Diversify & Chill: Index Funds 3.0

Financial markets are one of humanity’s most ambitious inventions, steering capital to fuel progress and amplify prosperity. They fund breakthroughs in medicine, construct hospitals, schools, and housing, build energy grids, deliver water and food, and connect billions worldwide. 

For centuries, financial markets were gated fortresses for elites, while the everyman peered in from downstream. The early 20th century introduced mutual funds, an actively managed prequel to passive investing that provided diversification and automatic reinvestment, though at a cost. Then came the seismic shifts: (1.0) passive index funds, slashing fees and broadening exposure, followed by (2.0) Exchange Traded Funds (ETFs), delivering intraday trading, tax efficiency, and retail accessibility. Each phase dismantled barriers, unlocked access, and reshaped wealth creation. 

Now, the $3.5T digital assets market and the $120B DeFi ecosystem are reshaping money, investing and banking. With secure, transparent transactions on public blockchains without costly or risky middlemen, the stage is set for the (3.0) leap, Decentralized Token Folios (DTFs) which bring structured products onchain, fully permissionless and open to all.

DTFs in a nutshell deliver the benefits of ETFs plus:

• For users: Easy, 24/7, borderless access to themes, sectors, and algorithmic strategies.
• For finance builders: Flexible index creation, remix-ability and DeFi trading.
• For society: Distribute owner governance power to preserve competition and ensure vibrant, equitable free markets.

This deep dive draws on insights from TradFi and DeFi veterans Kelly Ye, Chongwu Du, Reilly Decker, and Matthew Graham. Their insights, refined through experience at Fidelity, Goldman Sachs, CoinDesk Indices, IndexCoop, TokenLogic/Aave, and Securitize, were invaluable in shaping this post—though not an endorsement.

Let’s not keep brilliance waiting.

Three Financial Revolutions 

Financial markets power $100s of trillions in global assets across commodities, stocks, bonds, foreign exchange, derivatives, real estate, insurance, cryptocurrency and more. They're humanity's engine for progress, turning ideas into productive jobs, products, and wealth for many. The New York Stock Exchange (NYSE) alone accounts for $28 trillion in value since its 1817 launch, with 30+ other exchanges operating in the US. When markets freeze, progress dies, just ask the 1930s or 2008.

The NYSE took 200 years to grant regular people access through layers of middlemen. Digital assets are revolutionizing direct ownership at an extraordinary pace, enabling users to become owners in seconds, from anywhere. Index funds revolutionized old markets by cutting investor costs more than 90%. Digital assets are revolutionizing new markets by cutting entry barriers to near-zero.

Wall Street's evolution from 1817's paper ledgers to today's regulated electronic exchanges tells us what's next: digital assets will speed-run centuries of financial evolution within a few decades.

Three waves of financial democracy turned $10,000 minimum stock buys into $100 ETF trades: 

• (Prequel) Mutual Funds unlocked Wall Street for the middle class in 1924. 
• (1.0) Index Funds exposed active management's fee trap in 1971. 
• (2.0) ETFs shattered trading barriers in 1993, letting anyone trade billion-dollar portfolios quickly and turning stock-picking into buying the whole market. 

John Bogle summed up passive index investing, “Don’t hunt for needles. Buy the haystack.” 

What does this look like in action? A teacher in Argentina, using a local trading app, invests in an Emerging Markets Index fund backing growth in India, China, and Brazil without dissecting individual stocks. In the Philippines, a student taps into the power of sector compounding by starting with an ETF. Bond-focused funds finance Brazil's schools and healthcare centers, while clean tech indices empower Indian solar innovation. 

While these trades favor well-banked users with stock trading accounts, the funds still coordinate significant capital, compounding network effects across vital sectors.

History drops a useful hint about the next revolution in financial democracy, an intersection of crypto and indexing. In 1924, mutual funds launched into a regulatory void, burning investors for 16 years until the 1940 Investment Company Act transformed chaos into trust. Fast forward: Crypto hits its own 16-year mark, already surpassing $3 trillion. As government regulation hints toward embracing blockchain in 2025 and beyond, we're watching the same movie. Traditional funds took decades to reach $10s of trillions in regulated assets. Crypto's digital rails could crush that timeline and open to billions more users.

From Elites to (Almost) Everyone 

The American stock market’s emergence (1792–1900) fueled industrial growth, enabling businesses to raise capital and investors to build wealth. While elites and institutions dominated early participation–high risks, limited access, and knowledge gaps restricted broader involvement. Technological breakthroughs, like the telegraph and ticker, accelerated trading, while industrialization drew more businesses and investors into the fold.

