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KEY TAKEAWAYS:
- ProShares Bitcoin Strategy ETF (NYSE: BITO) was recently launched to provide investors a way to trade and gain exposure to Bitcoin without setting up a separate crypto trading account.
- BITO, as approved, is required to invest in short-term futures contracts of Bitcoin and not directly in the asset.
- Futures contract pricing includes interest and volatility components which investors pay for in addition to the cost of the underlying Bitcoin asset.
- Bitcoin futures contracts have a maximum term of 6 months (although BITO aims to invest in primarily shorter term, one-month contracts) so they must be “rolled,” which increases trading costs which are transferred to the ETF holder via higher expense fees.
Fancy New Threads
Guess who got a new suit and top hat this fall? The Monopoly Man? He probably did but that wouldn’t be news. No, it was Bitcoin! The good(ish) people at ProShares decided to dress the most popular and famous cryptocurrency, Bitcoin, up all fancy in a packaging and get it in the hands of more investors.
Whether it’s Bitcoin or an investment in a man in a fancy suit, make sure you understand how it works and where your money is going before blindly purchasing something based on a headline or fear of missing out (FOMO).
The number of crypto currencies is already massive, with new coins constantly appearing each week. Although they are a bit off from their highs, they still seem to be yielding high returns to early investors+. The graph below shows the value of Bitcoin over the past 5 years:
Crypto and the underlying blockchain technology is exciting and revolutionary, and companies, including financial companies, are seeking to profit from investors’ enthusiasm. Most recently, on October 19, 2021, the financial firm ProShares introduced the first SEC-approved exchange traded fund (ETF). The new ProShares Bitcoin Strategy ETF (NYSE: BITO) saw the second-most inflow of funds ever on its first day, with $550 million from investors. According to Morningstar, more than $1.01 billion of BITO shares changed hands on its first day of trading.
That reflects a lot of excitement for the new fund. I am not here to dampen the enthusiasm for crypto and the underlying technology or to debate crypto’s investment potential, but I do want to make sure that investors know what they are putting their money into with this new ETF (or anything really) because every investment is different. Know what you are investing in.
What is an ETF?
Let’s start with what an ETF is. An exchange traded fund (ETF) is a type of security that tracks an individual commodity, a sector, diversified broad market index, or a specific investment strategy and is typically traded on an exchange like a publicly traded stock. (This trading feature separates it from a mutual fund, which can only be exchanged at certain intervals after the value of the fund has been calculated). Most ETFs including the most traded ETF, the SPDR S&P 500 ETF Trust (SPY), hold a portfolio of the common stocks or assets that are included in the targeted index, with the weight of each stock corresponding to the weight of the stock in the index. The same concept of holding the underlying assets is true for sector and commodity indexes as well.
By holding the same assets as the index, SPY can employ a strategy of passive buy and hold to replicate the return of the index while minimizing trading fees since trading is necessary only when investors’ funds go in and out or when the index changes. This enables SPY to keep expenses, and therefore the expense ratio charged to investors, low. Some ETFs engage in active management (i.e., more trading) and, correspondingly, have higher fees.
Holding the assets is where the new Bitcoin Strategy ETF is different from the more basic ETFs just outlined. Whereas SPY buys and holds the underlying assets, BITO is barred from holding the underlying the assets directly and is only allowed to hold futures contracts .
Telling the Future
Futures contracts are standardized agreements to buy (or sell) an asset (commodity, security, etc.) at an agreed upon price at an agreed upon time in the future. These are legal contracts and require the entrants into the contract to follow through with the terms of the agreement unless they sell it to another investor or pay an investor to take it. Most futures contracts are closed by trading between two speculative investors (meaning neither investor owns the underlying asset). It is also important to note is that there is a definitive end to the contract.
Bitcoin futures are offered monthly for cash settlement by trading on the Chicago Mercantile Exchange (CME). Every month, the CME introduces new Bitcoin contracts that are listed for 6 months, with market makers setting the initial price. By the end of the 6 months, traders either need to close their position or roll the contract into a new position. Rolling simply means closing one position and opening a new one. Interestingly, per BITO’s prospectus, they aim to invest in the shortest term (usually one month) contracts, which therefore requires more rollover.
This process of rolling contracts raises several issues for the investor. First, trading fees are incurred both when positions are closed and when they are opened. The resulting additional trading fees diminish investors’ returns. And these fees are realized both when Bitcoin goes up and when Bitcoin goes down. Second, if the closing position results in capital gains, those capital gains will be passed on to the investors, who will need to include them in their tax returns.
Pricing Futures
Another issue is how closely futures track the price of the underlying asset. Because futures contracts are for a period in the future, the price of the contract is based on three things: the current value of the asset, the nominal interest rate, and asset value risk (volatility), which is based on the risk the price of asset will change.
For example, think about a contract for one dollar in 6 months. How much would you pay for it? You know a dollar is a dollar (starting asset value is easy), and there is almost zero asset value risk (volatility), but a dollar could be invested right now and you could earn interest on it. Therefore, you would pay a dollar minus what you think you could invest it for. With Bitcoin futures contracts, the asset value and interest rate component of the valuation works the same as the dollar. The volatility component is the tricky part.
Volatility pricing or implied volatility is hard to calculate. Finance textbooks have a formula for calculating it based on the Black and Scholes model: C = SN (d1) – N (d2) Ke -rt. Easy right? In finance class each of these values are nicely provided for you. Perhaps in a fancy word problem to make it harder for undergrads. The real world is much messier. Many trading platforms use the same formula to back into the implied volatility of the futures/option contracts they list in real time. Yet value changes by the minute. And that’s a proverbial minute because in today’s high-frequency trading environment these amounts change constantly.
The changes are largely based on investors’ expectations of what the market will do in the future given any number of factors: rapid market changes, political changes, regional conflicts, supply shocks, changes in inflation expectations, etc.
Understand the Nuances of the Investment Vehicle
When ETFs are purchased, the goal is, usually, to gain exposure to the underlying asset in the most efficient way possible. Basic low-cost ETFs based on major equity indexes do just that by holding the underlying assets and trading as infrequently as possible. BITO, however, is forced to trade frequently because of the short-term nature of the forward contracts, which means you are also subjecting yourself to a lot of fees.
These futures contracts carry additional market risk within the implied volatility.
So the question is, are you looking to invest in Bitcoin or fees and market-implied volatility? Until next time, spend less than you make, invest the difference in low-cost index funds, be kind to your neighbors, and you will succeed in reaching your financial goals and in making the world around you a happier place.
If you feel you could use some assistance along the way, please email us or leave us a comment below we’d be happy to talk about how we can help.