Bitcoin Euphoria Threatens to Break These ETFs
Author: Jack Pitcher, The Wall Street Journal; Translated by: 0xjs@jinsecaijignore
Investors are flocking to a pair of turbocharged ETFs to ride bitcoin’s momentum, but they carry hidden risks that aren’t widely understood.
The ETFs are designed to amplify the daily returns of MicroStrategy, the software company that has turned itself into a bitcoin-buying machine. They use complex derivatives bets designed to deliver double the daily returns of the stock — whether it’s up or down.
These ETF funds are managed by asset management companies Tuttle Capital Management and Defiance ETFs, and are inherently risky. MicroStrategy itself is a leveraged bet on Bitcoin, holding about $35 billion in cryptocurrency. However, bullish investors have pushed its market value to nearly $90 billion, more than double the value of its Bitcoin holdings. Skeptics say this is unsustainable.
The Defiance Daily Target 2X Long MSTR ETF and T-Rex 2X Long MSTR Daily Target ETF are designed for investors who want to bet more aggressively on the stock. Since their launches in August and September, respectively, the total assets of these two funds have swollen to about $5 billion.
Some analysts say these ETFs have driven a significant increase in MicroStrategy's stock price. They warn that if the stock falls by 51% in a single day, these ETFs could be completely destroyed, a collapse similar to what some volatility-linked ETFs experienced after the 2018 market event known as Volmageddon.
Importantly, these two 2X leveraged ETF funds have not performed as expected in recent days. On Wednesday, MicroStrategy's stock price rose by 9.9%, but the T-Rex fund only increased by 13.9%, instead of the expected target increase of 19.8%. When the stock fell, the fund's performance was equally disappointing. On Monday, when MicroStrategy's stock price fell by 1.9%, the fund dropped by 6.2%.
This performance has caused strong dissatisfaction among investors on social media, who question the discrepancy and feel deceived.
36-year-old Jesse Schwartz, a Washington state brewer and day trader, has been using these funds as tools to expand his investment in the stock.
Schwartz was surprised to find that the performance of these stocks was not as advertised. He called his broker Charles Schwab to inquire about the discrepancy but was unsatisfied with the broker's explanation. He sold all his shares over the weekend.
"At the very least, this is disappointing," Schwartz said. "I have taken on losses exceeding all downside risks without receiving any upside returns."
Since first gaining regulatory approval in 2022, niche fund managers have launched dozens of single-stock ETFs. So far, the performance of these funds has been largely consistent with their advertising. Popular funds aimed at doubling the daily returns of Nvidia and Tesla often closely track their targets, thanks to their use of financial contracts known as total return swaps.
Supporters of these funds say they allow ordinary investors access to strategies long used on Wall Street. Critics argue that these funds could be dangerous because they do not provide diversified investments. In the case of the MicroStrategy ETF, they increase leveraged exposure to volatile stocks that are tied to unpredictable cryptocurrencies. They warn that this hype is part of a general fervor among investors for speculative assets that will eventually collapse.
Managers of the MicroStrategy ETF fund say they may struggle to achieve the 2X target because their top brokers (companies that provide securities lending and other services to professional investors) have reached the limits of the swap exposure they are willing to provide.
Leveraged ETFs typically achieve their intended effects through the use of swaps, which are widely used on the largest and most liquid stocks. Swap contracts pay out returns directly linked to the performance of the underlying asset, allowing the fund to precisely double the daily performance of the stock or index.
Matt Tuttle, who manages the Tuttle Capital and Rex Shares 2x Long MicroStrategy fund, said he simply cannot obtain the amount of swaps required for his booming fund. He said his primary broker offered him $20 million to $50 million in swaps, while last week he could have used $1.3 billion.
Tuttle and competitor Defiance ETF's CEO Sylvia Jablonski both stated that they are turning to the options market to achieve leveraged returns for the MicroStrategy ETF. Traders can effectively use options to double the daily returns of assets, but analysts say this is more of an imprecise science. Option prices fluctuate, and large buyers like ETFs can move the market.
Tuttle said that the use of options is the main reason for the tracking deterioration.
On November 25, the decline of the Defiance ETF was nearly three times that of the underlying stock. On Friday, the ETF fell 1.76%, while MicroStrategy only dropped 0.35%.
Analysts say the launch of the leveraged MicroStrategy ETF has accelerated the movement of MicroStrategy's stock price. To achieve leveraged results, the ETF must increase or decrease its exposure daily. A network of market makers that provide swaps and options frequently buys or sells actual MicroStrategy shares to hedge their exposure.
"It's like putting a lead weight on your foot while driving. You can still control the gas pedal, but the default mode will be pushed to the floor," said Dave Nadig, a veteran of the ETF industry who has worked at VettaFi and FactSet.