By the 1920s, mutual funds offered smaller investors access to lower cost diversification and professional management. The 1929 crash exposed speculative excesses, spurring demand for safer, regulated options. Reforms like the 1940 Investment Company Act mandated transparency, reducing conflicts of interest and bolstering trust in mutual funds. Initially a domain of the wealthy, mutual funds gradually welcomed retail investors.

The 1970s and 1980s marked the institutional embrace of index funds, driven by modern portfolio theory, cost efficiency, and skepticism of active management. The 1974 ERISA Act further accelerated adoption, integrating index funds into retirement plans and highlighting their low costs and diversification benefits. Research later validated indexing's benefits, attracting analytical, self-directed professionals to the movement.

In 1993, the launch of SPDR S&P 500 (SPY) transformed index investing with easier exposure to sectors and broad trends. Regulatory changes enabled intraday trading with real-time pricing and tax-efficient fund flows, while the rise of internet adoption and online trading accelerated ETF growth. ETFs attracted active traders, tax-savvy investors, and advisors, while retail investors embraced lower minimums and derivatives traders gained tools for index exposure.

The 2000s saw the rise of tech-savvy investors shaped by the dot-com bubble and online forums. These self-directed users blended indexing with selective active bets, fueled by the internet’s democratization of finance. By the 2010s, Millennials fully sent it—adopting mobile-first platforms, robo-advisors, copy trading, and values-driven strategies like ESG investing.

By the 2020s, personalization and community-driven strategies define investing. Financial apps double down on real-time insights, fractional shares, and robo-advisory tools. Social media and online communities shape decisions, blending personal values with financial goals. Skepticism of ESG funds emerges while thematic ETFs (e.g. Bitcoin) and speculative crypto start capturing increasing attention at record pace.

Despite this progress, “there is still a substantial portion of the investment universe that ETFs cannot reach”, Ye reflects in a tokenization deep dive with CoinDesk.

Seven Index Construction Strategies Shaping Market Returns

Wall Street manages trillions of dollars through index funds, but not all indexes are created equal. While giants like BlackRock and Vanguard dominate traditional market-cap strategies, innovative weighting approaches are unlocking new ways to capture market returns. Du helps frame the discussion “indexing enables broad market exposure by tracking beta (relative volatility to a benchmark) in a cost-effective wrapper.”

Consider this your introductory field guide to index construction. For those interested in deeper research and technical specifications, excellent academic work can be found across the internet on portfolio theory and index mathematics. Here, we'll focus on understanding how a few indexing approaches work in practice.

A Smart Beta index blends the efficiency of passive investing with active strategies, leveraging alternative weighting to target factors like value, momentum, or low volatility.

Let's examine how exotic index weighting evolved through three groundbreaking ETFs: AGG, JAAA, and the record-breaking Bitcoin ETFs. These products showcase how liquid alternatives can transform niche, institutional-grade or emerging assets into accessible investment vehicles that capture sophisticated returns previously limited to hedge funds or degen traders.

Traditional bond trading happens in fragmented Over The Counter (OTC) dealer networks, creating a maze of complexity and outright inaccessibility for small investors. Enter the $118B AGG ETF, which transforms this opacity into instant fixed-income access, delivering a 3.4% yield through a single ticker.

The $15B JAAA ETF tackles an even more exclusive market, Collateral Loan Obligations (CLOs). By packaging AAA-rated corporate loan portfolios into an exchange-traded vehicle, it unlocks a 6.2% yield from the highest-quality slice of the CLO market. Think of it as owning the penthouse suite of corporate debt, but with the convenience of a regular stock trade.

Bitcoin presents a different challenge. While actively traded on crypto exchanges, the technical barriers of wallets, keys, and custody deter mainstream adoption. The Bitcoin ETF solves this by wrapping the asset in traditional market infrastructure. As Ye notes, it's "new wine in old bottles", stripping away the complexity while preserving pure Bitcoin exposure.

The market has spoken decisively: Bitcoin ETFs gathered $38 billion in net-inflows in their first 12 months, a milestone that took gold ETFs 6 years to achieve. This ~6x acceleration might just be a hint at what’s to come in the next generation of index products.

Passive Index Empires: A Hidden Monopoly Problem

Index funds now control 17.2% of U.S.-listed companies—double their ownership from a decade ago and passive investing has surpassed 50% market share. This concentration creates a hidden monopoly problem: The largest players like BlackRock, Vanguard, State Street end up holding dominant voting stakes across competing sectors and companies.

This concentrated power recently drew legal action: BlackRock, Vanguard, and State Street were sued last year, accused of climate activism that reduced coal production and raised energy prices. Collectively, they hold over 30% of the biggest coal producers yet were also pushing an ESG agenda with lobbyists and investments.

