Timely Insights

Lessons Small Cap Crypto Teaches You

San Francisco • September 27, 2018

We launched new small- and mid-cap crypto indexes. Here’s what we learned (including that high-quality small caps are hard to find).

On August 15, 2018, Bitwise launched three new cryptoasset indexes, giving it complete market-cap-based index coverage of the cryptoasset world. The company now provides the following indexes:

  • Bitwise 10 Large Cap Crypto Index (BITX)

  • Bitwise 20 Mid Cap Crypto Index (BITW20)

  • Bitwise 70 Small Cap Crypto Index (BITW70)

  • Bitwise 100 Total Market Crypto Index (BITW100)

The Large, Mid and Small Cap indexes are nonoverlapping, meaning the Large Cap index holds cryptoassets ranked 1-10, the Mid Cap index holds cryptoassets ranked 11-30, and the small cap index holds cryptoassets ranked 31-100. The Total Market index holds cryptoassets ranked 1-100; in other words, all the assets held in the Large Cap, Mid Cap and Small Cap indexes.

This article reviews some of the insights Bitwise gleaned from examining the new indexes.

Insight #1: There Is A Power Law In Crypto

The cryptomarket is driven in part by network effects, which leads to a concentration of value, interest, and opportunity in the largest cryptoassets. The breakdown of the total market capitalization of the cryptoasset universe captured by each index is as follows:

  • Bitwise 10 Large Cap Index: 84%

  • Bitwise 20 Mid Cap Index: 5%

  • Bitwise 70 Small Cap Index: 2%

  • Bitwise 100 Total Market Index: 91%

This is more concentrated than the equity market, where the large-cap segment typically captures 70-75% of the market, midcaps capture 20% of the market, and small-caps capture the rest.

It’s worth noting that the numbers cited above understate the true concentration of value in the largest cryptoassets. The vast majority of value not captured in the indexes above exists not in micro-cap assets outside the Bitwise 100, but rather in assets that are excluded from all Bitwise indexes for reasons of investability. For example, Cardano is a roughly $4 billion cryptoasset that is excluded from all Bitwise indexes at the moment because it fails our test for institutional custody (i.e., we do not believe it can be custodied in a way that meets the standards of institutional investors).

The concentration of value in the largest cryptoassets will likely persist into the future.

Insight #2: Beta And Volatility Increases As The Size Of A Cryptoasset Decreases

The primary insight gained from developing the new indexes is intuitive: The beta and volatility of the cryptoasset market increase as the size of the assets you’re looking at decreases.

The indexes have backtested data from January 1, 2017. Running that data through the end of Q2 2018, the index returns are as follows:

  • Large Cap 10: +868%

  • Mid Cap 20: +1918%

  • Small Cap 70: +2112%

Of note: All three dramatically outperformed Bitcoin, which rose “just” 562% during this time.

The higher beta of the smaller-cap indexes is expected. The cryptoassets held in these indexes are earlier-stage, less widely known, and therefore inherently riskier. When the cryptoasset market is rewarding risk, these assets naturally do well.

The flip side can bite you, however: As the chart of the indexes below shows, the strong returns of the mid- and small-cap indexes come with a risk (and historical reality) of substantially higher drawdowns. In the pullback that lasted from January 9, 2018, through April 6, 2018, for instance, the Large Cap 10 fell 64%, the Mid Cap 20 fell 69%, and the Small Cap 70 fell 78%.

Performance of an index is not illustrative of any particular investment. It is not possible to invest directly in an index. The dashed line of the Bitwise Indexes represent a hypothetical, back-tested, and unaudited return-stream that does not represent the returns of an actual account. Index performance does not include the fees and expenses that are charged by the Fund. Actual returns may differ materially from hypothetical, back-tested returns. Back-testing is calculated by retroactively applying a financial model or Index-weighting methodology to the historical data to obtain returns. Please refer to additional important disclaimers here (https://bitwiseinvestments.com/disclosures). The inception date for the Bitwise 10 Index is October 1, 2017. The inception date for the Bitwise 20 Index, the Bitwise 70 Index, and the Bitwise 100 Index is July 31, 2018.

The pattern has repeated in each bull and bear stretch since the indexes launched. In the bull market that ran from April 6, 2018, through May 3, 2018, for instance, the Large Cap 10 rose 74%, the Mid Cap 20 rose 109%, and the Small Cap 70 rose 127%. In the subsequent pullback, which lasted through June 30, 2018, the order reversed: Large Cap down 41%, Mid Cap down 55% and Small Cap down 59%.

