Article source: BlockBeats
Original title: (Bitcoin Euphoria Threatens to Break These ETFs)
Written by: Jack Pitcher, WSJ
Translation by: zhouzhou, BlockBeats
Editor's Note: This article analyzes the leveraged funds launched by Tuttle Capital and Defiance ETFs, focusing on MicroStrategy stocks to amplify their returns associated with Bitcoin. These funds use swaps and options for leverage but face liquidity issues, leading to underperformance. Investors are disappointed with the funds' deviant performance, and critics warn that these funds exacerbate the volatility of MicroStrategy's stock price and pose risks that could lead to losses.
The following is the original content (the original content has been reorganized for readability):
Investors are flocking to funds that seek to amplify MicroStrategy's daily returns, but these ETFs have recently failed to operate as expected.
MicroStrategy founder Michael Saylor, this 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 derivatives trading, they seek to provide double the daily return of the stock, whether it goes up or down.
These funds, launched by asset management companies such as 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 up to nearly $90 billion, more than twice the value of its Bitcoin holdings, leading skeptics to believe this situation is unsustainable.
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 respective launches in August and September, the total assets of these two funds have ballooned to around $5 billion.
Some analysts say these funds are driving the insane rise in MicroStrategy's stock price. They warn that if the stock drops 51% in a day, these ETFs could completely collapse, similar to some volatility-related ETFs that faced liquidation after the 2018 market volatility event 'Volmageddon.'
Worse yet, the recent performance of these two 2X leveraged ETFs has not operated as expected. On Wednesday, MicroStrategy's stock rose 9.9%, but the T-Rex fund only rose 13.9%, falling short of the 19.8% target. When the stock declines, the T-Rex fund's performance is also disappointing. On Monday, when MicroStrategy dropped 1.9%, the fund's price fell by 6.2%.
This has sparked widespread discussion among investors on social media, with many questioning this discrepancy and feeling deceived.
36-year-old wine merchant and day trader Jesse Schwartz has been using these funds to amplify his exposure to the stock in Washington State, and he was particularly surprised to see the stocks not performing as advertised. Schwartz called his brokerage firm Charles Schwab to inquire about the discrepancy, but he was not satisfied with the company's explanation and ended up selling all his shares before the week ended.
"At the very least, it's disappointing," Schwartz said, "I took on more risk on the downside without being compensated on the upside."
Since regulators approved single-stock ETFs in 2022, dozens have been launched by small fund managers. So far, these funds have mostly operated as expected. Popular funds aiming to double daily returns for Nvidia and Tesla typically track their targets closely, thanks to financial contracts known as total return swaps.
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 because they do not provide diversification. For example, the MicroStrategy fund exposes investors to highly volatile stocks through leverage, and that stock is linked to 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
The manager of the MicroStrategy fund indicated that they may struggle to achieve their goal of doubling returns because their main broker—companies providing securities lending and other services to professional investors—has already reached the limit of swap exposure they are willing to offer.
Leveraged ETFs typically achieve their expected results through the use of swaps, which are widely available for the largest and most liquid stocks. The payments of swap contracts are directly tied to the performance of the underlying asset, allowing the fund to precisely double the daily performance of a stock or index.
Matt Tuttle, the manager of the Tuttle Capital and Rex Shares 2x leveraged MicroStrategy fund, stated that he could not obtain enough swaps to support his rapidly growing fund. He said his main broker is currently offering him swap limits of $20 million to $50 million, whereas at some point last week he could have used $1.3 billion in swaps.
Tuttle and his competitor Defiance ETFs' CEO Sylvia Jablonski both stated they are turning to the options market to achieve leveraged results for the MicroStrategy fund. Traders can effectively use options to double the daily returns of assets, but analysts say this is a less precise method.
Option prices fluctuate, and large buyers like ETFs can influence the market. Tuttle stated that the use of options is the main reason for the exacerbation of tracking error.
The Defiance ETF fell nearly three times the decline of the underlying stock on November 25. Last Friday, when MicroStrategy fell just 0.35%, the ETF dropped 1.76%.
Analysts believe the launch of leveraged MicroStrategy ETFs has accelerated the stock's volatility. These ETFs must increase or decrease their exposure daily to achieve leveraged effects. Market makers providing swaps and options usually buy and sell actual MicroStrategy stock to hedge their risks.
"It's like driving with a weight tied to your foot; you can still control the gas, but the default mode is to floor it," said Dave Nadig, an industry veteran who has worked at VettaFi and FactSet.
