Lesson 3| The Structure of Stock and Crypto Indices

The idea behind this lesson can seem abstract, so let’s start with some images. Take a look at the following graph. Which would you rather own, the blue line or the black line?

Obviously, the black one–since it returns more. Here’s the weird thing about them: they are exactly the same holdings. They are both ETFs of the Standard and Poor 500 Index.

Why did one perform better?

Because they don’t hold the same amount of each stock. 

The worse performing ETF is the SPY, which gives greater weight to the largest companies of the index. The better performing ETF is the RSP, which gives 1/500 weight to each stock (= each one has equal weight). Since smaller stocks tend to grow more, the RSP tends to do better than the SPY.

Here’s the performance of those funds over the pandemic.

Yes, the SPY did better because those stocks are more resilient in a downturn. Interestingly, though, the RSP was bouncing back a lot faster–as you might expect from smaller companies.

Now, what if you combined this insight about the differences in return with these ETFs along with a strategy that traded them more intelligently. What would that look like over the last 22 years?

Well, here you go. Here’s an image of the SPY trading according to my basic economic cycle indicator–it’s the red line. The blue line is the better performing RPS (from above) over the same period of time.

So, you’ll notice that it’s a lot better than even the RSP–returning 2178% over that period of time.

Now let’s use that strategy trading the RSP, rather than the SPY.

Predictably, it’s even better–returning 2946%.

The lesson: just knowing the difference between these two indices gives you extra yield. Doing that with a smart strategy results in about 800% better yield.

That’s why it’s important to understand the structure of indices because even if they are holding the exact same companies (or coins) some will outperform others. And when combined with a smart trading strategy, you will get massively better results.

Paid subscribers (Crypto and Bubble Riders) get access to the basic economic cycle indicator which I use for trading things a little more exciting than the main stock market indexes.

This lesson, however, will give even them a better sense of what to do with these signals–as well as why I sometimes choose to do what would otherwise look strange. Let’s start with the basics here.

What Is An Index Good For?

In a line, saving money, time, and, as a result, offering more effective management. If you wanted to recreate the RSP yourself, you’d have to divide your portfolio into 500 equal segments and buy each stock. Then, when it is time to rebalance (likely every 3 months), you’d have to sell the relevant stocks, etc.

You’re going to lose to slippage (= getting slightly less than the ideal amount during a trade), and you’re going to spend a lot of time managing that. So, it’s worth it to pay .5% up to 1% to an ETF manager to get the same effect.

With cryptos, the problem is even more pronounced. Here’s the DPI, which you can get on indexcoop. All of its coins are decentralized finance coins that run on the Ethereum blockchain.

Typically, it costs between $8 and $80 for a transaction on the Ethereum blockchain, given what time of day you’re buying. Sometimes, it’s more.

At 16 different coins, the DPI saves you likely better than $1200 in transaction fees (to say nothing of slippage and the pain that it is to manage all of these coins). I think it’s a no-brainer why this approach makes sense when investing in cryptocurrencies.

The downside, of course, is that you can’t pick and choose yourself how much to allocate to each coin or stock. So, let’s look at that problem a little more closely.

The Standard and Poor 500 Index

This is generally considered the“stock market.” It represents the consensus view on which 500 companies will do the best of those that are publicly available, and it weights each one according to its size (= market capitalization weighting).

The methodology of the S&P500 is such that it must represent each of the 11 major sectors in the United States economy. These are the following (with their respective weight).

• Communication Services: 9.9%
• Consumer Discretionary: 10.2%
• Consumer Staples: 6.7%
• Energy: 6.0%
• Financials: 13.7%
• Health Care: 14.9%
• Industrials: 9.7%
• Materials: 2.5%
• Real Estate: 2.7%
• Technology: 20.8%
• Utilities: 2.8%

There used to just be 10 sectors, but 1 was added in September of 2018 because it didn’t make sense to classify companies like Amazon as a telecom company. So, the S&P 500 is a bit of a moving target, changing both the stocks in the index and the composition of the index itself.

No similar index exists for cryptos, because the three main use sectors, decentralized finance, NFTs and web 3.0 technologies, are scattered along different blockchains (ETH, SOL, LUNA, etc.) without any clear winner as to which platforms will survive.

The DPI, for example, is representative of decentralized finance only on the Ethereum blockchain. I don’t know of a similar product for SOL or LUNA yet.

There are some crypto top 50 indexes, but these can’t, by definition, have the same rationale for composition as the S&P 500. There’s just no reason to think that the top 50 coins are representative of much. As the industry matures, I imagine that better indices will be developed, but we are not there yet.

For the present, with cryptos, it’s not as easy to exploit index inefficiencies. But with stocks, it certainly is.

How Flaws in the Index Create Opportunities

Knowing index composition helps you to determine what might be mispriced. 

For example, when the stock market rebounded after COVID, obviously smaller stocks did better. But the energy sector did even better still. Here’s an image of the SPY (in black) relative to the XLE (in green).

The reason is pretty obvious. Once people realized that COVID wouldn’t crash the economy forever, oil stocks bounced back as investors recognized that eventually people would drive cars and start flying again.

So, maybe rather than buying the SPY as a rebound, it would have made more sense to buy the XLE. It’s been a bumpy ride, but you could have entered at both later and with a lower price to get a better return.

The only similar logic that holds with cryptocurrencies concerns market rotations. Often, you’ll see decentralized finance shoot off. Well, it might be worth looking at Web 3.0 or NFT coins. The MVI (MetaVerse Index) on indexcoop combines these two areas of the crypto world and you’ll notice something close to an inverse relationship between them.

Here’s the DPI over the past year (peaking in May).

And now here’s the MVI over the past year.

They’re not strictly inverse images of each other, but they do seem to take off at different times.

So, just as it’s often predictable that a sector of the S&P will outperform, so it’s predictable that a sector of the crypto world will outperform. Eventually, lagging sectors in the crypto-world catch up–and this is a mean-reverting strategy that’s useful to keep in the back of your mind (explained in fuller detail here).

Concluding Thoughts

This lesson had a lot of images and concepts, but the basic points are these:

• Indices are systematically composed aggregates of stocks or coins that tend to represent the consensus view of key assets.
• Buying these often saves you quite a bit of money and time (relative to buying all the same coins or stocks individually).
• Cryptocurrencies don’t have the level of development that the stock market has because it is so young, though there are crypto indices and they are still helpful.
• If you learn the structure of these indices, it’s not too hard to find missed price opportunities–either because of obvious tendencies (oil rebounding after COVID) or because of market rotation (from decentralized finance to NFTs).

When you put all that together with a set of basic indicators, you’ll get better performance from buying and holding exactly the same coins and stocks. Even on basic indexes, the combination of these insights does produce about an 800% better return over two decades.

My subscribers get access to the signals from my proprietary algorithms, which obviously do quite well. But even if you don’t subscribe, this information in combination with this lesson will help you get better returns.

That’s it for this week! Happy Trading!!

Disclaimers

General financial disclaimer: This post is provided for entertainment purposes only. I am not giving you financial advice and I am not a financial advisor. You should expect no financial returns one way or another based on my statements. These points hold equally for any statements that could be attributed to The Art of The Bubble or any related business entities. If you decide to buy or invest in anything, then your returns and potential losses are your own. No statements about taxation are taxable advice and you are encouraged to consult your own tax professional. You are also encouraged to do your own due diligence before investing in anything.