What’s an index fund?
In finance, an index is a collection of assets designed to give a broad overview of a market's performance. For example, the Standard & Poor's 500 (S&P 500) consists of 500 large U.S. equities. Initially, the purpose of these indexes was to help investors get a glimpse into the overall market sentiment.
An index fund refers to a tradable security that mimics the performance of major indexes. Firms that issue index funds will hold the same assets in whatever index they track. That means an index fund’s performance should mimic the underlying index’s market price. Brokerage platforms offer index funds similar to shares in individual companies.
Index funds are known as passive investment vehicles. Fund managers will only buy or sell assets to better reflect the index they're tracking. In contrast, active or managed mutual funds can constantly trade in and out of positions.
Since index funds don't require as much management as active funds, they tend to have the lowest "expense fees." If you hold an index fund, you have to pay fees to managers for as long as you keep your shares.
Although the idea for index funds was around in the 1960s, Vanguard's John C. Bogle was the first to offer this product to investors. The Vanguard 500 Index Fund (VFIAX) remains one of the most actively traded index funds that track the S&P 500.
Index funds are most closely associated with stock indexes like the S&P 500, Nasdaq, and Dow Jones Industrial Average. However, countless index funds are available in other sectors, including bonds, precious metals, and commodities.
Are index funds the same as ETFs?
ETFs (exchange-traded funds) are similar to index funds––both hold large pools of assets, and you can buy them with a stock brokerage account. However, there are a few differences between these investments.
Most notably, you can trade index funds only once per day when the stock trading is over. Comparatively, you can trade ETFs at any time during a regular trading session. Typically, short-term traders tend to prefer ETFs due to this enhanced liquidity.
Also, it's more common for ETFs to have lower minimum requirements and fees than index funds. You may pay a different tax rate if you sell an ETF versus an index fund.
ETFs have become an increasingly common investment vehicle due to their enhanced liquidity. However, it's always best to speak with a financial advisor to determine whether ETFs or index funds are better for your situation.
Examples of index funds
There are hundreds of index funds to choose from, but the most active funds track the following averages:
- S&P 500 Index: Vanguard's 500 Index Fund (VFIAX) was the first of its kind in 1975. Since then, many other firms like iShares, Fidelity, and Charles Schwab have been offering index funds that track these 500 large-cap American stocks.
- Dow Jones Industrial Average (DJIA): Created in the late 1800s, the DJIA tracks 30 of the largest companies in the U.S. Due to Dow's long history in the U.S. market, dozens of index fund and ETF managers offer shares that track the DJIA's performance. The SPDR DJIA ETF (DIA) and iShares Dow Jones US ETF (IYY) are two prominent DJIA-focused funds.
- Nasdaq Composite: The Nasdaq is an American stock exchange that began trading in the ‘70s. Although the Nasdaq isn't exclusively composed of tech stocks, it's most closely associated with the tech sector. Index funds that track the Nasdaq usually focus on the Nasdaq-100, which includes the 100 largest companies on this exchange. Examples of Nasdaq index funds and ETFs include Fidelity's Nasdaq Composite Index (FNCMX) and Invesco's QQQ.
Is there a crypto index fund?
A few index funds track cryptocurrencies, but most aren't available to retail investors. Currently, the only crypto index fund listed on most brokerage platforms is the Bitwise 10 Crypto Index Fund (BITW). Introduced in 2017, BITW holds a weighted portfolio of the 10 largest cryptocurrencies, excluding stablecoins. Below are the 10 cryptocurrencies in the BITW (at the time of writing):
- Bitcoin (BTC)
- Ethereum (ETH)
- Cardano (ADA)
- Solana (SOL)
- Polygon (MATIC)
- Polkadot (DOT)
- Uniswap (UNI)
- Avalanche (AVAX)
- Cosmos (ATOM)
- Chainlink (LINK)
Bitwise offers many other crypto index funds, but they are currently only available to accredited investors. These private index funds follow the price of more speculative altcoins, NFTs (non-fungible tokens), and metaverse projects.
While BITW is the most accessible crypto index fund, there’s a wealth of ETFs that track the crypto market. In 2021, the U.S. Securities and Exchange Commission approved many futures-backed Bitcoin ETFs, such as ProShares' Bitcoin Strategy ETF (BITO) and Valkyrie's Bitcoin Strategy ETF (BTF). While these Bitcoin ETFs hold futures contracts rather than physical BTC, they can give investors price exposure to BTC.
A few ETFs also track various segments of the cryptocurrency industry. For example, Fidelity offers ETFs that hold stocks related to the metaverse or peer-to-peer crypto payments. Valkyrie also has an ETF that holds stock in many Bitcoin mining companies.
Lastly, a few experimental tokenized crypto index funds are available on DeFi (decentralized finance) platforms. For example, Invictus Capital launched a token that tracks the top 20 cryptocurrencies by market cap. The CRYPTO20 token is currently available on decentralized exchanges (DEXs) like Uniswap.
There's also a DeFi Pulse Index (DPI) that tracks the top tokens in the DeFi sector. Although most crypto traders buy DPI on DEXs like Uniswap, it's becoming more accessible on centralized exchanges (CEXs) like KuCoin and Gemini.
Benefits of crypto indexes
Crypto index funds have unique advantages that may appeal to new Web3 investors, including:
- Portfolio diversification: Crypto index funds provide exposure to the blockchain industry. Plus, since these funds aren't all concentrated in one crypto project, investors may mitigate the volatility of investing in solo tokens.
- Accessible for traditional investors:Buying and selling shares in a crypto index fund is arguably easier than in a crypto exchange. If you already have a brokerage account, you could easily invest in BITW or a competing crypto ETF.
- No need to store private keys: Index fund managers are responsible for keeping all the cryptocurrencies in their portfolios. If you aren't comfortable transferring tokens and securing your seed phrase, you may feel more comfortable letting your fund handle crypto storage.
- Better regulated than crypto exchanges: The SEC constantly monitors index funds and ETFs on public stock exchanges, making it more comfortable for risk-averse investors to continue their trading activity.
Drawbacks of cryptocurrency index funds
Crypto index funds have potential advantages, but not without a few limitations.
- Relatively high fees: A major selling point for stock index funds is that they usually have low expense ratios. However, since the crypto industry is so volatile, crypto index funds tend to have higher-than-average fees. For example, the BITW currently has an expense ratio of 2.5%. On average, stock index funds have fees of less than 1%.
- Not as many options for non-accredited investors: Besides BITW, there aren't any easily accessible crypto index funds. Unless you're an accredited investor or familiar with DeFi, you won't find many opportunities to invest in crypto index funds.
- More volatile than stock index funds: The idea behind the first index funds was to reduce stock market volatility with diversification. By pooling various assets, investors should reduce the odds of experiencing severe drawdowns. However, the crypto market is inherently more volatile than stocks or bonds, which makes a crypto index fund less attractive to risk-averse investors. While the potential gains may be higher with a crypto index fund, there's a greater risk for steep declines.
Crypto index funds are nowhere near as dominant as stock index funds. However, it's now possible to find accredited crypto index funds like BITW on brokerage platforms. Many innovative crypto ETFs, accredited-only index funds, and DeFi tokens also monitor the crypto industry. These assets provide more opportunities to gain exposure to crypto without investing directly in a single coin or token.
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