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Index funds are an indirect way to get exposure to an entire market without having to put in the work to pick the underlying assets individually. Today, various types of index funds exist, including equity indexes, bond indexes, and commodity indexes, catering to diverse investment needs and preferences. 

In the age of digital assets, an NFT index fund is a vehicle that tracks a index of NFTs, typically from similar collections (e.g. Yuga Labs), traits (e.g. hoodie CryptoPunks), or prestige (e.g. Art Blocks Curated). This post will explore how NFT indexes work, what they enable, challenges uniquely faced by NFT indexes, and how those challenges may be overcome. However, before we jump into NFT index funds, it is helpful to understand a brief history of index funds in the traditional finance markets. 

## What is a traditional index fund?

An index fund is a type of mutual fund or exchange-traded fund (ETF) where a portfolio is constructed to match or track the components of a financial market index. Generally, traditional index funds offer broad market exposure, low operating expenses, and low portfolio turnover. 

Warren Buffett famously recommends index funds as a way to build wealth. Rather than training people to pick out individual stocks for investment, Buffett says that it makes more sense for the average investor to buy an index of the S&P 500. 

## How traditional index funds work

Index funds are typically considered a more passive type of fund management. As opposed to hedge fund managers who actively try to stock pick and time the market with buys and sells, index fund managers build up a portfolio of holdings to mirror the securities of a particular index. The idea is that the investment profile of the index matches the performance of a whole, broad segment of the market. 

For example, index fund investors can buy funds that focus on companies with small, medium or large capital values, or they can buy funds that focus on sectors such as technology or energy. While these more specific index funds may be less diversified than the broadest market index, they are still more diversified than if someone were to buy individual stocks within a sector. 

## Key Examples of Index Funds in TradFi

### S&P 500

In the United States, the S&P 500 Index is one of the most popular indices. The S&P 500 Index, or Standard & Poor's 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. It is not an exact list of the top 500 U.S. companies by market cap because there are other criteria that the index includes such as liquidity, financial stability, and a history of profitability. As a result, the S&P 500 Index offers a comprehensive representation of the U.S. stock market's health. The S&P 500 index is regarded as one of the best gauges of prominent American equities' performance.

### Dow Jones Industrial Average (DJIA)

Also known as the Dow 30, the Dow Jones Industrial Average (DJIA) is a stock market index that tracks 30 large, publicly-owned blue-chip companies trading on the New York Stock Exchange (NYSE) and Nasdaq. The Dow includes companies like Nike, Salesforce, Goldman Sachs, Visa, Coca-Cola and IBM. 

The DJIA is also designed to serve as a proxy for the health of the broader U.S. economy. Often referred to simply as the Dow, the DJIA is one of the most-watched stock market indexes in the world. Although the Dow encompasses a variety of businesses, each can be characterized as a blue-chip company that consistently generates stable earnings.

## What is an NFT Index Fund?

NFTs represent a new frontier of digital assets, art and internet culture. Composed of unique digital items that cannot be replicated or replaced, NFT index funds provide a novel way for investors to gain diversified exposure to the new asset class of non-fungible tokens without having to research and pick the individual NFTs themselves. 

An NFT index fund works similar to traditional index funds in that it tracks a basket of assets–in this case NFTs. To do this, the index fund manager will select NFT collections that qualify for the index based on specific criteria, such as rarity, popularity, or historical value. For example, the NFT index fund manager may track a basket of Yuga Labs NFTs, which include Bored Ape Yacht Club, Mutant Ape Yacht Club, Bored Ape Kennel Club, and Otherside NFTs. They will also consistently monitor the collections for various risks, as set forth by the index guidelines.

The index fund manager will also determine how often each index is rebalanced, generally monthly, quarterly, or bi-annually. This rebalancing process involves adjusting the weight of each collection within the index, typically based on factors like their floor price, appraised value, or overall market capitalization.

## Benefits of NFT Index Funds

### Ease 
With the rapid growth of the NFT market, NFT index funds offer a familiar and easy way for investors to gain exposure to the burgeoning market of digital assets in a manner that is very similar to how TradFi investors already operate. By leveraging the expertise of index fund managers, potential investors can enter the complex world of NFTs with greater confidence and reduced barriers to entry. 

### Diversification
The average investor does not have the capital to buy a breadth of NFTs to represent all of the various blue-chip NFT collections out there. With floor prices of blue-chip NFTs rapidly climbing, even one NFT purchase can eat up the majority of dry powder for an individual investor. NFT indices are a great way to gain broad exposure with a smaller amount of capital. Investors can enjoy the benefits of owning a diverse portfolio of NFTs, reducing the risk associated with concentrating investments in just a few assets. 

