Original title: Bitcoin Euphoria Threatens to Break These ETFs Original author: Jack Pitcher, WSJ Original translation by: zhouzhou, BlockBeats
Editor’s note: 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 leverage through swaps and options but face liquidity issues, leading to performance below expectations. Investors are disappointed with the funds' divergence in performance, and critics warn that these funds exacerbate the volatility of MicroStrategy's stock price and carry risks that could lead to losses.
The following is the original content (for ease of reading and understanding, the original content has been reorganized):
Investors are flocking to funds that seek to amplify MicroStrategy's daily stock 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) in an attempt to profit from the momentum of Bitcoin, but these funds carry hidden risks that are not widely understood. These ETFs aim 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 on the rise or fall.
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 to nearly $90 billion, more than double the value of its Bitcoin holdings, leading skeptics to believe this situation is unsustainable.
The Defiance Daily Target 2X Long MSTR ETF and the T-Rex 2X Long MSTR Daily Target ETF are designed for investors looking to make more aggressive bets on stocks. Since their launches in August and September, the total assets of these two funds have ballooned to about $5 billion.
Some analysts say these funds are driving the wild rise of MicroStrategy's stock price. They warn that if the stock drops by 51% in a single day, these ETFs could completely collapse, similar to some volatility-related ETFs that blew up after the market volatility event 'Volmageddon' in 2018.
Worse still, the performance of the two recent 2X leveraged ETFs has not run as expected. On Wednesday, MicroStrategy's stock rose by 9.9%, but the T-Rex fund only increased by 13.9%, falling short of the 19.8% target. When the stock fell, the performance of the T-Rex fund was also disappointing. On Monday, when MicroStrategy dropped by 1.9%, the fund's price fell by 6.2%.
This has sparked widespread discussion among investors on social media, with many questioning the discrepancy and feeling deceived.
36-year-old wine merchant and day trader Jesse Schwartz has been using these funds to amplify his exposure to stocks in Washington State, and he is particularly surprised to see these 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, ultimately selling all his shares before the week ended.
"At the very least, this is disappointing," said Schwartz. "I took on more risk on the downside but didn't get rewarded on the upside."
Since the regulators approved it in 2022, dozens of ETFs targeting single stocks have been launched by small fund managers. So far, these funds have mostly operated as expected. Popular funds aimed at doubling daily returns of Nvidia and Tesla typically closely follow their targets, thanks to 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 been using for a long time. Critics argue that they can be dangerous because they do not provide diversified investment. Taking the MicroStrategy fund as an example, these funds expose investors to highly volatile stocks through leverage, which are associated with unpredictable cryptocurrency price fluctuations.
Critics warn that this hype is part of a broader frenzy among investors targeting speculative assets that could ultimately collapse.
MicroStrategy holds about $35 billion in Bitcoin. Image source: KEVIN SIKORSKY
Managers of the MicroStrategy fund stated that they may struggle to achieve the target of 2x returns because their main broker—companies that provide securities lending and other services to professional investors—has already reached the upper limit of the swap exposure 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 asset, allowing funds to accurately double the daily performance of a stock or index.
Matt Tuttle, manager of the Tuttle Capital and Rex Shares 2x leveraged MicroStrategy fund, stated that he cannot obtain sufficient swaps needed to support his rapidly growing fund. He said his main broker is currently offering him swap limits of $20 million to $50 million, while at some point last week he could have accessed $1.3 billion in swaps.
Tuttle and Defiance ETFs CEO Sylvia Jablonski both stated they are turning to the options market to achieve leveraged outcomes 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 increase in tracking error.
The Defiance ETF dropped nearly three times the decline of the underlying stock on November 25. Last Friday, while MicroStrategy only fell by 0.35%, the ETF dropped by 1.76%.
Analysts believe that the launch of leveraged MicroStrategy ETFs has accelerated the volatility of the stock. These ETFs must increase or decrease their exposure daily to achieve a leveraged effect. 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 throttle, but the default mode is to floor it," said Dave Nadig, a veteran of the ETF industry who previously worked at VettaFi and FactSet.
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