January 18, 2022 – Pulse.inc announces a change to the methodology of the DeFi Pulse Index to be effective starting with the January 2022 rebalancing.
The DeFi Pulse Index is a digital asset index designed to track the performance of some of the largest protocols in the Decentralized Finance (DeFi) space.
Pulse.inc has decided to change the weighting rules that are part of the index methodology. The current rules in methodology v0.4 do not include a minimum weight requirement during the Determination Phase.
The methodology update to v0.5 will incorporate the Minimum Weight Requirement rule after the application of Flexible Capping. The Minimum Weight Requirement states the following:
“Any current constituent that has a weight less than 0.50% will be removed from the index, new tokens are required to have a weight of at least 2% to be added.”
The range from 0.5% to 2% acts as a buffer and prevents frequent adding and removing of tokens.
Related: Why Invest in an Index?
Why a Minimum Weight filter?
The primary objective of a blue-chip index is to represent the economic reality of the underlying market. For the DeFi Pulse Index this target market consists of DeFi projects with significant usage, traction and adoption. Removing constituents that have very small weights assigned will not distort what the index seeks to represent.
Another objective of an index is to provide diversified exposure. In order to assess how removing constituents with low weights would affect the diversification of the index, we look at the concentration of the portfolio. The Herfindahl Index (HI) is a commonly used measure for concentration, calculated as the weighted average of the index weights (Σw2). Hence, a completely concentrated portfolio has an HI of 1. A more intuitive metric is the inverse of the Herfindahl index that is usually called the effective number of assets of a portfolio in contrast to the actual number of assets. An equal weighted index of 100 actual constituents will have an effective number of assets of 100, an index with two constituents with 49% each and the remaining 2% of weight spread across the remaining 98 assets will have an effective number of assets close to 2 even though its actual number of assets is still 100.
Looking at these numbers for the DeFi Pulse Index shows that adding constituents with a low weight throughout 2021 did not necessarily lower the level of concentration of the index: The effective number of names remained in a range between 6 and 8. Therefore, removing constituents with low weights will not decrease the level of diversification.
Lastly, another objective of a financial index is to ensure it is investable: A passive tracker (Index Coop’s DPI token) has to be able to replicate the index and market participants have to be able to efficiently arbitrage the token price if it deviates from the net asset value. Removing constituents will directly lower the cost of this arbitrage process by lowering its fixed cost, the gas fees for the mint and redeem process.
In summary, introducing a Minimum Weight Requirement improves the replicability and tradability of the DeFi Pulse Index without harming its main objective of providing diversified exposure to blue-chip DeFi protocols.
Pulse.inc, a subsidiary of DeFi Pulse, is dedicated to creating and maintaining indices for a decentralized world.