Crypto Investment Management: The Role of Indices & Benchmarks

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Introduction

Benchmarks have been a natural part of a fund or investment strategy in traditional finance. They serve as critical performance evaluators for fund managers and index trackers. A host of providers offer sophisticated and nuanced benchmarks for almost any area of investment. With crypto investment management still being a rather niche area and asset class, the field of benchmarks and indices is still evolving. Some market participants argue that the price of Bitcoin itself is the best place to start when comparing fund returns: Bitcoin is by far the largest asset in the space, and most other cryptocurrencies are highly correlated with it. Any active fund strategy should at least outperform (on a risk-adjusted basis) a buy-and-hold Bitcoin strategy. The Bitcoin price of past transactions is on-chain and therefore publicly available, so one could argue it's straightforward to construct your own benchmark. However, in reality, even constructing single asset benchmarks in crypto comes with very unique challenges that differ from traditional finance.

Understanding Indices and Benchmarks

Indices aggregate selected asset prices to provide an overview of market performance, while benchmarks act as reference points against which the performance of investment strategies are measured. In crypto investment management, they replicate single assets, sectors, or themes, playing an essential role in portfolio construction and performance evaluation. This framework not only helps in asset allocation but also enhances transparency for investors with regards to fund returns or how closely they track a specific asset or group of assets. Public funds also tend to use independent benchmarks to ensure there is no conflict of interest in the performance calculation of the fund and the construction of the benchmark to measure it against. The most prominent, recent examples of crypto funds with benchmarks are BlackRock iShares Bitcoin Trust or the Bitwise Bitcoin ETF, which both utilize the CME CF Bitcoin Reference Rate - New York Variant (“BRRNY”).

The Complexity of Crypto Index Construction

Constructing indices in the crypto market presents unique challenges. It demands handling multiple data types and sources for the same asset, including trade data from diverse exchanges and assessment price data. This complexity is further amplified by the need to consider traditional finance market conditions (at a fund level) such as market closings or non-trading days, while the price data being tracked (at the underlying asset level) relates to the  24/7 crypto market. The rapidly changing nature of the crypto markets, as well as its evolving infrastructure, adds another layer of difficulty, necessitating frequent updates and adjustments to index compositions and processes.

Data Quality and Standardization Challenges

One significant hurdle in crypto index engineering is managing the quality and standardization of data. The nascent nature of crypto markets means that data from exchanges can be inconsistent and lightly documented, requiring considerable effort for interpretation and standardization. Furthermore, data feeds, tick sizes, and connectivity (read: APIs) can vary greatly. Achieving high data integrity is critical to ensuring that indices provide a true representation of market dynamics and are reliable for investors.

Adapting Indices to Market Conditions

As mentioned previously, there is a mismatch in market operations and timings between crypto and traditional markets that needs to be accounted for: Crypto markets operate 24/7 while traditional finance markets operate on set days and times. Certain indices need to incorporate traditional financial market conditions, including trading calendars, requiring flexible system designs to accommodate varying market operations. This adaptation is required to effectively bridge the gap between conventional and digital asset markets. The challenge becomes evident with a simple but not so simple question: What is the market close price on a specific day for e.g., Bitcoin? 4pm, 5pm? In which time zone? HKT, CET, ET, PST? What if a price from one exchange comes in shortly before or after that time on a specific day? Considering questions like these is important since it impacts valuation purposes, performance measurement, and investor reporting.

The Role of Methodology in Index Construction

Effective index construction begins with a clear understanding of the methodology, which involves data collection, storage, calculation, and output. Developing a crypto index can be a complex and time-consuming endeavor, depending on the scope and challenges encountered. A meticulous process ensures that indices accurately reflect market performance and adhere to regulatory standards. Well-defined methodologies also help in maintaining consistency across the index's lifecycle, reinforcing its credibility and reliability.

Managing Scenarios and Edge Cases

Benchmark engineers must navigate various scenarios and edge cases in crypto index construction. The absence of critical data on certain days demands robust fallback mechanisms and strategies to manage calculation failures, underscoring the need for resilient system and process designs. These strategies ensure the continuity and accuracy of index tracking, even during market anomalies or data disruptions. This is where specialized benchmark providers come into play to provide consistent and reliable data.

Conclusion

The integration of indices and benchmarks into crypto asset management represents an evolution, not just a mere extension of traditional finance practices. As the market matures, the role of sophisticated indices becomes increasingly critical in boosting investor confidence and broadening the scope of digital assets. While it is still a developing area within crypto asset management, we firmly believe it will only gain more importance with the growth of the asset class and more institutional investors entering the space. This is why Alloy comes with built-in performance measurement and benchmarking functionality, purpose-built for Digital Asset portfolios. Users can define custom benchmarks or incorporate a benchmark of their choice from various providers, thereby offering transparent and consistent performance evaluation of their portfolios.

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