funds containing large cap and small cap Defi tokens and have more planned (note I believe that the newer PieVaults use a market cap structure)
Synthetic funds
Synthetic funds differ in that they don’t contain the underlying tokens. Rather they are synthesised against collateral with the price determined by external oracles. The most widely available (/only ?) is sDeFi from Synthetix. This is a constant weight fund that has the advantage of zero cost rebalancing within the fund. Being a synthetic asset there is no need to issue / redeem from the underlying tokens. However, there is a subsequent counterparty risk introduced in the synthesis of the fund units.
Effect of fees
Fees are useful in that they allow the governance token holders to extract value from what they have created. This encourages them to create more and to maintain what they have created. However, each fee has an impact on the desirability of long term holding, or short term trading.
Asset under Vault (AUV) fees / streaming fees deter long term hold strategies as they slowly drain the holders assets.
Issue and Redemption fees have less impact on long term holders, but make arbitration less profitable. This means that a given pool is likely to drift further form the underlying NAV before a arbitration event happens. Less arbitration means more tracking errors compared to the index(and fewer fees for LP providers)
One advantage of the AMM type of structure is that fees can be charged on any arbitrators trading with individual tokens and the pool. So during the constant rebalencing, the pool is being enriched by the fees.
Part 3 can be found here
Disclosure and Disclaimer
This is not financial advice, all investments are risky, crypto investments are more risky than most. Do your own research. Do not invest more than you can afford to lose.