We expect some version of this pattern to persist, with one noteworthy caveat. Most of the small-cap coins were launched between 2016 and 2017. It is unclear if those coins will have staying power as they enter their third or fourth year, or if, as with equity-backed startups, there will be a wave of coins effectively shutting down if they fail to gain traction. This is a risk worth monitoring for small caps in the months and years to come.

Insight #3: The Dispersion Of Returns Within Each Index Is Massive

We have previously published research showing that there is a massive dispersion in the returns of coins within the Bitwise 10 Large Cap Index. But a look at the constituents in the Mid Cap, Small Cap, or Total Market indexes will tell you that this is true across the board in crypto.

Consider, for instance, the 24-hour return of all the constituents in the Bitwise 100 Total Market Index (to find those returns, follow this link, click “Constituents” and toggle the “Show All” button). Taking a random sample at 9:47 a.m. PT on August 28, 2018, we finds a massive difference in return: Gas (the best-performing coin) is up 24.8%, while Lisk (the worst-performing coin) is -2.0%.

This dispersion exists over any time period you look at, and it speaks to the challenges faced by concentrated strategies in the crypto space; it is easy for “crypto” to do well but individual projects to do poorly. It’s one of the reasons we favor taking a broadly diversified approach to the space.

Insight #4: Many Smaller Assets Have Trading Limitations And Exchange Concentration Risks That Make Them Inappropriate For Institutional Investors

The Bitwise 100 Total Market Index aims to capture the 100 largest coins as measured by free-float and five-year inflation-adjusted market capitalization. The index, however, subject those assets to rules and exclusions designed to ensure that they can be safely held, traded and custodied by institutional investors. Those exclusions include:

  • Liquidity: Assets must have traded at least 10% of their market capitalization in the past 30 days to ensure that they are liquid enough to support institutional investment

  • Exchange Concentration: Assets must trade on two or more eligible crypto exchanges, and must have reasonable volume on at least two eligible exchanges, so that a failure (or withdrawal problems) at one exchange doesn’t leave investors with an untradable asset

  • Custody: Assets must be able to be safely custodied, meaning that they can support true cold storage, including the ability for owners to sign transactions in an offline setting

These rules have a moderate (but important) impact on the Bitwise 10 Large Cap Index: There are certain coins, such as the aforementioned Cardano, which would qualify for the index based on market cap alone, but fail one or more of these tests and therefore are excluded from the index.

As you move into the small-cap segment of the market, however, the impact of these rules is significant. Consider that if you rank coins simply by market cap, you need to go through:

  • 13 coins to create the Bitwise 10 Large Cap Index

  • 26 coins to create the Bitwise 20 Mid Cap Index

  • 166 coins to create the Bitwise 70 Small Cap Index

In other words, while our screens block just a handful of large- and mid-cap assets, they block the majority of small-cap coins from entering the index. Interestingly, the primary test that eliminates these coins is exchange concentration risk (75 or 96 blocked coins fail this test, meaning they have significant trading on at most one exchange we consider reputable).

Few of the indexes available from other providers—and none of the publicly available crypto data websites—takes into account these critical rules around investability. From our point of view, indexes and data websites that don’t build these screens in from the start do not properly reflect the market, since they are capturing the returns of assets that no well-informed institutional investor would consider. Bitwise puts these crypto-native screens front and center to ensure that we capture and present the true crypto market as seen from an institutional asset management perspective.

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About Bitwise

Bitwise Asset Management is the largest crypto index fund manager in America. Thousands of financial advisors, family offices, and institutional investors partner with Bitwise to understand and access the opportunities in crypto. For six years, Bitwise has established a track record of excellence managing a broad suite of index and active solutions across ETFs, separately managed accounts, private funds, and hedge fund strategies. Bitwise is known for providing unparalleled client support through expert research and commentary, its nationwide client team of crypto specialists, and its deep access to the crypto ecosystem. The Bitwise team of more than 60 professionals combines expertise in technology and asset management with backgrounds including BlackRock, Millennium, ETF.com, Meta, Google, and the U.S. Attorney’s Office. Bitwise is backed by leading institutional investors and has been profiled in Institutional Investor, Barron’s, Bloomberg, and The Wall Street Journal. It has offices in San Francisco and New York. For more information, visit www.bitwiseinvestments.com.

  • Matt Hougan

    Matt Hougan

    Chief Investment Officer
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