Basics of Bitcoin and ETFs
To learn what bitcoin ETFs are all about, it’s important to know some basic bitcoin terminology and also understand the concept of exchange-traded funds (ETFs). We can define these concepts as follows.
- Bitcoin is a digital currency that is exchanged and transferred on the peer-to-peer bitcoin network. Since the currency exists beyond the control of any one person, group or entity, it eliminates the need for third-party involvement in financial transactions.
Individual bitcoins are created, exchanged and stored using an encrypted, decentralized ledger system (essentially a shared database) known as a blockchain. All bitcoins have distinct records of authenticity and chain-of-ownership, which, theoretically, prevents them from being mishandled or stolen. Once data is added to the blockchain, it cannot be changed or deleted. While the supply of bitcoin is finite, units are still being created and rewarded to blockchain miners that are able to successfully verify transactions.
- Exchange-traded funds (ETFs) are pooled investment vehicles that offer diversified access to an asset or a group of assets. Like mutuals funds, ETFs are sponsored by some of the largest, most reputable investment companies in the world. But unlike mutual funds, ETFs are traded like stocks and can be bought and sold throughout the day at fluctuating market prices.
Most ETFs are designed to be very low in cost and passively managed, tracking well-known indexes such as the Standard & Poor’s 500 index (S&P 500) or the Bloomberg U.S. Aggregate Bond Index. However, as the popularity of ETFs continues to grow, the vehicles are being structured in newer, more exotic ways — often using leverage- or options-based investing strategies.
What Are Bitcoin ETFs?
This brings us to the concept of a bitcoin ETF, which is an ETF made up of either bitcoin or assets that are closely related to the value of bitcoin. Unlike actual bitcoin, which is traded on specialized cryptocurrency exchanges, bitcoin ETFs are traded on traditional securities exchanges such as the New York Stock Exchange or the Nasdaq stock market.
Bitcoin ETFs are designed to make bitcoin much more accessible to the average investor, while also providing a high degree of liquidity and transparency. The funds allow you to gain exposure to bitcoin at a much lower cost than you’d pay if you were to buy the currency directly. Bitcoin ETFs also allow you to avoid the security hassles associated with cryptocurrency exchanges.
As of today, the U.S. Securities and Exchange Commission (SEC) has maintained a highly skeptical view of bitcoin and other cryptocurrencies, which has led to the rejection of many proposals to create new cryptocurrency ETFs. As a result, there are currently no cryptocurrency ETFs or bitcoin ETFs that directly represent an underlying coin. Instead, bitcoin ETFs have exposure to cryptocurrency through investments in futures contracts and companies that conduct bitcoin-related activities. We’ll explain more about this process next.
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How Do Bitcoin ETFs Work?
Generally, a standard ETF works in the following way, which is very similar to how a bitcoin ETF works:
- The sponsoring company establishes the ETF and buys the underlying assets it is designed to represent.
- Next, the ETF enters into contracts with large broker-dealers who act as authorized dealers for the fund.
- The authorized dealers then purchase large blocks of shares directly from the ETF and subsequently sell them to institutional and retail investors on a public stock exchange.
- In most cases, the shares are traded freely by investors within a price range that approximates the underlying value of the fund’s assets. However, imbalances between supply and demand can lead to erratic price swings.
- If sell orders outweigh buy orders, the dealers step in to handle the transactions.
- If the dealers’ inventories of ETF shares grow too large, they can redeem shares with the ETF, which will then trigger a sale of underlying assets.
The process would work the same way with a pure bitcoin ETF, if it existed. A pure bitcoin ETF would purchase and hold bitcoin and then offer fractionalized claims to it through the creation of publicly traded shares.
However, as noted before, the SEC has not yet approved an ETF that is directly backed by bitcoin, but it has approved bitcoin-linked ETFs. The first and largest bitcoin-linked ETF available to investors is the ProShares Bitcoin Strategy ETF (BITO).
A Deeper Dive Into the BITO Bitcoin ETF
Launched by ProShares in October 2021, the ProShares Bitcoin Strategy ETF (BITO) trades on the New York Stock Exchange and derives its value largely from futures contracts traded on the Chicago Mercantile Exchange (CME).
A futures contract is a standardized contract where two parties agree to exchange a specific quantity of an asset on a stated future date at a specified price.
BITO’s fund managers buy positions in one-month CME bitcoin futures contracts. As the contracts approach their expiration, the fund sells them and buys longer-dated contracts. As the price of bitcoin rises, BITO’s price appreciates, and its base of assets expands. As the price of bitcoin falls, BITO experiences price depreciation, and its base of assets contracts.
That said, the fund invests in futures contracts only when such positions are expected to be profitable. In addition to futures contracts, BITO invests in U.S. Treasury bills, which means that the performance of BITO does not perfectly replicate that of bitcoin. Fund management fees and technical differences between the futures market and the spot market also introduce additional tracking errors.
BITO has a market value of nearly $1 billion and an annual expense ratio of 0.95%, which is higher than most ETFs.
Other Bitcoin ETFs and Their Pros and Cons
In addition to BITO, a few other futures-based bitcoin ETFs are traded in the United States. The next largest funds in the market are the Valkyrie Bitcoin Strategy ETF (BTF) and the VanEck Bitcoin Strategy ETF (XBTF). The Valkyrie Bitcoin Strategy ETF has assets totaling about $40 million and an annual expense ratio of 0.95%, while the VanEck Bitcoin Strategy ETF has assets around $26 million and an annual expense ratio of 0.65%. Both funds were launched in the fourth quarter of 2021.
