Size (Still) Matters

(Though not a perfect fit for the topic, we borrowed this title from AQR)

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What does “large cap” mean for crypto?

This is a surprisingly tricky question for a young and growing asset class where two assets – Bitcoin and Ethereum – currently comprise nearly 70% of it.

Unfortunately, certain relatively long-running crypto investment products appear to lack an appropriate deftness when defining market capitalization bands for crypto, which may lead some investors to believe they’re obtaining meaningfully more well-rounded or diversifying exposure than just investing in Bitcoin and Ethereum. But are they?

We explore these questions from the perspective of crypto indices and show why we think an enhanced approach is required for defining market capitalization categories used by crypto investment products.

The Current Crypto Index Approach

Indices are generally used to benchmark a given market and are commonly used for passive investment products (ex: mutual funds and ETFs that aim to replicate an index) and by active managers seeking to “beat the benchmark.”

Some of the longest-running investable crypto indices in the U.S. portray “large cap” as the Top X assets, with X being some arbitrarily round cutoff number like 10 or 20. (This introduces another set of questions: why have an X? How is X determined?)

Given the lopsidedness of the crypto asset class, though, where Bitcoin and Ethereum represent nearly three quarters of the market, investors should pause to ask important questions about “Top X” or certain “Large Cap” products, such as:

• What is the purpose of a Top X-style exposure for crypto?

• Is it appropriate to categorize an asset with a market cap of $2 trillion (Bitcoin) in the same market cap category as an asset with a market cap of $8 billion (Uniswap)? The former is 250x the size of the latter.

Perhaps a third and better question is: does a Top X approach even work for crypto?

Avoiding a Crypto Peg in an Equities Hole

The typical purpose of a Top X index in “TradFi” is to track a sufficiently large sample of assets that represent a mainstream chunk of a given market and, generally, span a diverse set of industries. Turning to U.S. stock indices like the S&P 500 or Russell 2000, X is set at a relatively large number that encompasses the vast majority of their respective markets (i.e. large cap stocks for the S&P 500, small cap stocks for the Russell 2000) and spans a wide variety of sectors. The most concentrated stock in a typical equity index ranges from about 20 basis points (Super Micro Computer in Russell 2000) to a much larger ~13% (Apple in NASDAQ).

The “chunk” that a Top 10, Top 20, or even Top 100 market cap index tracks for crypto, though, typically amounts to 85-90% Bitcoin and Ethereum, and 10-15% “other.” While a simple Top X approach for equities generally produces sufficient diversification among constituent assets, we think this approach proves too brute-force for crypto, resulting in two issues: 1) an even more extreme concentration in the two current mega cap assets and 2) an overly simplistic approach to “other” constituent assets that may not reflect meaningful or consistent diversification.  

Extreme concentration in Bitcoin and Ethereum is the somewhat lesser of the offending issues. It still poses unique portfolio challenges by crowding out other assets and weakening diversification, but that’s true of the crypto market itself, and reflects the very early nature of the digital asset class. Managers can even make index construction decisions like imposing position limits (ex: no asset can comprise more than 35% of the index) to reduce concentration.[1] Still, passive investors should ask themselves whether this exposure is substantially different from Bitcoin and Ethereum alone, and if so, whether they are paying an acceptable amount for it.

The less excusable issue lies in the composition of the “other” constituent assets. Despite their small portion of the pie, do the remaining 8 assets of a Top 10 crypto product span a diverse set of crypto assets? Some index products seem to allege that they do, with statements like:

• “Galaxy Crypto Index Fund: Diversified, dynamic, institutionally-wrapped exposure to digital assets … Diverse exposure across the digital asset class.”

• “Diversified Crypto Exposure: BITW seeks to track an index of the 10 largest crypto assets, weighted by market capitalization … A secure way to get diversified exposure to bitcoin and leading cryptocurrencies.”

• “Grayscale's suite of investment products offer investors comprehensive exposure to crypto and the digital economy … Investors, advisors, and allocators turn to Grayscale for single asset, diversified, and thematic exposure.”

The answer depends on what “diversified” means.

New Dog, New Tricks

Diversification generally entails spreading risks across sectors, sizes, or even more technical categories like factors (ex: Value, Growth).

The stock market reflects a centuries-old playing field where competition for providing goods and services has evolved to become more evenly spread across a large set of companies and established industries, making simplistic size categories much more feasible. Investing in a particular size category (ex: Mid Cap, Large Cap, etc.) comes “pre-loaded” with diversification.

In comparison, Bitcoin was released in 2009 and most other major crypto assets today didn’t come along until somewhere between 2015 and 2022.[2] The digital asset class is evolving rapidly, still permeating various economic sectors and separating wheat from chaff among competing blockchain projects. This rapid competitive development potentially presents significant investment opportunities, but also requires a more thoughtful, dynamic, and forward-looking approach to properly categorize and capture the value of the overall crypto market.

