We are extremely early in the age of asset management in decentralised finance (DeFi). There’s Enzyme Protocol for active management and a few index/ETF providers like Index Coop, the community behind the DeFi Pulse Index, for example. However, we still sorely lack universally recognized, broad market indices that can be used as information aggregates, benchmarks for financial instruments and reference values for the health of the crypto market.
There are several reasons why this could be harmful:
- Universally recognised, broad market indices are a critical component for both passive and active investment products. There can’t be a passive product without an index it should be tracking. For active products, a universally used index serves as a benchmark, justifying performance and other fees.
- Without universal indices, most investors are blind when investing in pooled investment vehicles, particularly the retail investors. There is no way to measure if an investment product is delivering on its stated objective. No way to understand how much risk that particular product is taking to generate its returns. Without benchmarks, investment product managers have no accountability.
- Lack of universally used benchmarks could also lead to product saturation. For example, if there was a DeFi benchmark index, we could measure the performance, risk, correlation, beta exposure, etc. of different products to the index. It could be that all products would be broadly interchangeable. We could see a dozen new DeFi sector trackers launched in the next few months, and without a benchmark, we will not be able to tell if any of them have merit.
Perhaps, it could be useful to look at the evolution of financial products in traditional finance (TradFi) and consider if any lessons can apply to DeFi.
Well before mutual funds, index funds and ETFs, we had simple aggregate indices produced by business newspapers. The Dow Jones Transportation Average was created in 1894, followed by the Dow Jones Industrial Average (DJIA) in 1896. At launch, DJIA was composed of Western Union, the Pacific Mail Steamship Company and nine railroad stocks. These first indices were used to assess the state of the economy, analyse behaviour of financial actors and summarise, easily and concisely, the available information on the stock market.
The idea of index funds kicked off in the 1950s and 1960s, in response to academic research by future Nobel Prize winner Harry Markowitz on modern portfolio theory. The first index mutual fund was launched in 1973, followed by John “Jack” Bogle’s First Index Investment Trust that tracked the S&P 500 in 1975. That fund is now the Vanguard 500 Index Fund and Vanguard, in its entirety, manages more than $6 trillion of assets.
The next evolution in TradFi asset management vehicles was the introduction of ETFs. ETFs led to the development of passive investing, allowing investors to get beta exposure to markets by replicating indices like the S&P 500. The Toronto 35 Index Participation Fund, the first-ever listed ETF, was launched 30 years ago and the SPDR S&P 500 ETF Trust followed in 1993. Since then, we have seen an explosion in ETFs with the majority of it coming after the global financial crisis. Since 2008, assets under management in ETFs went from $800bn to more than $5.4tn, as of March 2020. There’s now almost 8,000 ETFs and ETPs worldwide from 450 providers. Some of the primary reasons for this rapid growth was the poor performance of active funds during the financial crisis and the ongoing fee pressure from institutional investors.
As the number of ETFs and funds exploded so did the number of benchmark indices. For 8,000 ETFs and ETPs, a related 2.96 million indices have emerged worldwide, according to the New York-based Index Industry Association. We’ve seen index innovation leading to factor-specific indices like growth, value and momentum, as well as ESG indices.
Looking at the cryptocurrency space today, few important things stand out.
1.Lack of universally used benchmarks
There is currently a lack of universally used benchmark indices in the crypto space. Historically, Bitcoin has been used as the primary measure of performance. Today, however, investing in a DeFi index is an act of faith in the index provider. There’s no way to measure the indices’ performance or risk levels and certainly no accountability for that same performance. In the environment where many DeFi asset management products charge hefty performance fees, the question is fees for what?
To a certain extent, DeFi projects seem to combine the concept of a benchmark index with a concept of an ETF. Using an index as an investment strategy includes 3 distinct phases: definition of the opportunity set, stock selection, and implementation. The first two phases constitute unique IP, a sort of encoded investment strategy, of an index provider, while implementation is done by a fund manager through a mutual fund or an ETF structure.
In TradFi, asset managers can’t really move to self-indexing due to concerns about the independence of a self-indexed product. In DeFI, however, due to the fundamental transparency of the blockchain infrastructure, a project can, in fact, be a benchmark index provider and also manage funds or ETFs to that same benchmark. Looking at the benchmark value chain in TradFi, we can effectively aggregate the first three types of players into one in DeFi.
The exciting opportunities that presents aside, DeFi seems to be missing widely-adopted benchmark indices that can be used as information aggregates, benchmarks for financial products and reference values.
2.Necessity of passive products vs. necessity of mainstream benchmarks
Passive funds are investment products that offer low fee and diversified portfolios. The main argument for passive investment rests on the notion that markets are efficient. This notion assumes that asset prices rapidly incorporate all publicly available information, meaning that there’s a limited opportunity to generate above-market returns over the medium to long time frame.
In the cryptocurrency space, the idea of passive investing faces two critical challenges. First, the market is anything but efficient. There’s plenty of private information available which is certainly not reflected in prices. Second, there are no universally agreed index benchmarks meaning that it’s impossible to measure if a given passive strategy is actually successful. With that in mind, we are all in the business of active fund management, not passive.
In that context, the development of more universally agreed benchmarks is as or potentially more urgent than the creation of dozens of supposedly passive investment products. From a business perspective, benchmark indices are a profitable business as methodology can be licensed. Furthermore, as mentioned above, there is no reason why a benchmark index provider can’t manage an ETF to that same benchmark. However, developing and defending these benchmarks should be as high a priority as developing the investment products. Developing both products is inherently virtuous.
In conclusion, there is currently a need and, certainly, room for a project to develop premier, benchmark indices for the crypto space and, at the same time, passive investment products tracking these indices. This should take priority over launching multiple products covering the same sector. Meanwhile, setting performance standards in the space will further facilitate the credibility and appeal of crypto investment products to institutional and retail investors alike.