Investors are rushing into funds that seek to amplify MicroStrategy's daily stock returns, but these ETFs have recently failed to perform as expected.
Investors are flocking to a pair of highly leveraged exchange-traded funds (ETFs) in an attempt to profit from Bitcoin's momentum, but these funds carry hidden risks that are not widely understood. These ETFs are designed to amplify MicroStrategy's daily returns, as the company has transformed itself into a Bitcoin purchasing machine. By using complex derivatives trading, they aim to provide double the daily returns 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. MicroStrategy itself is a leveraged bet on Bitcoin, holding approximately $35 billion in Bitcoin. However, optimistic investors have driven its market value up to nearly $90 billion, more than twice the value of its Bitcoin holdings, leading skeptics to believe that this situation is unsustainable.
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 ballooned to about $5 billion.
Some analysts suggest that these funds are driving the crazy rise in MicroStrategy's stock price. They warn that if the stock were to drop 51% in a single day, these ETFs could completely collapse, similar to the situation where some volatility-related ETFs blew up after the market volatility event known as 'Volmageddon' in 2018.
Worse yet, the recent performance of these two 2X leveraged ETFs has not met expectations. On Wednesday, MicroStrategy's stock rose by 9.9%, while the T-Rex fund only increased by 13.9%, falling short of the 19.8% target. When the stock declined, the T-Rex fund's performance was also disappointing. On Monday, when MicroStrategy fell by 1.9%, the fund's share price dropped by 6.2%.
This has sparked widespread discussion among investors on social media, with many questioning the discrepancy and feeling deceived.
Investors take on more risk when the market declines.
36-year-old wine merchant and day trader Jesse Schwartz has been using these funds to amplify his positions in the stock while in Washington State. He is particularly surprised to see these stocks not performing as advertised. Schwartz called his brokerage firm, Charles Schwab, to inquire about the discrepancies, but he was not satisfied with the company's explanation and ended up selling all his shares before the week was over.
"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 them in 2022, dozens of single-stock ETFs have been launched by smaller fund managers. So far, these funds have mostly operated as expected. Popular funds aimed at doubling daily returns of Nvidia and Tesla typically track their targets closely, thanks to the financial contracts known as total return swaps that they use.
Supporters of these funds argue that they provide ordinary investors with investment strategies that Wall Street has long used. Critics, however, believe they can be dangerous because they do not offer diversification. Taking the MicroStrategy fund as an example, these funds expose investors to highly volatile stocks through leverage, which are associated with unpredictable movements in cryptocurrency prices.
Critics warn that this hype is part of a broader investor frenzy targeting speculative assets, which could ultimately collapse.
Managers of the MicroStrategy fund have stated that they may struggle to achieve the goal of double returns because their primary broker— a company providing securities lending and other services to professional investors— has reached the limit of swap positions they are willing to provide.
Leveraged ETFs typically achieve their intended effects through the use of swaps, which are widely available for the largest and most liquid stocks. The payments from swap contracts are directly linked to the performance of the underlying assets, allowing the funds to accurately double the daily performance of the stock or index.
Matt Tuttle, the manager of Tuttle Capital and Rex Shares 2x Leveraged MicroStrategy Fund, stated that he has not been able to secure enough swaps to support the rapid growth of his fund. He said that his primary 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, Sylvia Jablonski of Defiance ETFs, both indicated that 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 the assets, but analysts say this is a less precise method.
Option prices are volatile, and large buyers like ETFs can influence the market. Tuttle stated that the use of options is the main reason for the increase in tracking error.
Defiance ETF fell nearly three times the decline of the underlying stock on November 25. Last Friday, when MicroStrategy was down only 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 increase or decrease their exposure daily to achieve the leveraged effect. Market makers who provide swaps and options often buy and sell actual MicroStrategy stock to hedge their risks.
"It's like driving with a weight strapped to your foot; you can still control the throttle, but the preset mode is to floor it," said Dave Nadig, a veteran in the ETF industry who has worked for VettaFi and FactSet.
