Rethinking Indexes in The DeFi Ecosystem

By Roberto Talamas and Mason Nystrom

Over the past ten years, the investment paradigm in traditional financial markets has drastically shifted towards passive investments. As of the beginning of 2020 assets managed by index funds exceeded $10 trillion, driven by attractive characteristics such as low fees, wide market exposure, and diversification. However, concentration risks may arise depending on the index’s construction methodology reducing diversification and increasing the overall risk of the instrument.

Index Funds and The Shift Towards Passive Investing

An index fund is a type of mutual fund or exchange-traded product (ETP) designed to provide direct exposure to the returns of a financial market index. Many investors are drawn to this kind of instrument because they abstract away the complexities of active management - the process of selecting individual stocks to invest in – and simplify access to a given market by providing broad market exposure resulting in a well-diversified portfolio. Additionally, index funds tend to follow a passive investment strategy, which generates lower fees when compared to actively managed funds.

For these reasons, there has been a monumental shift in investor preference from active management to passive management. In September of 2019, assets under management by passive U.S. equity funds surpassed those of active U.S. equity funds as more investors became aware of the difficulties of “beating the market”.

Given the usefulness and popularity of index funds in traditional finance, it is no surprise to see the emergence of this financial primitive in the crypto ecosystem. Protocols like Index Cooperative, Synthetix, and PieDAO have built their respective DeFi indexes providing crypto investors with easy exposure to the DeFi sector without the need to be an expert in the space. As the crypto ecosystem ports every conceivable financial product in traditional finance onto cryptonetworks, indexes are primed for rapid growth, especially amongst DeFi assets.