Investors are pouring into funds seeking 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 aim to amplify MicroStrategy's daily returns, with the company having 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 were inherently high-risk when launched by asset management companies such as Tuttle Capital Management and Defiance ETFs. MicroStrategy itself is a leveraged bet on Bitcoin, holding about $35 billion worth of Bitcoin. However, optimistic investors have driven its market capitalization up to nearly $90 billion, more than double 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 who wish to make more aggressive bets on the stock. Since their launch in August and September, respectively, the total assets of these two funds have swollen to about $5 billion.
Some analysts say these funds are driving the wild rise in MicroStrategy's stock price. They warn that if the stock falls by 51% in a single day, these ETFs could completely collapse, similar to the situation where some volatility-related ETFs blew up after the 2018 market volatility event "Volmageddon."
Worse still, 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 fell, the T-Rex fund's performance was also disappointing. On Monday, when MicroStrategy fell by 1.9%, the fund's price dropped by 6.2%.
This has sparked widespread discussion among investors on social media, with many questioning this discrepancy and feeling deceived.
Investors take on more risk on the downside.
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 was particularly surprised to see that the stocks did not perform as advertised. Schwartz called his brokerage, Charles Schwab, to inquire about the discrepancy, but he was dissatisfied with the company's explanation and ultimately sold all his shares before the week ended.
"At the very least, it's disappointing," Schwartz said. "I've taken on more risk on the downside, but I haven't been rewarded on the upside."
Since the regulators approved it in 2022, dozens of single-stock ETFs have been launched by small fund managers. So far, these funds have mostly operated as expected. Popular funds aimed at doubling daily returns for Nvidia and Tesla typically closely follow their targets, thanks to financial contracts known as total return swaps.
Supporters of these funds argue that they provide ordinary investors with investment strategies that Wall Street has long used. Critics, however, argue that they can be dangerous because they do not offer diversification. For the MicroStrategy fund, these funds expose investors to highly volatile stocks through leverage, and that stock is associated with unpredictable changes in cryptocurrency prices.
Critics warn that this hype is part of a broader investor frenzy targeting speculative assets that could ultimately collapse.
Managers of MicroStrategy funds have stated that they may find it difficult to achieve the 2x return target because their primary broker— a company providing securities lending and other services to professional investors— has already reached the limit of swap positions they are willing to offer.
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 on swap contracts are directly tied to the performance of the underlying asset, allowing funds to precisely 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 has been unable to obtain enough swaps to support his rapidly growing fund. He said that his primary broker is currently offering him a swap capacity of $20 million to $50 million, whereas at some point last week he could have accessed $1.3 billion in swaps.
Tuttle and his competitor Defiance ETFs' CEO Sylvia Jablonski both stated that they are turning to the options market to achieve leveraged results for MicroStrategy funds. 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 influence the market. Tuttle stated that using options is the main reason for tracking error exacerbation.
Defiance ETF's decline on November 25 was nearly three times that of the underlying stock. Last Friday, when MicroStrategy fell just 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 leveraged effects. Market makers providing swaps and options typically 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 preset mode is floor it," said Dave Nadig, a veteran in the ETF industry who has worked at VettaFi and FactSet.
