Passive index investing is huge, with over $21 trillion in assets under management and by some estimates passive investing could overtake active investing by 2026. 

DeFi has the potential to disrupt the passive investing industry by lowering fees, increasing competition and innovation, and providing more choice to savers and investors.

This article explores the basics of how passive investing works, how it could be reimagined in DeFi, and why DeFi is better.

How passive index investing works today

Let’s start with what an index is.

An index is a measure of how a collection of things change. For example, the FTSE100 index follows the price of the 100 largest public companies in the United Kingdom weighted by market capitalization, with the constituents updated each quarter. Indices today are administered by index administrators such as FTSE or Standard & Poor’s.

Passive index investing is when a fund is set up to buy the constituent assets of the index, so the value of the fund mirrors the value of the index. Investors can then buy shares in the fund, allowing them to invest in a range of assets across whole geographies or sectors (as measured by the index), without having to actively pick individual assets. This is why it’s called passive investing.

Index funds are administered by fund managers (e.g. BlackRock or Vanguard) who maintain centralized ledgers of who has shares in the fund. Fund managers work with other intermediaries such as custodians (e.g. BNY Mellon) and central securities depositories (e.g. DTCC), who maintain ledgers of who owns the underlying stocks.

But while passive index investing is widely considered the most cost-effective way of investing today (because the asset-picking is effectively an algorithm), there are still a plethora of intermediaries that have to each manage their own internal ledgers, as well as generate a profit. These costs are passed down to investors in the form of fees, and limits the choice and competition in the funds that are available.

How passive index investing works in DeFi

DeFi is all about an open and interconnected peer-to-peer system for finance. In this peer-to-peer system, assets are represented by tokens, and they can be owned, exchanged, and programmed to have behaviors and properties, as demonstrated in the example below.

For an index fund in DeFi, an investor would supply the fund with liquidity by exchanging a token, such as the stablecoin USDC, with a token that represents a share of the fund. This exchange could be facilitated via a decentralized exchange such as Uniswap.

As part of that same transaction, a smart contract for the fund could also automatically use that newly supplied USDC to purchase stock tokens, which represent a legal claim on their respective stocks. 

Periodically, the fund token smart contract would rebalance its portfolio automatically based upon a feed from an oracle of the prices of the stock tokens on-ledger, just how an index would be updated manually by an index administrator.

To establish legal claim on the underlying stocks, the stock tokens could be set up as either:

• a security token - which is where token holders have a direct legal claim on the equity;
• tokenized securities - which is where token holders have a legal claim to redeem the equity as per the ledgers of custodians and CSDs.

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Why passive index investing is better in DeFi

First, building a passive index as a DeFi dApp means that an index-based investment can be represented as a token, rather than in the centralized ledgers of traditional finance companies. This makes the investment fractionalizable to the nth degree and instantly transferable to anyone without requiring anyone’s permission, resulting in greater liquidity and transferability of assets in DeFi over traditional finance.

Second, because tokens and smart contracts are automated, novel types of passive investment funds can be constructed. For example, a “fund of funds” dApp could automatically invest in other fund tokens, with its own predefined rules determining how it manages risk, governed by its own token holding community, issuing its own fund token. 

Third, the typical administrative overhead cost of creating and maintaining a fund can be eliminated - requiring just the time it takes for a developer to write and maintain the dApp. This allows almost anyone to create their own fund, catalyzing innovation, competition and choice. Investors don’t have to invest in only a limited number of products, such as the Dow 30, but can find a niche that aligns with their own personal values, interests, and objectives. Examples of which might include an index of NFTs for certain artistic subcultures; or an index that provides claim over carbon credits for a collection of forestry initiatives.

We have already started seeing index tokens in DeFi gain some traction, such as the Index Coop with its DeFi Pulse Index that tracks a basket of DeFi tokens; or Indexed Finance or PowerPool Finance, which are both Decentralized Autonomous Organizations (DAOs) that allow participants to vote on creating new indices and investment strategies.

Just how the internet democratized the distribution of news, so too will DeFi democratize the distribution of investment opportunities. And that has implications for how society as a whole funds and values things that it thinks are useful - not what a close-knit coterie of fund managers think are useful. 

But for all this to work, you need a decentralized network that no longer suffers from DeFi hacks, bugs and exploits, as otherwise, how do you know your money is safe? You need a network that makes it easy to develop on, in order to unleash that creativity, innovation and competition. And you need one that will always have low transaction fees to ensure that anyone will always be able to participate and invest no matter how small the amount.

Radix has spent eight years solving all of these problems with its game changing Scrypto programming language and Cerberus consensus. To get started with Scrypto, check out our blog Alexandria: Scrypto is Here.