We think a typical Top X approach to digital assets categorization fails to deliberately capture consistent diversification in two ways:

1. Underrepresented sector breadth

   Examining three non-Truvius "Top X"-style investable crypto products, we observe that the “Other” portion of assets exhibits weak sector diversification, with higher concentration in fewer digital asset sectors compared to the overall crypto market, including no exposure to the Media Services and Metaverse sectors. One product contains no sectors other than Value Transfer and Smart Contract Platform – the same two sectors that Bitcoin and Ethereum belong to (see Figure 1). Crude categorization tactics shouldn’t be the reason that market cap indices under-represent different fundamental use cases of blockchain technology.

   

2. Too slow and high-level

   Equity markets are less volatile than crypto markets, meaning stocks change market cap bands (ex: going from Mid Cap to Large Cap) comparably infrequently and the dollar levels of the bands (ex: between $10B and $200B for Large Cap) are more stable. This provides a more consistent expectation of the assets investors can expect exposure to within a given mark cap band, and for the bands themselves to remain more fixed and widely accepted by investors.

   This approach doesn’t translate well for crypto, where the “other” assets beneath Bitcoin and Ethereum fluctuate substantially and often, jockeying for market share and investor attention in a newer arena. The volatility of digital assets makes defining “Large Cap”, “Mid Cap”, etc., a moving target given more pronounced price variation. (An entire band like “Large Cap” today could become “Mid Cap” in mere days.) Crypto indices could simply reconstitute less frequently to minimize constituent turnover but then may miss out on exposure to the latest winners. Yet even Top X indices that reconstituted reasonably frequently (ex: monthly) may not keep up with the substantial remaining portion of innovation occurring beyond the current X assets or ensure diversification.

If a Top X approach doesn’t currently fit investing in digital assets, then what does?

The Truvius Approach

Crypto investment products require a careful, deliberate, and asset class-specific allocation framework. Instead, certain size-oriented indices suffer from ill-fitting top-down approaches that appear optimized to conform to familiar marketing terminology (ex: Top 10) and may lead some investors to believe they’re obtaining meaningfully more well-rounded or diversifying exposure than just investing in Bitcoin and Ethereum.

At Truvius, we take a four-step approach to creating investment products that intend to deliver more consistent and fine-tuned exposure to more accurate market cap bands:

1. Refine the asset universe: this first step is not unique to Truvius—crypto index products already do this—but of the thousands of digital assets, start with ones that meet a baseline of criteria, like historical price data, liquidity, and tradability. Determining that baseline is subjective, and we take a reasonably conservative approach to defining the levels for these criteria.

2. Moving target approach: instead of defining “Large Cap” as assets between $A and $B, or as Top X, we create market caps bands based on moving averages of market cap dominance. For example: Large Cap assets may be those where their 90-day moving average of market cap dominance has been greater than 0.50% of the total market for the trailing 30 days. This addresses the impact that price volatility has on using dollar levels to set market cap bands and allows a nimble approach to not just defining Large Cap, but also Mid Cap, Small Cap, etc.

3. Separating out Mega Cap: we think the difference between Bitcoin, Ethereum, and “other” is too extreme to ignore, and that these two assets are (currently the only) Mega Cap assets that deserve a dedicated Mega Cap classification. “Large Cap,” to us, warrants a smaller, different bracket beneath Mega Cap.

4. Strategically allocating to multiple size indices: with a more durable classification system for market cap sizes in place, we then strategically allocate to different Truvius size indices within a Truvius Model.

The fourth step above represents what we view as a stronger framework for allocating to a more truly diversified size-oriented portfolio of crypto assets. Let’s expand on this further.

Strategically Allocating to Multiple Size Indices

At Truvius, we take a strategic allocation approach to investing in various segments of the overall crypto market by way of our indices and models.

First, we build custom crypto indices powered by systematic rules and criteria specific to digital asset markets. We then use models to strategically invest in multiple underlying indices. (In other words, we often use indices to represent specific segments of the crypto economy, such as size-based segments of the market, and strategically combine them within a model to achieve controlled exposure to those segments.)

For example, the Truvius All Cap Model is allocated 70% to the Truvius Mega Cap Index, 20% to the Truvius Large Cap Index, and 10% to the Truvius Mid Cap Index:

In addition to more dynamic index-level criteria, this approach enables us to set (and if needed, adjust) deliberate allocations to different size categories commensurate with the overall crypto market. Compared to typical Top X crypto products, this approach produces fuller sector and size representation among constituent assets on a more consistent basis and more proportionally to how those sizes and sectors exist in the market:

We extend this approach to sector categories as well, with investment offerings like the Truvius Multi-Sector Model, which strategically allocates to sector-based indices:

Conclusion

We think the Top X approach poorly fits the young and fast-moving digital asset class. Instead, crypto investment products call for careful portfolio controls and a crypto-specific allocation framework that’s better positioned to capture growth across a wider array of upstart blockchain technologies.

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Footnotes

[1] The Galaxy Crypto Index Fund does this, limiting individual constituent weights to no more than 35% of the index.

[2] Coin Telegraph | History of Crypto: The ICO Boom and Ethereum's Evolution

* We approximate the total crypto market with the Top 515 crypto assets (excluding stablecoins and wrapped tokens) that meet our sector categorization criteria.

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