A few weeks ago, I made my first allocation to direct Bitcoin exposure and quickly lost 10% on the position. Needless to say, anything written hereafter should absolutely not be taken as investment advice. Rather, I am sharing thoughts for educational and entertainment value as Bitcoin begins to find its place among traditional portfolios and mainstream liquid fund structures.
Background
Looking into 2022 I decided to include additional allocations to alternatives in my personal retirement portfolio, a minor portion may include direct commodity & currency exposures. This portfolio currently has indirect exposure to crypto currencies and blockchain technology through equities. While I do not have a strong opinion on the future of Bitcoin, I decided to allow minimal direct Bitcoin exposure for two mainly psychological reasons. First, it serves as an asymmetrical hedge against missing another exponential leg up; also known as a disciplined FOMO trade. Secondarily, I simply wanted a tiny bit of skin in the game as I keep abreast of crypto’s journey into the mainstream asset management industry.
My investment choices were limited to those available in my current IRA as I did not want to open a new account for this nominal “fun” position. I was pleased when my self-directed brokerage required an acknowledgement of extreme risks associated with my chosen investment and further risk tolerance confirmation as “most aggressive”. Given the 10% stumble right out of the blocks, kudos to Fidelity for the double-check. Ten percent over a couple weeks is hardly worth mentioning in the crypto world, but a significant move for traditional retirement saving.
Current Landscape of Retail-Friendly Bitcoin Funds
With appropriate investment options limited to four, the major decision for me involved liquidity. Two very different exchange-listed fund structures exist which offer retail investors direct bitcoin price exposure. Each has distinct advantages and disadvantages. Grayscale’s Bitcoin Trust holds Bitcoins and periodically offers its shares on the OTC. Since the trust offers shares only periodically and does not currently operate a redemption program (yes, you read that correctly), its shares tend to trade at a premium or discount to the market value of each share’s proportional number of Bitcoin. They resemble closed end fund shares in this respect, but premiums may run very high and discounts very deep comparatively. The trust charges a management fee of 2% annually and must pay costs associated with acquiring its Bitcoin. It was interesting to learn the trust may accept airdrops of new crypto assets and earn benefits from blockchain forks, which seem to me like a cool crypto blend of warrants, interest, and dividends.
The other available structure includes the first Bitcoin strategy ETF, launched in late October ‘21 by ProShares, which holds cash-settled Bitcoin futures and continuously creates and redeems its shares traded on the NYSE. VanEck and Valkyrie have also launched Bitcoin futures-based ETFs with shares offered continuously on the CBOE and Nasdaq, respectively. I chose to focus the bulk of my futures fund due diligence on the ProShares product owing to the manager’s long track record of beta-tracking with derivatives, their status as first-to-market, assets, and trading volume. All three of the futures-based products are actively managed ETFs, so there will likely be performance variances although they broadly seem to lean towards front month contracts. Price is an obvious difference among the three with ProShares and Valkyrie each charging 95bps and VanEck at 65bps.
Since the launch of the first Bitcoin strategy ETF in October, much buyer beware has been written about futures-based funds. The ETF sponsors themselves are doing a very good job loudly and transparently describing the objectives and limitations of their products. I appreciate the advantages these products offer but opted for the less liquid Bitcoin-holding trust primarily based on my very long time horizon. I was also willing to accept the additional risks, attracted to its premium/discount trading.
Looking forward
A spot Bitcoin ETF stands as the Holy Grail with more than 10 SEC filings seeking approval. It seems logical the Grayscale Bitcoin Trust has the best chance of securing first approval with its recent filings to modify current operations to resemble some of the established commodity & currency ETFs currently enjoying success in the market. Like State Street’s GLD (largest physical gold ETF) and many other commodity & currency ETFs, the Grayscale Bitcoin Trust is structured as a Grantor Trust. Its AUM is approximately $37B compared to GLD at approximately $59B. The regulators are moving cautiously, concerned with the Bitcoin market’s maturity and ability to support mainstream investment products. Given the amount of industry attention, missteps would be embarrassing and costly for some participants. On the other hand, there is clearly strong demand for a spot Bitcoin ETF and the introduction of such products will likely add liquidity and improve operations across exchanges and custodians. If the spirit of innovation is not enough motivation, allowing a mechanism for regular redemptions of shares will likely generate increased tax revenue for the government.
Both Valkyrie and VanEck have also filed with the SEC for spot Bitcoin products and will probably succeed in launching these ETF’s eventually, so it will be interesting to see how they operate their respective futures-based strategies until that time and beyond. By claiming their places in the market early, both firms are gaining valuable expertise and track records managing crypto strategies in liquid, open-end structure. Once the SEC has cleared the way for ETFs to directly hold Bitcoin, there will be a need for competition in the market to drive efficiency and lower costs. It will also encourage the development of innovative features like the nuanced differences seen among some commodity & currency ETFs.
After spot products are launched, a sizable market for futures-based strategies will likely remain as tactical traders may prefer futures-based ETFs for a variety of reasons. The ProShares ETF will probably maintain its leadership in that class, and I expect to see them launch an inverse / short Bitcoin strategy relatively quickly to provide the market with easy access to both sides of the trade. These also will provide institutional managers with convenient tools for hedging, tactical position sizing, and managing liquidity. When short term interest rates finally rise again, futures-based funds will offer investors an interesting advantage by paying shareholders interest earned on the fund’s large cash holdings.
Regardless of Bitcoin’s price action from here it is certainly fun to observe this new chapter of creative product development and think about what the future holds. I am particularly excited to see how these new crypto-based ETFs are adopted by model portfolio managers.