The Simplicity, Elegance and Utility of a Market Cap Weighed Fund
My personal opinion on why a market cap weighing the optimum design for a fund.
A repost of my old blog from 8th November 2020
Introduction
Market capitalisation fund designs are the most common form in TradFi. DeFi allows other structures to be used without transaction costs. However, I believe that market cap structures are preferable.
Unit-based hold and forget
I think the key concept to understand with a market cap based fund is to focus on the units and not the price nor total market cap. If there are 1,000 of share A and 20,000 of share B, and you own 1 A and 20 B you will always hold a market cap portfolio that is worth 1/1,000 of the total value for A and B. It is irrelevant what happens to either price.
For a traditional finance share, you could buy all the shares in the S&P 500 and place paper certificates in a safe and know you would retain the same ownership 5 years later. With a crypto portfolio, you can achieve the same using a hardware wallet: buy the required tokens in the correct ratio and hold.
This means that you have the benefits of diversification with downside protection. If you buy and hold the index, you are guaranteed average performance (which is better than most active traders). In addition, the market cap weighting relies on the wisdom of the market to accurately price each asset over the long term. (Note that this requires an efficient market with little miss pricing, something we may not have achieved yet with crypto markets…).
In contrast, constant capital weight designs require two things:
Somebody to select the “correct” $USD value / cap for components. This is effectively saying that the methodologist is better at pricing an asset than the market is.
Continual trading with the market, which can incur fees. For crypto funds, smart contracts can push this cost onto the arbitrageurs. However, it requires the entire wallet to be live to the market at all times.
Rebalancing
While paper-based certificates can replicate an index EFT, there is a continual turn over of members, as the markets move. Currently, S&P members have an expectancy of 12 years in the fund. So, ideally, you should keep adding new shares to your collection to match the fund. In addition, as companies issue and buy back shares the total available for each company changes. So it becomes easier for most investors to maintain market exposure by buying a single EFT.
Crypto markets and protocols move at a much quicker rate than TradFi with new tokens being launched frequently, and significant increases in circulating token supply ($UNI is currently being issued at a rate of 333,333 or 0.015% of circulating supply per day). Therefore there is a need for frequent rebalancing. Again this is an advantage of pooled investments such as index funds.
Downsides of Market Cap
One downside of a market cap based approach is that the index can become very heavily dependent in a few key members. For example, the top 6 shares within the current S&P 500 fund make up 21% of the total fund value and the index is heavily focused on technology with ~35% in this sector (Figure 1). When I started using TradFi indices in 2000, I thought that the FTSE100 was too heavily focused on the financial and oil sectors. So I started to buy equal £ quantities of the FTSE 100 (100 largest companies listed in the UK) and the FTSE 250 (next 250 companies by market cap). This meant that i was disagreeing with the market in terms of asset pricing. However, I had a portfolio that was more diversified.
The same can be seen with crypto portfolios. If you simply buy a index based on market cap, you will spend 63% of your money on Bitcoin and 11% on Ether. With such a concentration of assets, you may be better constructing your own portfolio with the two tokens. Figure 2 presents the performance of Bitcoin and a fund comprising the top 100 tokens (bitwise 100) in market cap weighting. For the last 18 months there has been little difference between the two.
Final Thoughts
I find the focus on constant unit weights in a market cap fund to be a more elegant approach than to rely on others to decide the “correct” USD value / cap for an asset and continual trading to maintain these chosen values.
I think that pure market cap approach for all of crypto may add an unacceptable risk of over concentration on dominant tokens with little benefit of diversification. Personally, I look at purchasing an index fund where I can gain exposure to a sector (e.g. $DPI for DeFi) that I believe has promise, with the inherent market monitoring and downside protection within a fund.Then I will add this fund to my core holding of BTC / ETH.
Disclosure and Disclaimer
I’m a long term investor in crypto currencies including DeFi. I am an active member of the INDEXcoop which manages the $DPI fund.
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.