Bitcoin ETFs: More Choices; More Concerns

Editor’s note: Seeking Alpha is proud to welcome Richard Lehman as a new contributor. It’s easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA Premium. Click here to find out more »

Another year in crypto mania

On the surface, Bitcoin (BTC-USD)had another stellar year of performance in 2021. But lots of people might argue otherwise. Calendar year performance logged a 59% advance, but many short-term traders and second-half-of-the-year buyers got slammed. If you had purchased on 217 of the calendar days during the year (that’s 60%!), you would have lost money by December 30th. Meanwhile, the institutionalization of Bitcoin took a leap forward as the token briefly surpassed a trillion-dollar market capitalization and, like mushrooms popping up after the rain, seven new ETFs emerged on US exchanges.

How do I love thee, Bitcoin? Let me count the ways

Despite being rejected by the SEC for a spot Bitcoin ETF, issuers came to market with several new ways for investors to gain “exposure” to bitcoin. (You have to love the fact that Wall Street uses the same word to describe the desirability of adding a risky asset to your portfolio that the rest of the world uses to describe life-threatening dangers like contagious pathogens or nuclear radiation.) Anyway, the past year brought us new Bitcoin and blockchain ETFs, but before you jump into them, it may be wise to look under the hood and manage your expectations.

The only ‘pure play’ in Bitcoin investing is, of course, purchasing the token directly from a crypto dealer or exchange. While that’s widely available now, venturing outside the regulated securities environment places many investors on unfamiliar turf. Quotes and orders from crypto exchanges aren’t quite as investor-friendly, and transaction costs can be quite a bit higher. You may also not have the same investor protections, should your crypto dealer or exchange collapse. Plus, if you want to own or trade cryptos, you’ll generally need to get a separate account for that and for Bitcoin IRA accounts, you’ll also get hit with some hefty fees.

For those who prefer the familiar turf of equity markets, regulated exchanges and online brokers, there are now a variety of publicly traded securities whose businesses may directly or indirectly benefit from either price appreciation or increased use of Bitcoin. These Bitcoin proxies or surrogates have garnered quite a bit of attention and it was only a matter of time before ETF issuers packaged them up into the equivalent of a new sector investment. In addition, the SEC approved the first ETFs to trade Bitcoin derivatives in 2021. So, investors now have nine ETFs trading on US exchanges to satisfy their hunger for cryptos, but they are not all the same and attributes such as composition and structure can make a world of difference in their performance.

What can Bitcoin ETFs hold?

Among the holdings of Bitcoin ETFs, you will find:

• Bitcoin futures and other derivatives
• Stocks of Bitcoin mining companies
• Stocks of companies whose businesses or assets relate in some way to Bitcoin or Blockchain
• Other Bitcoin funds
• Other cryptos
• International securities

Each of these can have unique attributes and risks.

Bitcoin futures

The SEC didn’t do investors any favors by approving ETFs holding Bitcoin derivatives without allowing ETFs to own spot Bitcoin itself. Futures funds and ETFs are generally not designed as long-term holds for investors. The big reason is that futures expire and must therefore be ‘rolled’ to another contract to keep the investment intact and roll costs can create a significant headwind for a fund. As long as the price for Bitcoin futures in upcoming months is higher than the current price, it will cost to roll the contracts, resulting in fewer contracts after each roll. This will likely be the case most of the time. Investors in volatility funds like iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX) learned a hard lesson about the constant drag on performance of futures contracts that have to be rolled forward every month. This drag is decidedly non-trivial. Other futures funds have seen roll costs of up to 10-20% per year or more. The bottom line is that these are trading instruments and should not be considered long term holds.

A fund’s legal structure can make things worse. For funds using closed end trust structures, they can trade at substantial premiums or discounts. GBTC, for example, is classified as an ETF, but is a closed end trust whose shares trade over the counter. Unlike other ETFs, there is no creation and redemption mechanism that keeps the price of the fund’s shares close to their true NAV. Consequently, Grayscale Bitcoin Trust (GBTC) shares are currently priced at around a 26% discount to their NAV. It can seem on the surface like a bargain to buy a fund at a 26% discount to its assets, but there is nothing that says the discount couldn’t go to 40% and no scheduled exit plan that would redeem shares to holders at NAV. On the other side, if you had purchased GBTC shares when they were at a premium to NAV, you would certainly now be an unhappy camper at the current discount.

Web sites like YCharts.com will tell you whether an ETF is trading at a premium or a discount. Here’s the link for GBTC on the YCharts site.

Stocks of Bitcoin mining companies

While they may be public companies, crypto miners have a business model unlike any other business enterprise, so I separate them from the more conventional public companies described below. Miners essentially exist for a single purpose – to solve the complex algorithms necessary to create Bitcoin or other cryptos. To accomplish this, they operate large computer installations. Their model would make them a logical proxy for Bitcoin in the equity world, since the greater the value of Bitcoin, the greater their profits. But it’s nowhere near that simple. Several issues should be considered regarding miners:

1. Some immediately convert the Bitcoin they produce into cash or produce it for customers, while others stockpile the Bitcoin to gain from future appreciation.
2. Some miners are actually profitable on an operating basis, though most are not.
3. Many are financially leveraged, having raised debt to build their installations.
4. They all use enormous amounts of power, which impacts their costs as well as their reputation.
5. Some have operations outside the US, where regulation and political risks exist. (China banned all miners last year and others had to relocate due to power availability.)
6. If the price of Bitcoin falls below a certain level, they could be immediately unprofitable.
7. Public companies are normally priced for perpetuity, with growth expectations built into their valuations. The mining business model may not be able to grow over the long-term in the same way other public companies can, given the fact that Bitcoin mining is periodically made more difficult by design and there will ultimately be a maximum number of coins minted, which will halt new mining altogether. While miners may still be able to generate revenue for years to come, there are questions about whether their current valuations are sustainable.

