Salkku Cryptocurrency Index has been launched to help with assessing returns of most used cryptocurrencies, and to measure the value creation of the overall cryptocurrency ecosystem.
Why create an index?
By following cryptocurrencies for a while, an observer might have notice the extraordinary volatility of cryptocurrencies compared to more traditional asset classes. Daily price swings of +-10% or more are a pretty common thing even for currencies with high exchange volume (and thus better price discovery). Volatility of cryptocurrency investments might be just too high for quite a lot of people to stomach. It is also used frequently as negative advice for people considering cryptocurrency investments.
Financial innovation in stock markets brought us indexes, and index funds as a way to mitigate volatility. The idea of index funds is to hold the stocks that comprise the index, and therefore expose your portfolio to the aggregate volatility of the index. Volatility of the index is (usually) lower when compared to individual investments. Lower volatility is the consequence of index constituents having correlation less than (minus) one, so the sum total of individual stock price movements over time averages itself out as lower total volatility for the index.
Moreover, index funds, also called passive funds, seem to routinely beat the actively managed funds when comparing the total return. Exactly why this is so is not necessarily intuitive. Index funds might seem outside as just passive holders of stocks, but we have to look more carefully into how these indexes are constructed to understand their dynamics. Market capitalisation weighted index funds are actually momentum funds, i.e. over time, they keep winners and discard losers. Successful companies (rising stock prices) receive larger weightings in the index. Likewise, unsuccessful companies (declining stock prices) receive smaller weightings. When stock price declines enough, that stock is eventually removed from the index to make room for new stocks with positive momentum. [1]
Salkku Cryptocurrency Index
Salkku Cryptocurrency Index was created to find out if indexing helps to lower volatility and/or give better returns compared to holding just one cryptocurrency. Initial date for the index was chosen to be first of June, 2013. Number of index constituents was set to be 10, as that would include enough of the market capitalisation of this relatively young market.
Cryptocurrency space has been largely dominated by the first and biggest cryptocurrency, Bitcoin. Only recently this has begun to change with the advent of Ethereum and other competing currencies and tokens with unique properties compared to Bitcoin. Bitcoin still has by far the largest market capitalisation and would therefore dominate the index on its own. Therefore the index is constructed so that index share of any individual cryptocurrency is capped (currently 20%).
The index is rebalanced periodically, so that index represents the top 10 cryptocurrencies by market capitalisation on each rebalancing date. Rebalancing means recalculating the index constituents and their weights on rebalancing date. Currently rebalancing is done every third month.
Performance comparison with other cryptocurrencies
It would be interesting to compare index performance vs. holding just one cryptocurrency. If one would build a cryptocurrency fund based on index, ideally we’d hope to have better performance and lower volatility in aggregate vs. holding just one or two cryptocurrencies. And those are the properties many index funds are being sold with. Ideally passive index funds should able to deliver better performance, and/or lower volatility vs. actively managed funds.
We’ll see if that’d be the case with our index. We’ll choose a somewhat arbitrary time period, and compare the index performance to top 10 cryptocurrencies in at the beginning of that time period. Time period was chosen to be 4th of January 2015 - 29th October 2017, and the results are shown in Table 1 below. Please note, that performance results are approximate because data was spotty/limited for some of the currencies between those dates.
| Index/crypto (# in market capitalization) | Value gain | Annualized gain | Biggest drawdown |
|---|---|---|---|
| Salkku Cryptocurrency Index | 2,836.02 % | 208.50 % | -38.57 % |
| Bitcoin (#1) | 1,951.03 % | 173.73 % | -43.40 % |
| Ripple (#2) | 851.11 % | 111.87 % | -83.18 % |
| Litecoin (#3) | 2,810.33 % | 207.60 % | -65.92 % |
| PayCoin (#4) | -99.80 % | -87.33 % | -99.94 % |
| Bitshares (#5) | 265.57 % | 54.05 % | N/A |
| MaidSafe Coin (#6) | 665.38 % | 97.07 % | -75.69 % |
| Nxt (#7) | 239.85 % | 50.35 % | -85.86 % |
| Dogecoin (#8) | 540.95 % | 85.75 % | N/A % |
| Stellar (#9) | 569.41 % | 88.46 % | -85.47 % |
| PeerCoin (#10) | 136.56 % | 33.24 % | -77.61 % |
The results are pretty clear. The index was able to deliver BOTH better total gain and lower maximum drawdown (maximum drop between successive All-Time-Highs) compared to any of the top 10 cryptocurrencies. This means, that selecting and holding any combination of those cryptos was guaranteed to produce inferior results compared to our index.
So based on this rather arbitrary comparison, it’d seem, that there might be significant benefits to be gained for using some form of indexing to balance your cryptocurrency investments over time.
Development
Interesting subject for further studies would be to answer the question whether these results change substantially when changing index parameters. Does indexing benefits manifest itself with even smaller index constituent number, say top 3 by market capitalisation? Cryptocurrency market is characteristically winner-takes-all market right now, meaning that most of the value gains go to the biggest currencies, so it is conceivable that holding just a few currencies from the top could deliver same kind of results as having a bigger selection of cryptocurrencies in the index.
We’d also want to compare results over wide variety of different time periods. Adjusting the time period is naturally rather difficult because of the limited time cryptocurrencies have been on the market, so additional data is needed to fully draw meaningful comparisons of benefits of indexing.
Sources
- Nasdaq: THE CAPITALISM DISTRIBUTION - Observations of individual common stock returns, 1983 – 2006. http://business.nasdaq.com/media/The_Capitalism_Distribution_Blackstar_Funds_tcm5044-42315.pdf