Martin Green
Coinbase recently announced they are launching an index fund.
Long term, this is very good for the industry and the Coinbase Index fund is a great first step. There are concerns, however, and before launching Coinbase should address some of the minor mistakes and major flaws noted below.
Investment index funds have much promise for investors:
- low fees for easy access to the broad, diversified market
- low turnover, so high tax efficiency
- long-term compounding with fewer stock selection and market timing mistakes
In an industry such as digital assets, which could deliver 10+ years of exceptional compounding, we think that it’s great that Coinbase is introducing an index fund to their customers. Done well, history has shown that retail investors will benefit far more from an index fund vs trading individual assets (the bulk of the Coinbase business).
If blockchains are a major revolution, one wants to have efficient exposure beyond just one or two digital currencies or assets. But for an Index fund to deliver this for investors, it has to do the job right.
Coinbase should be applauded for launching a retail index fund. It’s a great first step and it’s simple to understand, which is hugely important.
But, while it’s important to keep things as simple as one can, erring on the side of too much simplicity can produce unintended consequences. Before they deploy customer capital, Coinbase needs to fix some of these issues and hire an index or factor-based portfolio manager to research and re-design the index rules. Consulting with indexing experts (such as the Bletchley folks) and getting it right before launch will go a long way towards ensuring that investors will not get hurt.
Some of the concerns with the index fall under the category of quibbles; a couple others we believe are major flaws.
Quibbles:
Premature launch: Coinbase would be wise to wait until they launch 10 major assets to launch the index fund (see BitWise Hold 10). Otherwise people will be buying into 60% Bitcoin via the fund and they’ll be selling Bitcoin aggressively just because new assets are added given that Bitcoin is about 40% of the market right now.
Rebalance frequency is once per year on Jan 1. This isn’t frequent enough to deal with the dynamics of our industry. We’d suggest much more frequently.
Supply fixed in the index. There are massive differences in the rates of supply inflation between assets and the index needs to take them into account over time. There’s a reason most equity index funds incorporate dynamic supply in their models.
Asset managers would consider these to be big issues in any Index fund outside of the digital asset industry.
But the Coinbase Index has two larger flaws:
- The digital asset space is not mature enough to just use market cap weightings. Doing a purely passive market-weight might work for equities, but for digital assets at this stage in the maturity of the industry and capital markets it is very, very risky, and even more risky the more assets are added to the fund.
Market capitalization is currently easily manipulated and therefore the Coinbase index will overweight the most manipulated, the most overvalued, and the least liquid assets.
Check out the sources of liquidity for Cardano: the #6 or #7 Market Cap Asset on Coinmarketcap and Onchainfx. By our estimates, ~80% of volume over the past month has been on one Korean exchange. Unlike the heterogeneous and deep trading volumes of other digital assets like Bitcoin or Ethereum, Cardano’s “market cap” of >$6bn can be easily manipulated and perhaps doesn’t reflect “real” price discovery. If Coinbase decides to list Cardano on GDAX and Coinbase, the Coinbase Index fund investors will automatically own Cardano in large proportion – this proportion would potentially be much higher than it should be.
Coinbase needs to work on multiple risk factors such as price discovery, liquidity, exchange concentration and a whole host of other risk factors to properly weight assets. But in the interest of simplicity, they are simply using easily-manipulated price in a basic market cap weighting.
- The Index automatically lists the assets traded on Coinbase and excludes anything not traded on Coinbase. While expedient for Coinbase, this fails a fiduciary test for the Index investors.
As written, the Coinbase Index is NOT a fund for investors to get proportionate exposure to the digital asset market. It’s a fund to invest in the assets traded by Coinbase. Can you imagine Goldman Sachs launching such a bond index just for things it trades? An Index Fund should represent the market, not the activities of one broker.
Why? If Coinbase the exchange doesn’t list Ripple, Monero or 0x for reasons to do with the business model or the strategy of the exchange, or does list a smaller but heavily traded and profitable asset such as Litecoin, BCash or Cardano before something else like XRP (which they have already done), should the index buyers be subservient to the customers and the business model of Coinbase-the-exchange?
The Cardano example perfectly illustrates the problem. The very reason it may be profitable for Coinbase to list Cardano on GDAX (illiquidity, lack of competition and fat spreads), are the reasons it may create problems for index investors unwittingly buying a high market cap asset that has insufficient price discovery. And because it’s just market weight, make no mistake, they are overweight. Decoupling the decision to list on the exchange from the decision to include in the Index is the right answer.
An index fund should have one fiduciary responsibility: the investors in the fund. This is a major flaw that should be changed.
Coinbase says they’ll have two independent members of an index committee. We hope the announcement serves as a job requisition and they get good people quickly.
An index fund sounds simple, but it’s not. Coinbase needs to address these issues before their retail investors get hurt.
Over time, it should be fine.
Like Coinbase, my partners and I are incredibly excited about the future of blockchain projects to enable assets to flow across the globe in a peer-to-peer, permission-less and programmable set of systems. We are equally excited about the long-term value to accrue to investors and market participants who hold these digital assets.
And we are excited about ways to make it easier, cheaper, less risky and more efficient to invest in digital assets, and we think Coinbase has an important role to play in both US and globally.
For those who want to see the Coinbase methodology. It’s here
Disclosure: As the co-CIO of an institutional focused digital asset management firm, the author absolutely has a horse in this race.
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