### Lower Time and Knowledge Requirements 
The NFT market moves lighting fast—collections can take off or dump within a weekend of news. It is exhausting for the average NFT participant to keep up with the major sources of news, especially when much of the information lives on Twitter or private Discord servers. Similar to how average TradFi investors are not listening to every public company earnings call, NFT indices allow people to participate in a broad manner without having to understand every detail. This not only saves time and energy, but also helps mitigate the risk of making financial decisions based on incomplete or inaccurate information.

### Liquidity 
One of the challenges NFT investors face is the lack of liquidity in the market, as buying and selling individual NFTs can sometimes be difficult due to their unique nature and varying demand. NFT index funds can help address this issue by providing investors with an investment vehicle that is easier to trade in and out of compared to individual NFTs. The pooled nature of index funds typically allows for greater liquidity, making it more convenient for investors to adjust their positions as needed.

## Complexities with Building NFT Indexes 

### Some Only Track Floor NFTs
Today, the NFT index funds that do exist typically only track floor price. Floor NFTs are not indicative of the entire collection, especially when some collections have grails (or rare NFTs) that are worth several orders of magnitude more than the floor NFT. The limited scope of floor NFTs does not accurately reflect the true diversity and potential value within a collection, which can lead to suboptimal investment performance. 

### Pricing 
NFT indices typically weight-adjust their portfolios based on the floor price of a collection. This does not take into account the collection as a whole, which would require pricing algorithms to better understand the value of the entire collection. Developing sophisticated pricing models for NFTs can be challenging due to the unique characteristics of each asset and the lack of historical data compared to traditional financial assets.

### Liquidity and Capacity Issues 
NFTs are non-fungible assets that often have low-velocity. Given that each asset is unique, they change hands much less frequently than traditional ERC-20 tokens or stocks. It is difficult for an NFT fund to curate an index and have the right capacity on the open market to rebalance it as needed. Additionally, the process of acquiring and disposing of NFTs can be time-consuming and costly, which may limit the fund's ability to efficiently and effectively manage its portfolio.

## Possible Solutions to Building NFT Indices 

### NFT Appraisals 

NFT appraisals allow NFT indices to place a better basket of assets that more accurately reflect the broader collection, beyond simply adding floor assets. They can better index the higher end of the NFT market by taking into account rarity, metatraits, and historical trading patterns, among other factors. Developing comprehensive appraisal methodologies and leveraging advanced ML models can help index fund managers more accurately assess the value of each NFT within a collection, leading to a more representative index.

### Capacity
NFT index funds may face capacity constraints due to the illiquid nature of the assets they hold. To address capacity issues, NFT index funds can implement strategies such as limiting the size of the fund, focusing on more liquid NFT collections, or utilizing derivatives and other financial instruments to gain exposure to the underlying assets without directly owning them. This approach can help improve the efficiency and flexibility of portfolio management while minimizing the impact of liquidity constraints. 

In traditional finance, the high-yield bond market, also known as the "junk bond" market, faces similar capacity constraints due to the illiquidity of these assets. To manage these constraints, some high-yield bond index funds employ strategies like sampling, wherein the fund invests in a representative sample of the bonds in the index, rather than holding each bond in the index. This sampling approach allows the fund to maintain a more manageable portfolio while still aiming to achieve a similar risk and return profile as the overall index. By adopting similar strategies, NFT index funds can address capacity constraints and provide investors with diversified exposure to the NFT market, even in the face of illiquidity challenges.

### Synthetics & Perpetuals
A synthetic asset is an asset that tracks the value of another asset, essentially mirroring its price movements without the need for direct ownership of the underlying asset. One common form of synthetic asset is a perpetual contract, or perp, which is a type of derivative that does not have an expiration date. In order to create a synthetic asset, a pool of capital and a reliable price feed that consistently updates are required. A well-known example of a synthetic asset is DAI, which tracks the value of the US Dollar. Utilizing price feeds for an NFT index can provide investors with synthetic exposure to the index through instruments like perpetual contracts. This approach may help mitigate some of the capacity issues and potentially simplify the design of an investable NFT index product, making it more accessible for a wider range of investors.

## The Future of NFT Index Funds with Upshot
For several decades, traditional financial markets have offered investors the opportunity to get broad exposure to various asset classes by simply buying into a basket of goods that serve as a proxy for the market. As NFTs emerge as a novel class of digital assets, investors are increasingly eager to have vehicles that give exposure to the asset class without having to put in the time and effort to pick various jpegs individually. 

As the NFT market continues to mature, innovative solutions to these problems will play a crucial role in addressing the complexities and challenges associated with building and managing NFT indices. By providing robust and accurate pricing methodologies, Upshot can empower index issuers to easily overcome obstacles such as liquidity constraints, capacity issues, and accurate valuation of assets within a collection. As a result, the development and adoption of NFT index funds will become more seamless and efficient, ultimately making the world of NFT investing more accessible and attractive to a broader range of investors. Ultimately, NFT indices will be an increasingly important frontier in allowing individuals to interact with the new digital renaissance. 


Introduction To NFT Index Funds

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