Original title: (Bitcoin Euphoria Threatens to Break These ETFs)
Author: Jack Pitcher, WSJ
Translated by: zhouzhou, BlockBeats
This article analyzes the leveraged funds launched by Tuttle Capital and Defiance ETFs, focusing on MicroStrategy stock to amplify its returns associated with Bitcoin. These funds use swaps and options for leverage but face liquidity issues, leading to performance that falls short of expectations. Investors are disappointed with the funds' deviation from performance, and critics warn that these funds exacerbate the volatility of MicroStrategy's stock price and carry risks that could lead to losses.
Below is the original content (for readability, the original content has been compiled):
Investors have poured into funds seeking to amplify MicroStrategy's daily returns, but these ETFs have recently failed to perform as expected.
MicroStrategy founder Michael Saylor, whose software company has turned into a Bitcoin purchasing machine. Image source: LIAM KENNEDY/ BLOOMBERG NEWS
Investors are flocking to a pair of highly leveraged exchange-traded funds (ETFs) trying to profit from Bitcoin's momentum, but these funds carry hidden risks that are not widely understood. These ETFs aim to amplify MicroStrategy's daily returns, a company that has transformed itself into a Bitcoin purchasing machine. By using complex derivative trades, they aim to deliver double the daily returns of the stock, whether up or down.
These funds, launched by asset management companies like Tuttle Capital Management and Defiance ETFs, are inherently high-risk, as MicroStrategy itself is a leveraged bet on Bitcoin, holding about $35 billion in Bitcoin. However, optimistic investors have pushed its market value to nearly $90 billion, more than twice the value of its Bitcoin holdings, leading skeptics to believe this situation cannot be sustained.
The Defiance Daily Target 2X Long MSTR ETF and T-Rex 2X Long MSTR Daily Target ETF are designed for investors looking to make more aggressive bets on the stock. Since their launches in August and September, the total assets of these two funds have swollen to about $5 billion.
Some analysts say that these funds are driving the crazy rise in MicroStrategy's stock price. They warn that if the stock drops 51% in a day, these ETFs could completely collapse, similar to the situation with some volatility-related ETFs that blew up after the 2018 market volatility event 'Volmageddon'.
Worse yet, the recent performance of these two 2X leveraged ETFs has not met expectations. On Wednesday, MicroStrategy's stock rose by 9.9%, but the T-Rex fund only rose by 13.9%, falling short of the target of 19.8%. When the stock drops, the T-Rex fund's performance is also disappointing. On Monday, when MicroStrategy fell by 1.9%, the fund's price dropped by 6.2%.
This has sparked widespread discussion among investors on social media, many of whom question this discrepancy and feel deceived.
36-year-old wine merchant and day trader Jesse Schwartz has been using these funds in Washington State to amplify his exposure to stocks, and he is particularly surprised that these stocks did not perform as advertised. Schwartz called his brokerage Charles Schwab to inquire about the discrepancies, but he was not satisfied with the company's explanation, and ultimately sold all his shares before the week ended.
"At the very least, this is disappointing," Schwartz said. "I took on more risk on the downside, but did not get rewarded on the upside."
Since regulators approved single-stock ETFs in 2022, dozens have been launched by small fund managers. So far, most of these funds have operated as expected. Popular funds aiming to double daily returns for Nvidia and Tesla typically closely follow their targets, thanks to the financial contracts known as total return swaps that they utilize.
Supporters of these funds say they provide ordinary investors with investment strategies that Wall Street has used for a long time. Critics argue that they can be dangerous as they do not offer diversified investments. For example, with the MicroStrategy funds, these funds expose investors to highly volatile stocks through leverage, and this stock is associated with unpredictable cryptocurrency price fluctuations.
Critics warn that this hype is part of a broader investor frenzy targeting speculative assets, which could ultimately collapse.
MicroStrategy holds about $35 billion in Bitcoin. Image source: KEVIN SIKORSKY
Managers of the MicroStrategy fund say they may struggle to achieve the 2x return target because their main broker—providing securities lending and other services to professional investors—has already reached the limit of the swap exposure they are willing to provide.
Leveraged ETFs typically achieve their intended effects by using swaps that are widely available for the largest and most liquid stocks. The payments from swap contracts are directly tied to the performance of the underlying assets, allowing funds to precisely double the daily performance of stocks or indices.
Matt Tuttle, manager of the Tuttle Capital and Rex Shares 2x leveraged MicroStrategy funds, says he cannot obtain enough swaps to support his rapidly growing fund. He said his main broker is currently offering him a swap limit of $20 million to $50 million, while at some point last week he could have used $1.3 billion in swaps.
Sylvia Jablonski, CEO of Tuttle and competing Defiance ETFs, both say they are turning to the options market to achieve leveraged results for the MicroStrategy funds. Traders can effectively use options to double the daily returns of assets, but analysts say this is a less precise method.
Options prices are volatile, and large buyers like ETFs can influence the market. Tuttle says that the use of options is the main reason for the tracking error exacerbation.
Defiance ETF's decline on November 25 was nearly three times that of the underlying stock. Last Friday, when MicroStrategy only fell by 0.35%, the ETF dropped by 1.76%.
Analysts believe that the launch of leveraged MicroStrategy ETFs has accelerated the stock's volatility. These ETFs must adjust their exposure daily to achieve leveraged effects. Market makers providing swaps and options typically buy and sell actual MicroStrategy stock to hedge their risks.
"It's like driving with a lead weight tied to your foot; you can still control the gas, but the default mode is to floor it," said Dave Nadig, a veteran in the ETF industry who has worked at VettaFi and FactSet.
