Overexposed: DeFi indexes aren't as diversified as you think

New research suggests that indexes based on decentralized finance tokens lack diversification which is less than ideal for advanced investors seeking to mitigate risk.

Indexes are a very popular way to get broad exposure to a market without the hassle of researching and buying individual assets. With the explosion in DeFi protocols and related tokens this year, a number of indexes have been launched.

Analytics provider DeFi Pulse was one of the first to launch their own index in mid-September at the height of the boom, however, Messari analyst Roberto Talamas has concluded that it is heavily weighted towards certain assets. He wrote:

“While DPI is a good investment for beginners, it may not provide the diversification that sophisticated investors demand, leaving them overexposed to individual DeFi assets.”

He added that despite the positive attributes of broad exposure and lower fees, index funds can become highly concentrated reducing the diversification benefits of the product.

Diversification is one of the top reasons investors flock to indexes, but after analyzing the DeFi Pulse Index the researcher found that just four assets accounted for 77% of the portfolio's total risk.

In terms of percentage risk contribution those four assets are Uniswap’s UNI token which has over a quarter of the share (26.12%), Aave’s native token (20.18%), Yearn Finance’s YFI  (17.87%), and Synthetix's SNX token (13.29%). These four alone make up over three quarters of the portfolio so any large moves in one of them will affect the overall index performance.

The issue appears to be common with other DeFi indexes such as Synthetix’s sDEFI which is also heavily weighted with just four tokens — Compound, Maker, Kyber Network, and SNX — making up almost 60% of the portfolio.

At the time of writing, the DPI token was trading at $100, down 6.7% over the past 24 hours as DeFi tokens followed the general crypto market pullback. The index based token peaked just after launch at $125 but declined to its lowest level of $60 during the first week of November.

Compared to general DeFi token performance however, DFI has recovered much better and is only 20% off its all-time high whereas a large number of tokens including SWRV, CRV, SUSHI, BZRX, and MTA remain more than 60% down from their peaks.

Indexes are also available for the general cryptocurrency markets but they too are underperforming at the moment. Crypto 20, or C20, was launched in an ICO as the first tokenized crypto-only index fund in 2017.

It tracks the top 20 cryptocurrencies by market capitalization but is way down from its peak of almost $4 in January 2018 and is trading at just $0.90 today. This is despite total crypto market cap having recovered to $560 billion, just 32% off its all-time high of more than $830 billion which came during the same month.