#5 Q&A: The F5 Crypto Index
I regularly get asked for more information on our Index at Conferences & Meetups.
With that in mind, the following blog post will answer the most common questions our team encounters as succinctly as possible.
I’ll also pop some further reading for you down below.
So what is a crypto index?
A crypto index maps a basket of various cryptocurrencies. The selection and weights of index members are subject to defined rules, so that the index is (often) independent of active management decisions.
Why have a crypto index?
An index of cryptocurrencies serves as a reflection of the most relevant cryptocurrencies. It maps market events as comprehensively and dynamically as possible. A crypto index may act as a benchmark for the performance of other Crypto Assets, portfolio strategies or other indexes.
Furthermore, financial products in the crypto sector need a basic and reliable strategy. Structured products such as crypto-index certificates, a crypto-ETF or even a crypto-fund base their investment behavior, partially or exclusively, on a passive index strategy.
Ultimately, a crypto index achieves a broad and dynamic picture of the market, combined with low volatility (compared to individual Crypto Assets) and improved diversification.
What’s available in the market?
Currently, there are very few crypto indexes available and an even smaller proportion of them are actually suitable for financial products in practice.
Crypto indexes can be boiled down into three camps:
- Price index
- Indexes by market capitalization
- Scientific Indexes
More on that here: The Top 5 Scientific Cryptocurrency Indices
What is the F5 Crypto Index?
Our F5 Crypto Index is the first of its kind. Backed by science, it was constructed by Prof. Hermann Elendner (Humboldt University Berlin) and tracks the performance of its 12 index members like nothing else in the marketplace. Selection of index constituents is based on market capitalisations and defined by exclusion rules. And the weighting of index members follows our innovative financial methodology: Equal weighting plus momentum factor.
What data is used to calculate the F5 Crypto Index?
Every day, we track data in relation to the top 100 cryptocurrencies by market capitalization. We refer to the API data of CoinMarketCap, CryptoDataDownload, Binance, Bitfinex, Bittrex, Gdax, HitBTC, Kraken and Poloniex.
The broad database can easily compensate for erroneous and missing prices of individual crypto exchanges.
How are the F5 Crypto index members determined?
First of all, we look at the top 100 crypto currencies according to their market capitalization. Market capitalization is determined by an exponentially weighted moving average over a period of time.
Afterwards, our filters run through the top 100 in which we have defined certain exclusion criteria. The following criteria are applied:
- No stablecoins
- No privacy coins
- No non-multi-signature compatible coins
- No coins with serious security concerns
- No scam coins (eg pyramid schemes)
- No illiquid coins in terms of trading volume
As a result of this process, only a fraction of coins are available to choose from.
Our scientific white paper (see below), which was written by Prof. Hermann Elendner (Humboldt University of Berlin), has found that the diversification effect of 12 cryptocurrencies in a crypto index is sufficiently high.
How is the weighting of the F5 Crypto Index Members carried out?
The previously selected 12 index members are initially weighted with a 1 / N weighting parameter, here 1/12 (8.33%) per Crypto Asset.
Then, the 12 equally weighted Crypto Assets are multiplied by a Momentum Factor.
The current weighting of the F5 Crypto Index can be viewed in our Index Factsheet.
Why did you choose an equal weighting to balance index members rather than weighting according to market capitalization (in addition to the momentum factor weighting parameter)?
On the one hand, we consciously opted for an equal weighting because we put robustness above the “standard” (weighting by market capitalization).
Scientific studies suggest (see whitepaper ) that an equally-weighted index is much harder to beat, especially on a risk-adjusted basis. Likewise, the equal weighting index strategy is immune to overfitting of index parameters that could prevent the most accurate mapping of the crypto market. The outliers in the crypto market in particular, are not weighted too high by this approach.
On the other hand, we opted against a market capitalization weighting, as focusing on the currently dominant Crypto Assets such as Bitcoin, Ethereum and Ripple does not represent a broad picture of the crypto market and leaves little room for optimization to generate alpha.
There is also a statistical problem in relying on mere market capitalization (defined as the price per coin * of outstanding coins). The market capitalization, as stated on the CoinMarketCap website, does not take into account pre-mined coins held by founders; no coins that have been irretrievably destroyed; and the growth rates of outstanding coins that do not have a fixed number of final coins are ignored.
What does the weighting parameter Momentum Factor include?
In addition to equal weighting, we combine our F5 Crypto Index with a momentum factor that significantly affects the equal weighting.
Financial market literature and crypto-specific research suggest that a momentum factor may partially explain developments in the crypto market (Yale University, Humboldt University Berlin). We take advantage of this effect. The momentum factor is supposed to generate alpha, that is, to beat the average performance of the crypto market.
The strength of the impact on weighting is considered to be a trade secret of F5 Crypto Capital, which we have long researched and tested. What we can reveal is that we are sticking to a cryptocurrency-relevant Winner-Minus-Loser (WML) approach that is calculated over a certain period of time.
It can thus be said that the F5 Crypto Index reflects the market as broadly and passively as possible through its equal weighting, but also considers a strategic component, the momentum factor that should outperform the broad market.
Is there a regular rebalancing of the F5 Crypto Index?
The 12 index members are selected quarterly according to their market capitalization. Cryptos leaving the index will be liquidated, new cryptos will be added. The existing positions are balanced with each other.
It is possible to draw an “emergency rebalancing”, which must be actively justified and executed by the F5 Crypto Capital Management.
What’s behind the Smart Rebalancing algorithm of F5 Crypto?
For the index, a smart rebalancing algorithm has been developed that minimizes trading activity while keeping it close to the target weighting.
For this purpose, we have developed certain corridors in which no action is taken, although this does not achieve the optimal target weighting. Nonetheless, such “no-trade” regions are valuable for an index in the real world, as they can massively save trading costs that offset the loss of an optimal weighting.
In the corridors, we have set certain soft and hard thresholds. These were designed assuming average trading costs, and tested as well as optimized in numerous scenarios.
How can the F5 Crypto Index be used in practice?
In science, the F5 Crypto Index is used as a benchmark for researches in the cryptocurrency sector.
Together with Bank Frick, a crypto index certificate has been set up based on the F5 Crypto Index. It is available to professional investors in the EU and the EEA.
The Crypto-Index Certificate is truly innovative and unique, solving all the problems of professional crypto investors in one go in terms of: trading, custody, allocation and the legal investment vehicle. It is an all-in-one solution with a state-of-the-art strategy for the cryptocurrency sector.
Summary
I hope I’ve cleared up any burning questions you may have been asking yourself in this blog post.
In sum, the F5 Crypto Index is an innovative and scientific index for cryptocurrencies. It broadly and passively depicts the crypto market with its 12 index members via an equal weighting; this weighting is extended by an active strategy component, the momentum factor.
With quarterly rebalancing and the ability to make active management decisions, the F5 Crypto Index can also be summarized as a dynamic, index-based investment strategy.
Do feel free to get in touch with us if you need assistance, our team would be delighted to help. In the meantime, here are some additional resources and further reading for you:
Thanks for reading!
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Florian Döhnert is a managing director at F5 Crypto Capital GmbH. The views and opinions expressed by Florian are solely his own and do not necessarily reflect those of F5 Crypto Capital GmbH. This piece is for informational purposes only and should not be relied upon for investment decisions.
The author may hold long or short positions in the securities discussed.
Originally published at https://f5crypto.com on May 17, 2019.
