Original title: Bitcoin Euphoria Threatens to Break These ETFs
Original author: Jack Pitcher, WSJ
Original translation: 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 swaps and options but face liquidity issues, leading to underperformance. Investors are disappointed by the funds' deviation from expected 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 (edited for readability):
Investors flocked to funds seeking to amplify the daily returns of MicroStrategy stock, 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 Bitcoin's momentum, but these funds carry hidden risks that are not widely understood. These ETFs aim to amplify MicroStrategy’s daily returns, which has transformed itself into a Bitcoin purchasing machine. By using complex derivatives trading, their goal is to provide double the daily returns of the stock, whether it rises or falls.
These funds are inherently high-risk when launched by asset management companies like Tuttle Capital Management and Defiance ETFs, 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.
Defiance Daily Target 2X Long MSTR ETF and T-Rex 2X Long MSTR Daily Target ETF are designed for investors who wish 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 approximately $5 billion.
Some analysts say these funds are driving the crazy rise in MicroStrategy's stock price. They warn that if the stock drops 51% in a single day, these ETFs could completely collapse, similar to the situation where some volatility-related ETFs blew up after the market turmoil event "Volmageddon" in 2018.
Worse yet, the recent performance of these two 2X leveraged ETFs has not gone as expected. On Wednesday, MicroStrategy's stock rose 9.9%, while the T-Rex fund only increased by 13.9%, falling short of the 19.8% target. When the stock drops, the performance of the T-Rex fund is also disappointing. On Monday, when MicroStrategy fell 1.9%, the fund's price dropped 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 broker Charles Schwab to inquire about the discrepancy but was dissatisfied with the company's explanation, ultimately selling all his shares before the week ended.
"It's disappointing, to say the least," Schwartz said. "I've taken on more risk on the downside without getting rewarded on the upside."
Since the regulators' approval in 2022, dozens of single-stock ETFs have been launched by small fund managers. So far, these funds have operated mostly as expected. Popular funds aimed at doubling the daily returns of Nvidia and Tesla typically closely track their targets, thanks to financial contracts known as total return swaps.
Supporters of these funds argue that they provide ordinary investors with investment strategies long used by Wall Street. Critics contend that they can be dangerous because they do not offer diversified investments. Taking the MicroStrategy fund as an example, these funds expose investors to highly volatile stocks through leverage, and this stock is linked to unpredictable cryptocurrency price movements.
Critics warn that this hype is part of a broader investor frenzy targeting speculative assets that may ultimately collapse.
MicroStrategy holds about $35 billion in Bitcoin. Image source: KEVIN SIKORSKY
Managers of the MicroStrategy fund say they may struggle to achieve the 2X return goal because their main broker—who provides securities lending and other services to professional investors—has reached the 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 of swap contracts are directly linked to the performance of the underlying assets, allowing funds to accurately double the daily performance of stocks or indices.
Matt Tuttle, manager of the Tuttle Capital and Rex Shares 2X leveraged MicroStrategy fund, stated that he is unable to secure sufficient swaps to support his rapidly growing fund. He mentioned that his main broker is currently offering him a swap limit of $20 million to $50 million, whereas at some point last week he could have accessed $1.3 billion in swaps.
Sylvia Jablonski, CEO of Tuttle and competitor Defiance ETFs, both stated that 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 an asset, but analysts say this is a less precise method.
Option prices fluctuate, and large buyers like ETFs can impact the market. Tuttle indicated that using options is the main reason for the exacerbation of tracking error.
Defiance ETF's drop on November 25 was nearly three times that of the underlying stock. Last Friday, when MicroStrategy only fell 0.35%, the ETF dropped 1.76%.
Analysts believe that the launch of the leveraged MicroStrategy ETF has accelerated the volatility of the stock. These ETFs must increase or decrease their exposure daily to achieve the leveraged effect. 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 accelerator, but the default mode is to floor it," said Dave Nadig, a veteran of the ETF industry who has worked at VettaFi and FactSet.
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