Azar, Schmalz, and Tecu’s 2018 found that common ownership of airlines correlated with higher ticket prices and less competition. Similar concerns exist in pharmaceuticals, where concentrated ownership raises fears of price-setting collusion and stifled innovation. Similarly, the insurance industry has come under intense scrutiny recently, as frustrations mount over coverage denials and cancellations. 

Borrowing from Brigham Buhler on a recent Tucker Carlson Show: “Guess who owns the majority of the largest insurance companies? BlackRock, Vanguard, State Street. Guess who owns the majority of the pharmaceutical companies? It's BlackRock, Vanguard, State Street. Guess who owns the majority of the media outlets? It's BlackRock. Vanguard, State Street. You start to sense a trend here.”

While concentrated governance power can arise with any asset manager, it may be amplified within a single index fund. In all fairness, conflicted actions could harm both index and non-index holdings, and have implications on fiduciary duty. However, the optics of concentrated influence remain problematic, highlighting the need for transparency or regulatory safeguards to ensure fair competition.

A potential breakthrough lies in DTFs governed by tokenholder communities, delegates or AI agents. Fully onchain, these indexes improve transparency and resilience with freedom to concentrate ownership while distributing governance power. This structure fosters vibrant and competitive free markets.

How AI is Reorienting Index Investing

AI is reshaping ETFs and index products with a surge of advanced analytics and operational efficiency. From indexing top AI firms to crafting dynamic, real-time portfolios, its potential to redefine the industry is unreckoned. What innovations are taking center stage?

Indexing top AI companies may be the low hanging fruit. The $2.6 billion Global X Artificial Intelligence & Technology ETF (AIQ) tracks a market-cap-weighted index of developed-market equities driving AI and big data innovation.

Sentiment analysis uses Natural Language Processing (NLP) to gauge public sentiment from news and social media, influencing thematic ETF creation. Tools like Refinitiv's MarketPsych ESG Analytics process millions of posts daily, identifying ESG violations faster than traditional methods. AI ensures ETFs stay compliant, cutting human error and legal costs.

AI-driven smart index construction identifies trends, filters noise, and selects assets using historical and real-time data. The AI Powered Equity ETF (AIEQ) leverages IBM Watson to construct an index of U.S. companies across all market caps.

Portfolio optimization leverages machine learning to refine weighting, rebalancing, and cost efficiency by analyzing millions of data points in real time. These algorithms track market signals across asset classes, improving diversification and reducing costs.

AI-powered Smart Beta indices aim to outperform traditional market-cap weighting by dynamically leveraging factors like value, momentum, and low volatility. Qraft AI-Enhanced U.S. Large Cap ETF (QRFT) exemplifies this approach, leveraging AI to analyze real-time data and uncover patterns. This real-time adaptability may give QRFT an edge over static, rules-based indices.

AI agents autonomously sense, decide, and act to achieve goals. Decker underscores, “AI agents could dynamically adjust index composition to outperform rigid strategies in crypto’s fast-evolving market.” Experiments like Spectral Labs showcase strategies such as overweighting stablecoins in bear markets and Bitcoin in bull markets. Without access to traditional banking, these agents could rely on Decentralized Finance (DeFi) stablecoins, trading and lending markets as critical infrastructure.  

Onchain AI agents could construct an index to outperform Bitcoin in bear markets and the S&P 500’s 10-year trend—using only DeFi assets, operating 24/7 with zero human intervention. Over time, they could evolve into market makers, deploying efficient, low-risk strategies and governance backstopped by decentralized communities on major parameter or partnership changes.

From ETFs to DTFs: Indexing’s New Era

Crypto surged to 60 million MAUs in 2024, entering its predictable four-year growth cycle post-Bitcoin halving. By 2026, it could hit 500 million MAUs—just 6% global penetration. Citigroup forecasts $4 trillion in tokenized assets by 2030, signaling vast indexing opportunities. Meanwhile, memecoins, though controversial, thrive as user acquisition tools in onchain-first environments. @LeonidasNFT observes: “We’re in a brief window where institutions struggle to custody memecoins. When this changes, I anticipate they’ll evolve into a trillion-dollar asset class.”

Unlike traditional markets, crypto never sleeps, offering 24/7 trading and settlement. Stock settlement cycles compressed from T+5 in the 1980s to T+2 today, but onchain systems push toward near-instant intraday settlement. Permissionless onchain access could shapeshift liquidity, democratized indexing, and social investing—unlocking opportunities for 1.4 billion unbanked adults worldwide. It can foster innovative portfolio creation supporting local communities while expanding global financing.

