Since we last looked at Bitcoin a lot has changed. Several of the potential bear cases we discussed (such as attempted government regulation and concern over the amount of energy used while mining) came to pass, and the price of bitcoin fell substantially. However, the price of Bitcoin has since recovered, and is once again at all-time highs.

A new way to invest in Bitcoin has been making news in recent weeks, as some “Bitcoin ETFs” have been approved and have come to market. In this article, we will take a look under the hood of Bitcoin ETFs, and examine exactly how they gain exposure to Bitcoin.

Does a Bitcoin ETF own Bitcoin?

This may seem like a simple question, but the answer is a little more complex.

While there are ETFs waiting to be approved by the SEC that own actual Bitcoin, the current Bitcoin ETFs available do not own any Bitcoin directly. Instead, they trade Bitcoin futures to gain exposure to the price movements of Bitcoin. To accomplish this, the ETF issuer will buy Bitcoin futures contracts and offer a securitized version to investors in the form of an ETF. Neither the ETF issuer, nor the investor in the ETF own the underlying asset (Bitcoin). However, by trading the futures contracts, the ETFs do provide a means of gaining exposure to the price movements of Bitcoin. ETFs can be purchased in just about any investment account eliminating the need for an investor to open a virtual wallet.

Building Blocks

As we dive in, we first need to understand some key terms and theories to develop a basic understanding of Bitcoin ETFs:

Bitcoin: A cryptocurrency based on block chain technology. For more information on Bitcoin, take a look at our previous blog: A Beginner’s Guide to Understanding Bitcoin.

In this case, Bitcoin is the exposure that the investor in the ETF wishes to gain.

ETF: An ETF, or exchange traded fund, is a basket of securities (like a mutual fund) that is traded intra-day on exchanges (like a stock). Most ETFs track an index of stocks or fixed income assets. In the last decade, ETFs have seen a dramatic increase in popularity and there are ETFs for almost any area of the economy in which an investor would like to participate.

The ETF structure is the vehicle that allows the issuer to bring their strategy to the public for investment.

Futures Contract: A futures contract is an agreement to buy or sell a specific asset at a predetermined time and price. These contracts are standardized and can be traded on the futures exchange. A futures contract can be used to speculate on the direction the price of an asset will move during the life of the contract.

A classic example of a futures contract is a farmer growing wheat. The farmer can sell futures contracts on that wheat and lock in a price that he now knows he will get when his wheat comes to market. For example, the farmer may sell futures contracts for 200 bushels of wheat 3 months from now at a futures price of $100 per bushel. A speculator buys the contract, betting that the market price of wheat will be higher than $100 in three months. If it is, his gain is the difference. The futures contract is marked to market each day, and can be traded on an exchange.

The Bitcoin ETF is buying futures contracts with the goal they will increase in value as the price of Bitcoin increases. Thus, providing a means for investors to participate in the price appreciation of Bitcoin.

Derivatives: A futures contract is known as a derivative because its value is based on that of the underlying asset. In the case of a Bitcoin ETF, the futures contracts are settled in cash, meaning the two sides are simply settling the difference in price based on the fluctuation of the underlying asset.

Futures vs Spot Price:

• • Spot price: Also called the market price, is the value of the asset at a current moment as set by market forces. If you own Bitcoin, that is the price of your shares at that current time. When you hear “bitcoin has crossed above $60,000” that is a reference to the spot price.
  • Futures price: The price stated in the futures contract. If the spot price is higher than the agreed upon futures price for that contract at expiration, the buyer makes money.

Tracking Error: Is the term for the difference between the performance of an investment strategy (the Bitcoin ETF) and the performance of the underlying asset (the spot price of Bitcoin). There are several potential reasons for a high tracking error; including management fees and execution costs related to buying new futures contracts to replace expiring ones.

For example, if over a month, the price of Bitcoin was up 10%, but a bitcoin ETF was up 7%, you would say the tracking error of the ETF is 3%.

Pros/Cons:

Pros:

• It is an easy, accessible way to add bitcoin exposure to your portfolio. These ETFs are traded on almost every brokerage site and can be held in almost any type of investment account.
• Bitcoin ETFs can be held in IRAs and other tax advantaged retirement accounts, shielding the investors from potential capital gains taxes.
• Their emergence will lead to Bitcoin being more investable for institutional investors.

Cons:

• Higher cost: the expense ratio charged on an annual basis is most likely higher than any cost incurred for holding bitcoin in a digital wallet.
• Tracking error: the potential for a high tracking error over time is significant, especially if the forward price of new contracts is higher than the market price. This situation is referred to as “contango” and means that when a futures contract expires, the ETF issuer must buy a slightly more expensive contract to replace it. Over time this can eat into the performance of the ETF.
• It does not own any bitcoin. Although these ETFs do provide exposure to the price movements of Bitcoin, the owners do not actually have a claim on any Bitcoin.

Putting it all Together

We have learned the Bitcoin ETFs currently available do not hold any actual Bitcoins as the underlying asset. Instead, they use futures contracts on Bitcoin to gain exposure to the change in the price of Bitcoin. They are convenient in that they can be held in any investment account, but they come with higher costs and may not track the movements in the price of Bitcoin exactly. Stay tuned as we continue to examine the developments in cryptocurrency and the best ways to invest in this emerging asset class.

How We Can Help

As with any investment, it is important to weigh the risk against the potential returns. If you are interested in finding out if investing in a bitcoin ETF or cryptocurrency is right for you, or if you would simply like to learn more, contact us online or at 410-685-9685.