ETFs may buy shares of mining companies anywhere in the world, but the five mining company stocks that trade independently on US exchanges are HIVE Blockchain Technologies Ltd. (HIVE), Hut 8 Mining Corp. (HUT), Marathon Digital Holdings, Inc. (MARA), Riot Blockchain, Inc.(RIOT), and now Core Scientific, Inc. (CORZ), which just opened for trading on Jan 20, 2022.

Companies whose businesses or assets relate to Bitcoin or Blockchain

This is where a Bitcoin ETF can dilute its Bitcoin emphasis in a big way. In a typical sector ETF, the portfolio will include an array of stocks deemed to have a substantial part of their business in the selected industry. Classifying Bitcoin-related companies is a lot more challenging. In reality, there are few companies outside of crypto miners whose prospects are directly dependent on the value and use of Bitcoin. Bitcoin ETFs therefore have to stretch their universe somehow.

Some do this by adding companies in electronic payments, banking, or high-end retail, who are sticking a toe in the crypto pond. When they do this, they not only mix the fund’s performance with that of non-related industries, they are also likely picking up stocks with crypto halo in their valuations in the same way the companies with ‘dot-com’ in their name picked up Internet halo in the late 1990s. Halo can inflate stock values as a consequence of hype rather than substance.

Others expand into companies using blockchain technology, which as we know, can have little or nothing to do with Bitcoin.

Then you have complete anomalies like MicroStrategy (MSTR). MSTR is present in some ETFs because it holds a lot of its corporate cash in Bitcoin. But its business (and all its operating profits) are in computer services that have nothing to do with Bitcoin.

Some ETFs are hybrids, mixing their equity investments with Bitcoin futures.

Other Bitcoin Funds

This can be somewhat disconcerting on two levels. First, it suggests that there is ownership overlap, causing the potential for exaggerated price moves and cascading losses. Secondly, if your ETF owns shares in another ETF, you are likely being subjected to management fees from both.

Other Cryptos

Some ETFs focus on Bitcoin only. Others embrace top-selling cryptos beside Bitcoin, and still others might invest in some of the thousands of altcoins. International Securities

Some ETFs are reaching outside the US for Bitcoin plays. The biggest issue here is that both geopolitical and cybersecurity risks are heightened for entities outside the US. China completely banned crypto mining this past year and a number of crypto operations exist in third world countries.

There are currently at least nine Bitcoin ETFs now available on US exchanges:

BITO	Proshares Bitcoin Strategy ETF Bitcoin futures
BTF	Valkyrie Bitcoin Strategy ETF Bitcoin futures
BITQ	Bitwise Crypto Industry Innovators ETF Crypto-related equities designed to track the Bitwise Crypto Innovators 30 Index
BITS	Global X Blockchain & Bitcoin Strategy ETF A hybrid fund investing in both equities, other funds, and Bitcoin futures
DAPP	VanEck Digital Transformation ETF Crypto-related equities
SPBC	Simplify US Equity PLUS GBTC ETF Invests in companies and the Grayscale bitcoin trust
BITW	Bitwise 10 Crypto Index Fund Top 10 cryptos in a partnership-structured trust.
GBTC	Greyscale Bitcoin Trust ETF Bitcoin derivatives in a partnership-structured trust.
XBTF	VanEck Bitcoin Strategy ETF Bitcoin derivatives and other funds

Correlations

Given the disparities among Bitcoin ETFs, it is important to examine each one carefully to see if its structure and holdings suit your objectives. For help in quantifying your analysis, one additional way to size up a Bitcoin ETF is to measure its price correlation with Bitcoin itself, which can be very informative.

I would prefer to look at correlations over a year, but since most of these ETFs were not around that long, I had to settle for 20-day correlations.

	20-day correlation to $BTCUSD	20-day correlation to $SPX
BITO	0.72	0.41
BTF	0.71	0.42
BITQ	0.58	0.63
BITS	0.66	0.51
DAPP	0.60	0.59
SPBC	0.17	0.92
BITW	0.74	0.28
GBTC	0.67	0.51
XBTF	0.66	0.44

Source: Stockcharts.com

Conclusions from this table:

SPBC and BITQ correlated higher with the SPX than with Bitcoin, suggesting that their holdings are more representative of the general market than of Bitcoin. For the rest, correlations to Bitcoin were 58-72%, which is certainly a strong positive correlation, but if you were expecting 80-90% correlations, you aren’t likely to get that. The general direction of these ETFs will mirror the price direction of Bitcoin reasonably well over time, but could be quite different from day to day or even week to week.

Other than SPBC, the remaining ETFs were modestly positive when correlated against the SPX, which says that you can expect them to be sensitive to the broader equity market as well.

Bottom Line

Investors looking to play Bitcoin through publicly traded stocks or ETFs now have more choices but they differ greatly and they shouldn’t be purchased blindly just to satisfy your fear of missing out on the Bitcoin craze. The important thing is to understand what you are buying and to manage your expectation on the degree of correlation with Bitcoin (both risk and opportunity) that you are comfortable with. And that might still mean none of them if you don’t see what you want.