A handful of additional bitcoin ETFs are designed to invest in the common stocks of companies focused on promoting and trading bitcoin. Listed in order of market size, three notable funds are described below.
- Simplify U.S. Equity PLUS GBTC ETF (SPBC)
- This $100 million fund invests predominantly in the S&P 500 and allows for up to 15% of its assets to be invested in bitcoin-related companies. Launched in May 2021, the fund has an annual expense ratio of 0.74%.
- Global X Blockchain & Bitcoin Strategy ETF (BITS)
- Launched in November 2021, this $13 million fund invests in a combination of bitcoin futures and blockchain-related companies. It has an annual expense ratio of 0.65%.
- Valkyrie Balance Sheet Opportunities ETF (VBB)
- Launched in December 2021, this nearly $1 million fund invests at least 80% of its assets in companies that are holding bitcoin on their balance sheets. The remainder is invested in bitcoin-related companies. It has an annual expense ratio of 0.75%.
Owning Bitcoin vs. Bitcoin ETFs
As covered previously, there are various ways you can gain exposure to bitcoin in an investment strategy. Essentially, the three ways can be summarized as follows.
- You can buy bitcoin directly via a cryptocurrency exchange. This is the purest way to gain exposure to bitcoin, but you’ll need to be comfortable with bitcoin’s potentially hard-to-understand technology and relatively imperfect security measures.
- You can enter into a bitcoin futures contract or a micro bitcoin futures contract. This option is very similar to buying bitcoin directly, but the nuances of the futures market introduce some tracking error. With five bitcoins per futures contract, the minimum amount of money you’ll have to invest will be significant. The use of margin reduces your outlay, but it also magnifies your risk. A micro futures contract can be established for 1/50th of the cost of a regular futures contract.
- You can purchase a bitcoin ETF that is either based on futures contracts or companies conducting bitcoin-related activities. This is the most accessible way for everyday investors to invest in bitcoin. Your monetary outlays are minimal, and you’ll have a high degree of liquidity. However, aggregate fees may be higher than those associated with buying bitcoin directly or entering into a bitcoin futures contract.
Which Type of Bitcoin Investment Is Right For You?
As suggested above, unless you’re an institutional investor or a high-net-worth individual with lots of capital to invest, the easiest way to put your money in bitcoin is with a bitcoin ETF. The chart below compares the most common bitcoin investment options.
| Key Features | Direct Ownership | Future Contacts | ETF Ownership |
|---|---|---|---|
| Storage & Security Measures | You must purchase bitcoin via a cryptocurrency exchange, and your holdings must be safeguarded with a security key. The exchange may offer to store the key for you, but it can be lost, hacked, or stolen. | No special storage or security measures exist. Futures contracts are highly regulated, like other financial derivatives. | No special storage or security measures exist. ETFs are highly regulated, like other publicly traded financial securities. |
| Fees | Generally, cryptocurrency exchange charge fees to buy and sell bitcoin, but they typically do not levy ongoing management fees. | Brokerages charge commissions for placing future trades. This compensates them for handling downstream administrative matters with the future exchange. | Some brokerages charge commissions for ETF trades, but this is growing increasingly uncommon. ETF sponsors charge ongoing management fees. |
| Liquidity | Bitcoin can be traded fairly easily at any time across the globe. However, it is not as liquid as traditional investments, given it comparatively limited adoption. | Futures contracts aren’t generally traded following establishment. Rather, contracts are closed-out prior to expiry by establishing an offsetting contracts. | ETFs trade just like stocks. Generally, they are highly liquid, but they can impacted by supply and demand imbalances. |
| Leverage | Leverage isn’t an inherent aspect of directly investing in bitcoin. | The use of leverage can greatly magnify losses. | Leverage isn’t an inherent aspect of investing in a bitcoin ETF. However, with margin brokerage accounts, ETFs can be brought using borrowed money. |
How Do You Purchase Bitcoin ETFs?
If your brokerage firm offers them, you can purchase bitcoin ETFs through your broker or financial advisor. All of the ETFs mentioned in this article are available from the leading online brokerage firms, which include Charles Schwab, E-Trade and Fidelity Investments. These brokerage firms will facilitate your trade, maintain pertinent records and safeguard your investment.
Investing in bitcoin directly is not as straightforward. You must purchase bitcoin on a cryptocurrency exchange, and your holdings must be safeguarded with a security key. The cryptocurrency exchange may offer to store the security key for you, but this can be lost, hacked or stolen.
Bitcoin ETF positions can be easily established within existing individual retirement accounts (IRAs). However, to hold bitcoin in an IRA, you must establish a new account specifically designed to house cryptocurrency.
Closing Thoughts
Bitcoin is a headline-grabbing asset that has made some lucky enthusiasts rich beyond their wildest dreams. With a market capitalization of $425.66 billion in mid-September 2022, bitcoin appears to be firmly entrenched in our economy despite dropping from a high of $1.3 trillion reached in November 2021.
- That said, smart investors should tread lightly when thinking about investing in bitcoin, whether directly or indirectly. Bitcoin is a highly volatile asset, and it does not provide a reliable store of value — as evidenced by a string of boom-and-bust cycles over its relatively short existence.
Buying bitcoin with the hope of achieving triple- or even quadruple-digit price returns is not realistic. However, if you’re looking to diversify your portfolio, investing in bitcoin could serve you well. The asset is largely uncorrelated with traditional investments. As a result, establishing a small allocation, say 5% to 10%, could improve risk-adjusted performance.
