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 ETFs, managed by asset managers Tuttle Capital Management and Defiance ETFs, are inherently risky. MicroStrategy itself is a leveraged bet on Bitcoin, holding about $35 billion in the cryptocurrency. But bullish investors have pushed its market value to nearly $90 billion, more than twice the value of its Bitcoin holdings. Skeptics say that's unsustainable.
The Defiance Daily Target 2X Long MSTR ETF and the T-Rex 2X Long MSTR Daily Target ETF, designed for investors who want a more aggressive bet on the stock, have swelled to about $5 billion in combined assets since their respective launches in August and September.
Some analysts say the ETFs have driven a sharp rally in MicroStrategy’s stock price. But they warn that the ETFs could be wiped out if the stock drops 51% in a single day, a crash similar to what happened to some volatility-linked ETFs after the 2018 market event known as Volmageddon.
Importantly, the two 2X ETFs have not performed as expected in recent days. On Wednesday, MicroStrategy's stock price rose 9.9%, but the T-Rex fund rose only 13.9%, instead of the expected target gain of 19.8%. When the stock fell, the fund's performance was equally disappointing. On Monday, when MicroStrategy's stock price fell 1.9%, the fund fell 6.2%.
The performance sparked a backlash on social media from investors, who questioned the discrepancy and said they felt cheated.
Jesse Schwartz, a 36-year-old Washington state winemaker and day trader, has been using the funds as a vehicle to expand his exposure to the stock.
Schwartz was surprised to find that the stocks did not perform as advertised. Schwartz called his broker, Charles Schwab, to inquire about the discrepancy, but was not satisfied with the broker's explanation. He sold all of his shares over the weekend.
“It’s disappointing, to say the least,” Schwartz said. “I took more than my entire downside risk and got no upside reward.”
Niche fund managers have launched dozens of single-stock ETFs since they first received regulatory approval in 2022. So far, the funds have largely performed as advertised. Popular funds that aim to double the daily returns of Nvidia and Tesla tend to track their targets closely, thanks to their use of financial contracts known as total return swaps.
Supporters of these funds say they give ordinary investors access to strategies long used on Wall Street. Critics say the funds can be dangerous because they don’t offer diversification. In the case of the MicroStrategy ETFs, they add leveraged exposure to volatile stocks tied to unpredictable cryptocurrencies. They warn that the hype is part of a broader frenzy among investors for speculative assets that will eventually crash.
Managers of the MicroStrategy ETF say they may have trouble reaching their 2x target because their top brokers — firms 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 effect through the use of swaps, which are widely used for the largest, most liquid stocks. The swap contract payout is 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, who manages Tuttle Capital and the Rex Shares 2x Long MicroStrategy fund, said he simply can’t get the amount of swaps his thriving fund needs. He said his prime broker offered him $20 million to $50 million in swaps, when he could have used $1.3 billion last week.
Tuttle and Sylvia Jablonski, CEO of rival Defiance ETFs, both said they are turning to the options market to leverage MicroStrategy ETFs. Traders can effectively use options to double an asset’s daily return, but analysts say it’s more of an inexact science. Options prices fluctuate, and big buyers like ETFs can move the market.
Tuttle said the use of options was the main reason for the deterioration in tracking.
The Defiance ETF fell nearly three times as much as the underlying stock on Nov. 25. On Friday, the ETF fell 1.76%, while MicroStrategy fell just 0.35%.
Analysts say the launch of the leveraged MicroStrategy ETF has accelerated the move in MicroStrategy's stock price. To achieve the leveraged results, the ETF must increase or decrease its exposure every day. The network of market makers that offer swaps and options frequently buy or sell actual MicroStrategy shares to hedge their exposure.
"It's like putting a lead weight on your foot while driving. You can still control the accelerator, but the default mode is going to be floored," said Dave Nadig, an ETF industry veteran who previously worked at VettaFi and FactSet.