This convergence of onchain user growth, tokenization, and AI creates a perfect storm for innovation. DTFs, the onchain successors to ETFs, vow broader access and customization, unlocking opportunities we’ve only begun to imagine.

Startup investing has always been asymmetric but crypto makes that edge available to everyone, offering the potential of 10x to 100x returns traditionally reserved for accredited investors. Ye quips, “crypto flips the startup investing model, enabling capital raising from broad user bases rather than a select few.” Indexing startup portfolios allows passive participation in high-growth opportunities. Early pioneers like SpiceVC and Science Blockchain made bold strides in carving a path through uncharted terrain, but this decade’s DTFs and an improving regulatory climate could bring their vision to life. 

Next-gen indexing is smarter, faster, and more customizable. AI-driven optimization, Smart Beta strategies, and customized indices redefine possibilities. Imagine DTFs for MicroStrategy’s convertible bond exposure to Bitcoin, JAAA’s CLOs, or fully native ETH staking pools. “The next evolution of indexes will focus on making crypto assets productive, starting with staking and expanding into yield strategies”, Graham points out. DIY indexes could combine these and add startup portfolio exposure. With lower barriers and faster experimentation, winners and losers emerge at unprecedented speed. 

Who will drive adoption? Early adopters are likely those seeking passive, unfettered access to unconventional assets. If history is any guide, Ethena USDe’s success in simplifying a delta-hedged yield strategy into a single token offers valuable clues. Likely candidates include retail investors, family offices, hedge funds, and pension funds.

What sets next-gen indexing apart? Differentiation must deliver a 10x better experience and beauty is in the eye of the beholder. It's uncertain which lever—superior returns, lower fees, broader assets, Smart Beta, AI, transparency, or accessibility, will be the fulcrum. In due time, markets will decide.

The accompanying table glimpses nine products—ETFs such as IBIT to pure indexes like COIN50 to variations of onchain DTFs like ETH+. The table spans from centralized to increasingly decentralized, highlighting differentiators through a common lens. Moving left to right, ease of use for the well-banked gives way to permissionless transparency, access, and customization.

A likely outcome is not a winner-takes-all scenario but a convergence, what some call the DeFi mullet, blending a Fintech-friendly front end with a crypto-powered backend. A recent example of the DeFi mullet is Coinbase announcing Bitcoin-backed loans powered by DeFi protocol Morpho.

DTF Challenges

How can we make index funds 10x better?

Efficiency erosion stems from operational friction eating into performance. Typically assets are onboarded at their peak health and liquidity, and often offloaded when underperforming. Slippage during these trades compounds inefficiencies, particularly in fragmented crypto markets where long-tail assets lack centralized exchange listings or robust market makers. “Including assets in a crypto index will create liquidity shocks, especially in fragmented markets with thin order books”, says Du. For less liquid tokens, the costs of rebalancing soar due to exorbitant gas fees or thin liquidity, further dragging on returns. 

Timing magnifies the issue. Many index funds rebalance at predictable intervals, enabling sophisticated traders to front-run these movements, increasing slippage and reducing fund efficiency. Such dynamics often leave index managers with tough decisions: condense holdings into fewer, more liquid assets, or cap fund sizes to limit exposure to these risks. Both approaches can help safeguard performance but constrain the breadth and appeal of the index.

Early winners in this space may be demand-driven indexes wrapping large-cap assets with strong liquidity. By focusing on assets listed on centralized exchanges, these funds minimize onboarding and offboarding inefficiencies. However, “hedging during rebalancing, leveraging derivatives or full asset coverage could offer a meaningful edge in resilience”, Graham notes. Performing this type of hedging fully in smart contracts would be a revolutionary innovation in DeFi.

Asset quality and diversity are critical to creating resilient crypto index products capable of thriving through both bullish and bearish markets. Access to inversely correlated assets plays a crucial role in index composition, as it may help buffer downside during volatile cycles. Yet, many crypto assets lack real product-market fit or sustainable network effects, with shitcoins still blanketing the landscape.

Despite these challenges, crypto-native products have unique opportunities to leverage assets and instruments unavailable in TradFi, potentially offering a competitive edge. Many index buyers want products that outperform BTC and ETH bull markets yet safeguard from crypto bear market 40-70% drawdowns. In those moments, precise asset selection separates success from mediocrity, or worse.

Regulation adds another layer of complexity. Crypto has operated in regulatory gray areas since its inception, a familiar story in financial innovation. The past offers parallels: mutual funds, born in 1924 as a diversification breakthrough amid fraud/mismanagement chaos, took 16 years to gain clarity under the 1940 Investment Company Act. Coincidentally, Bitcoin, also 16 years old, saw its ETFs approved, swiftly becoming the largest Bitcoin holder globally, with over $100 billion AUM.

