BullsEye Crypto10: The Crypto Cap-Weighted Index for Private Investors
If the cryptocurrency asset class is to mature into a well-respected and stable investment proposition it will likely need to acquire some of the hallmarks of other, more traditional, asset classes.
What first comes to mind when you think of equities? If you're like me, probably some of the global stock exchanges. Traditional equity markets are characterised by exchanges that are household names - think NASDAQ, New York Stock Exchange, London Stock Exchange - and their associated benchmark indices - think Dow Jones, FTSE100, S&P500, NASDAQ Composite and so on.
These household stock exchanges not only provide investors with reputable services for trading equities and Exchange Traded Funds, but they also provide useful market indices to help investors measure performance. Typically these indices are defined by value (market cap) or by industry sector - but all serve that one core purpose of providing a yardstick against which individual or portfolio performance can be measured.
So what about cryptocurrencies and digital tokens?
Well, for starters, over the last few years as the cryptocurrency market has evolved and matured, leading global crypto exchanges have started to emerge. If you're a keen crypto trader I'm sure you'll have your favourite exchange(s), but love them or hate them, these exchanges play an integral role in the functioning of the crypto market.
Coinbase, Binance, Bittrex, Bithumb are a few that come to mind, but there are many more out there. Some are global, some regional, but all provide much-needed liquidity and a platform for investors to trade. These exchanges are starting to become brands in their own right, which inevitably leads to publicity - the good and the bad - and over time will exert an increased ability to influence the wider market and, in particular, the individual investor.
As time passes and the crypto markets mature, natural selection will take hold. Some exchanges will continue to proposer - those that offer reliable, secure, transparent and fairly-priced services - and others will fall away - those that, well, don't. It's likely that there will be a consolidation over time.
So there are plenty of crypto exchanges out there. But what about reliable benchmark indices for cryptocurrencies I hear you ask? Investors (and the markets more generally) require reliable reference points to enable them to measure performance - this stands as true for cryptos as it does for stocks.
**Measuring investment performance is vital and therefore understanding how to do this is a critical skill for any investor. We explore this issue in more detail separately here: Alpha - can you beat the market?**
A few crypto indices have popped up over time, but there remains a lack of leadership in this space. But before I continue, let's first briefly explore some examples of the types and calculation methodologies of the more traditional stock market indices.
Common Types of Stock Market Indices
A capitalisation-weighted index takes the individual components and 'weighs' them according to their total market capitalisation. The 'larger' components carry higher percentage weightings, while the smaller components have lower weights. This type of index is also known as a 'market value-weighted index'.
A large number of well-known market indices are cap-weighted - such as the Standard and Poor's (S&P) 500 Index, the NASDAQ Composite Index or the Hang Seng Index. In a cap-weighted index, large price movements in the largest components can signficantly effect the value of the index. Some comentators feel that this 'overweighting' towards the larger components gives a distorted view of the market, but the fact that the largest companies also have the largest shareholder bases makes the case for having the higher relevancy in the index. Calculating the index value in this way ensures that proportionality is maintained.
It is however possible for companies to grow to the point that they take up an inordinate amount of space in an index (I'm sure you can see the obvious parallels with cryptocurrency market too!). As a company grows, index designers are obligated to appoint a greater percentage of the company to the index. This can have a negative impact on a diversified index by placing too much weight on one stock's performance.
Interestingly, index funds buy more of the stock as its market cap increases, meaning its share price has gone up. This goes against the traditional investing mantra of buying at low rather than high prices and acts as a self-fulfilling prophecy.
A price-weighted index is an index in which the components are weighted according to their market price per share, rather than by market capitalisation or other factors.A price-weighted index is simply the sum of the members' stock prices divided by the number of members. Using an example with five components:
$5.05 + $9.00 + $25.25 + $20.45 + $1.50 = $61.25
$61.25 / 5 = 12.25
Therefore in a price-weighted index, stocks with higher prices receive a greater weight in the index, regardless of the issuing company's actual size or the number of shares outstanding. Accordingly, if one of the higher-priced stocks has a huge price increase, the index is more likely to increase even if the other stocks in the index decline in value at the same time.
The Dow Jones Industrial Average (DIJA) is probably the best-known and most widely followed index in the world. At its inception, the DJIA started with just 12 stocks and was priced at 40.94 - a world away from today's levels. The Dow now consists of just 30 stocks, making it one of the least diversified indices around. The calculation behind the actual Dow value is quite complex, but essentially it is derived by summing up the prices of all 30 member stocks and then dividing that figure by a "magic number" (also referred to as the divisor).
Say hello to BC10: a cap-weighted crypto index
BC10 is a daily cap-weighted index which uses the market capitalisations of the top ten cryptocurrencies on any given day to calculate its value.
Why does BC10 matter?
As part of our service offering to private investors we aim to provide the necessary toolkit to help inform day-to-day trading and investing decisions in a simple and accessible way. BC10 is a key component of that - a component we could not find elsewhere, so we created our own.
Now, we briefly explored the tried and tested calculation methodologies used by the global stock markets above, and whilst it might seem like an awesome idea to create a new, all-singing-all-dancing, crypto index - to reinvent the wheel, so to speak - we decided a simple and easy-to-understand cap-weighted crypto index would be a great starting point.
So that's exactly what we did.
We first calculated the BullsEye Crypto10 index on 1st September 2018.
Since then, we have been calculating and setting the BC10 value each day and have embedded it as part of our platform. Our users can use BC10 in their alpha calculations to track crypto portfolio performance over time. This way, BC10 serves its core purpose - to act as a general crypto market performance benchmark from which individuals can measure their own investing performance.
As explained above, BC10 employs the capitalisation-weighting methodology - but why only the top ten cryptocurrencies I hear you ask?
Well, to put it simply, the cryptocurrency markets are relatively immature, with new coins being introduced through ICOs on a regular basis. The market also continues to show an extraordinary level of price-correlation, driven primarily by the price movement of Bitcoin. This high-level of coin turnover, combined with the current lack of stability and over-reliance on Bitcoin, made cap-weighting, as opposed to price-weighting, the obvious choice. We decided to draw the line under the top ten as the extended market outside of this sphere is much more turbulent and prone to volatility.
Using 27th February 2019 as an example, you can see how the BC10 calculation works:
As you can see, the top ten cryptos are ordered by market capitalisation (USD). Then, the total market cap across the top ten is calculated, before a set divisor (chosen for no other reason than it allowing the output to become more manageable) is used to calculate the BC10 value for the day.
BC10 - the story so far
Following the amazing bull-run at the back end of 2017, 2018 and early 2019 have been brutal for crypto investors. As you'd expect the BC10 index chart (Sept 2018 - Feb 2019) shown below reflects that story in all its glory!
We believe BC10 provides a simple yet robust performance benchmark for crypto investors.
Being the most established components of the crypto market, the top ten provides a *relatively* stable market segment. Relative to the rest of the crypto market that is!
Using this market segment in combination with the cap-weighted approach means that the volatility which characterises the budding crypto market is somewhat tempered, and only significant swings in the top cryptos would materially impact the BC10 value. However, as I touched on earlier, with regularity we see large swings in one of the top ten cryptos typically accompanied by a wider market trend in the same direction. I'm sure you've noticed that if Bitcoin, XRP or Ethereum increase or decrease in market value over a relatively short period, the rest of the market tends to follow.
The design of the BC10 index means it will inherently reflect the market performance as a whole, even within a relatively immature and unpredictable market such as cryptocurrency.
BC10 therefore provides a useful yardstick against which investors can measure the performance of a crypto portfolio or investment.