Upon its launch in October, I analyzed what is widely being called the first Bitcoin ETF in the U.S. — and came to the conclusion that the title is a mischaracterization. In my opinion, a better, more accurate way to refer to it would be the first ETF providing Bitcoin exposure.
It’s a distinction with a difference. The headlines and hoopla surrounding cryptocurrency and cryptocurrency products are driving investor interest and excitement. Your clients may not have the foggiest notion what the blockchain is or even how an ETF works, but you can bet they have heard of Bitcoin and of people amassing huge fortunes from it in short periods of time. That’s why, before financial advisors and planners can cut through the considerable hype and explain cryptocurrency products to clients in layperson’s terms, they must first master their nuances and the differences between them.
First of all, the ProShares Bitcoin Strategy ETF (BITO), and the newer Valkyrie Bitcoin Strategy ETF (BTF), do not actually hold the digital asset Bitcoin. Instead, BITO and BTF typically buy derivatives contracts on Bitcoin and utilize these contracts to provide exposure to the underlying asset. This is confusing to many investors who equate the price of Bitcoin with the “spot” price, which is what it would cost to go in the market and buy one bitcoin. (The volatile asset was hovering at around $47,000 as this column went to press).
It’s an important difference because derivatives prices generally do not exactly track the spot price of Bitcoin, as derivatives prices are meant to predict what the spot price of Bitcoin will be at some point in the future, when the contract is set to expire. The further out many of the derivatives’ contracts are set to expire (one month to three months), the greater the volatility in price between spot Bitcoin and the derivatives prices, now and looking ahead. Typically, derivatives with prices that are higher than spot are referred to as contango, and derivatives prices that are at a discount to spot are referred to as backwardation.
Similar to commodities, the factors that drive a difference in price between spot and derivatives (specific to Bitcoin / digital currency and not commodities) can include:
· Macroeconomic expectations
· Mining capacity
· Political involvement (for instance, China’s ban on crypto mining)
· Regulatory change
· Headline risk
When contango and backwardation exist above a certain time value of money expectations, institutions may have the ability to profit from the arbitrage between the spot price of Bitcoin and the derivatives’ implied price. They simply pair long and short positions of the two strike prices and wait until maturity, locking in the difference as profit.
To prevent a person or entity from cornering the market on a commodity and artificially driving up its price, the Commodities Future Trading Commission puts limits on the amount of futures contracts that any one entity can hold. This means there are a limited number of 30-day, or “front month” contracts available, which provide the closest derivatives exposure to the spot price. After 30-day contracts are sold, 60-day contracts must be purchased and after that it steps out to three-month contracts.
Meaning of the curve
My analysis shows that with each additional step out of the maturity curve, the difference in price/performance of the fund versus the movement of Bitcoin spot price has a greater chance of diverging.
Once the difference between a Bitcoin ETF and an ETF with Bitcoin exposure is clear, the question for advisors becomes whether or not exposure to Bitcoin provides a useful diversification tool in clients’ portfolios.
Keep in mind, the potential for divergence between spot and derivative prices means the quoted Bitcoin price an investor sees on TV could go up, but the fund’s price could go down. This kind of performance drift is common with these types of funds, but may come as a nasty little surprise for the investor who thought they were investing in a Bitcoin ETF, not an ETF with Bitcoin exposure.
How likely is it that an ETF with Bitcoin exposure will have to buy longer-dated contracts than front month? That is difficult to say and there are a number of factors that determine how quickly derivative contracts sell, but in my observance, BITO almost reached its limit (on front month contracts) on its first day of trading.
It is also critical for investors to know that each month as the current derivatives positions expire, the fund needs to roll its exposure into new contracts — akin to having to “trade” the entire notional value of the fund every month or few months, depending on the contracts owned.
These trading costs can be considerable and are added on top of the 95 basis points BITO is charging in total expense ratio. At Harbor, we always take into account value for cost, and I believe this is a somewhat hefty price to pay on a rolling basis for Bitcoin exposure. All of these factors lead me to believe the likelihood for a potential negative client experience in these products is high.
But one thing is certain: It is up to advisors to educate themselves on the considerations outlined above so that they can clearly communicate them to their clients.