These Aren't the Bitcoin ETFs You're Looking For

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. The first bitcoin futures exchange-traded funds are about to begin trading. Joining me today to discuss these strategies in particular and the prospects for other cryptocurrency-related funds waiting in the wings is Ben Johnson. Ben is Morningstar's global director of ETF research. 

Hi Ben, thank you for being here today.

Ben Johnson: Hi, Susan. Thank you for having me.

Dziubinski: The SEC greenlighted the first futures-based bitcoin ETFs, and there are a few other futures-based bitcoin funds waiting in the wings, but these funds will not be investing directly in bitcoin. Tell us a little bit about these strategies.

Johnson: Well, that's the all-important point here, Susan, is that these bitcoin ETFs are not the bitcoin ETFs that I think many investors are looking for, frankly. They're the bitcoin ETFs that SEC chairman Gary Gensler and his colleagues at the SEC will allow for the time being. And they will allow them almost explicitly, almost exclusively, because they invest not in actual bitcoin, but in bitcoin futures. And as opposed to actual bitcoin, bitcoin futures are already an established financial product that are regulated, that are traded on an exchange, that have more there, there, if you will, than underlying bitcoin, which is an area of the market where in all its many comments on the various filings for bitcoin ETFs, be they futures-based or chiefly physical, the SEC has really raised fundamental concerns with respect to chiefly fraud in market manipulation. The SEC's concerns as it pertains to bitcoin futures ETFs are clearly far fewer, given that they didn't so much greenlight these ETFs as they didn't give them a red light.

Dziubinski: Despite the obvious risks of investing in something as volatile as bitcoin, what are the other risks that investors need to be aware of when they're investing in these futures-based strategies?

Johnson: Well, let's not for a moment let the primary risk here be set aside, which is that bitcoin is an immensely volatile asset class. It's still very new. It's still very unclear what is sort of the fundamental story there that drives its value. The narrative around why bitcoin is worth anything at all has really shifted. But it's gotten to the point where enough people have believed that it's worth something for long enough to give it a significant amount of value. As it stands today, its total market cap, if you want to use that term, is in excess of a trillion dollars. So, the fundamental risk here still, the big risk, capital R risk, is the risk of bitcoin itself. The volatility, and frankly, the behavioral issues that that might present. Investors historically have had a very difficult relationship with volatile assets buying exactly at the wrong time often, and often selling at exactly the wrong time.

Now, secondary to that--and secondary I would say by a mile--has everything to do with the fact that these ETFs will invest, again, in bitcoin futures and not actual bitcoin. So, by virtue of investing in actual bitcoin futures, what you see is that there are some issues most notably related to maintaining that exposure. It's the intention of most of these ETFs to invest in the front-month futures contract. That front-month futures contract, like any futures contract, is going to expire. And when that futures contract expires, the funds will have to invest in another month's futures contract, and they have a bit of latitude as to how they allocate across a variety of different bitcoin futures contracts. And what can happen in the process is that if that next futures contract, or those next futures contracts, are trading at prices that are above the ones that the fund currently owns, they will be in effect systematically selling low and buying high.

Now, in futures markets, the shape of that curve is often known as contango, which is not a dance, but a way to lose money by trying to maintain exposure to an underlying commodity, or bitcoin in this instance, by virtue of investing in it through regularly rolling futures contracts. And it's something that, depending on the shape of the futures curve, so if it particularly steep can be particularly costly. And indeed, we've seen this movie before with oil futures contracts, natural gas futures contracts, and the ETFs that have offered investors exposure to those underlying commodities.

The other risk investors should be aware of is tax risk. Unlike traditional ETFs, these ETFs are going to deal chiefly in cash. They're not going to be bringing in futures contracts on an in-kind basis, sending them out the back door on an in-kind basis, they're going to be dealing in cash. So, there could potentially be tax costs to be cognizant of as well that investors will absorb potentially, irrespective of whether or not they're buying and selling these funds themselves.

Another very important risk that investors in a bitcoin futures ETF need to be aware of is that there is a strict limit on the amount of any given futures contract that these funds can own. Now, if these funds were to gather enough assets such that they would bump up against these limits, there is the risk that they would actually have to suspend new share issuance. So, they would have to close their doors to new investors. And what would happen as a result, in all likelihood, is that these ETFs prices could trade at a significant premium to their underlying net asset value, which isn't a good situation for anyone involved in, and certainly not investors, at least not those that are trying to liquidate to try to capitalize on that temporary premium.

Now, if this all sounds very familiar, it's a scenario that we've seen play out historically with those ETFs that also access underlying markets via futures, most notably and most recently with USO, the United States Oil Fund, which uses futures contracts to tap into oil markets.

Dziubinski: And then, Ben, who are some of the asset managers behind these futures-focused bitcoin ETFs?

Johnson: If you look at the litany of asset managers that have filed for bitcoin ETFs, the first out of the gate is going to be ProShares with their bitcoin strategy ETF. The ticker for that fund is going to be BITO. That is going to launch as we sit here today, tomorrow, Tuesday, Oct. 19. Now there are others that may follow soon behind, including Valkyrie, Invesco, VanEck, and others that are still further down the path. I would not be surprised that a month or two months from now we see a minimum of a half dozen different bitcoin futures-based ETFs out there on the market competing for investors assets.

Dziubinski: Now that the SEC has approved these futures-based bitcoin ETFs, what does that mean for other types of crypto strategies awaiting approval on that ETF wrapper?

Johnson: Now that the SEC has let bitcoin futures ETFs pass, I think the question on many minds is when might the SEC allow for bitcoin ETFs that invest directly in bitcoin itself to see the light of day. I'm not about to make a guess there. My best guess is that the SEC probably feels that it's bought itself a sufficient amount of time to give that can a good firm kick further down the road. In the meanwhile, the SEC is going to have any number of different asset managers knocking on its door making the case for an ETF that invests directly in underlying bitcoin. Most recently and most notably was Bitwise Asset Management, which pushed across a 100-plus page research document further trying to bolster the case for an ETF that would directly invest in underlying bitcoin. Frankly, I think that's the ETF that most investors want. Frankly, whether or not you believe bitcoin is a good investment, I think it would be a superior offering to what we've got coming here imminently, which is these ETFs that invest in not bitcoin, but bitcoin futures.

Dziubinski: Well Ben, thank you so much for your perspective today on these new breed of ETFs that we're going to be seeing tomorrow, it looks like. Thanks for your time.

Johnson: Thanks again for having me, Susan.

Dziubinski: I'm Susan Dziubinski. Thanks for tuning in.