Other challenges persist. DAO governance wrestles with regulatory compliance, struggling to handle corporate basics, while TradFi users face friction accessing DeFi—glaring imbalances begging for innovation. It’s unclear whether DAOs or TradFi will lead this convergence, but achieving parity will be transformative. Regulatory clarity and easier access could bring $100 trillion onchain in the next decade.

Distribution is a critical differentiator. Crypto protocols, often with scant history and weaker network effects, tend to build first and scramble for partnerships later. This leaves them grappling with the steep challenge of constructing distribution from the ground up. In stark contrast, Vanguard and BlackRock, fortified by five decades of experience, wield formidable network effects, securing demand before designing products. These titans listen to customers, then deliver exactly what they want. For them, success hinges not on groundbreaking tech but on unmatched distribution.

Ethena stands as a compelling DeFi example securing several billion dollars of TVL with a few months of launch. By blending a Vanguard/BlackRock style aligning demand and partnerships alongside tech development, they left the "build it, and they will come" philosophy in the dust. 

While Boomers remain anchored to TradFi, a pivotal question arises: where will Zillennials entrench their financial loyalties? Ironically, the recent much-criticized memecoin mania may emerge as a critical gateway for crypto adoption, drawing users into new products beyond TradFi’s reach and reshaping speculative markets in surprising ways.

Last Words

Indexing has been over a century in the making. In the 1980s, critics like the Leuthold Group derided index funds as “Un-American,” but history has flipped the script. Four decades later, passive investing stands vindicated, quietly compounding wealth and reshaping finance.

In his 1993 letter to Berkshire Hathaway shareholders, Warren Buffett highlighted “by periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals.”

The coming generation of DTFs will thrive by combining strong distribution networks with novel technical implementation that pushes the boundaries of what is possible today: 24/7 borderless access to more themes and strategies—remixable, onchain, and governed for vibrant, competitive markets.

Pension funds and academic research were the driving force behind index fund adoption in the 1970s and 1980s, while retail investors amplified the momentum in the 1990s and 2000s. 

2010s speculators, tinkerers, and builders paved the way for institutions to enter the crypto market in 2024. However, these hands-on investors often are not the “set it and forget it” types and may not drive initial DTF growth unless entirely novel products emerge.

While giants like BlackRock and Vanguard may continue to dominate market cap-weighted ETFs, the boldest innovation will come from unexpected corners. The next big thing will start out looking like a toy. If history is a teacher, permissionless transparency, access, and customization pledge a surge of novel products. 

What are a few DTF possibilities?

• Crypto regulatory clarity is poised to unlock trillions in tokenized commodities and securities onchain. DIY Dragon Portfolio, trading 24/7, without a brokerage account.
• Memecoins brought waves of users in 2024; a passive index could capture them effortlessly, and trade on the weekends.
• AI-machine economies will spawn bespoke currencies and value-stores, that can be indexed effortlessly with dynamic regulatory compliance sans middlemen.
• Base, the Coinbase integrated and fastest-growing blockchain ecosystem, lacks a native token—index its top 10 DeFi, AI, gaming and meme assets for seamless exposure.
• For billions without elite finance, DTFs won’t be exotic but a straightforward path to an 8% yield from a diversified real-world asset index, inflation-resistant and bank-free.
• High-yield airdrop & staking indexes maximize investor returns while driving user-funded growth for emerging projects.
• A new era of hedge funds onchain will compete on open-access, financial returns, transparent health metrics, while preserving strategy security via representative governance.
• Crowd-directed indexes could directly integrate stake-weighted prediction markets, a model already being tested in projects like Numerai and Ocean Protocol Predictoor.
• Before the tokenization of everything is realized, start with an index of indexes composing SPY (S&P 500), VGSLX (real estate), PDBC (commodities), and COIN50 (crypto) into one tokenized portfolio.

If journalism, software, and education can disrupt and then accelerate through democratized production and distribution, so can investing. DTFs do this.

As emerging platforms compete to break through with DTFs, many will fail, but the few that succeed could redefine the world order. The next BlackRock won’t resemble the current one. Capital always goes where attention flows.

The excitement isn’t just about the potential variants of DTFs, it’s that anyone reading this will be able to create one, effortlessly and permissionlessly. Whether you’re a Fortune 500 company or a Starlinked anon on a beach, the future of finance is yours to co-create.

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Disclosure: Author James Glasscock (@0xJMG on 𝕏) was a seed investor in the Reserve protocol.