MicroStrategy has turned into a bitcoin buying machine. Photo: Liam Kennedy/Bloomberg News
Investors have flocked to a pair of turbocharged exchange-traded funds to ride the momentum in bitcoin, but they contain hidden risks that aren't widely understood.
The ETFs seek to amplify the daily return of MicroStrategy, the software company that has turned itself into a bitcoin buying machine. Using complex derivative bets, they aim to offer double the daily return of the stock -- to the upside or downside.
The funds, from asset managers Tuttle Capital Management and Defiance ETFs, are inherently risky. MicroStrategy itself is a leveraged bet on bitcoin, holding some $35 billion of the cryptocurrency. But bullish investors have swelled its market value to almost $90 billion, or more than twice the value of the bitcoin it holds. Skeptics say this is unsustainable.
The Defiance Daily Target 2X Long MSTR ETF and the T-Rex 2X Long MSTR Daily Target ETF were designed for investors who want to place an even more aggressive bet on the stock. Collectively the two funds have ballooned to roughly $5 billion in assets since launching in August and September respectively.
Some analysts say the funds are contributing to the furious rally in MicroStrategy shares. They warn that if the stock were to drop 51% in a single day, the ETFs could be completely wiped out, a blowup similar to what happened with some volatility-linked ETFs after the 2018 market episode dubbed Volmageddon.
On top of that, the two 2X ETFs haven't been working as intended in recent days. MicroStrategy shares rose 9.9% Wednesday, but the T-Rex fund rose just 13.9%, instead of the 19.8% target. The fund's performance disappointed when the stock declined, too. Its share price dropped 10.7% on Nov. 25 when MicroStrategy fell 4.4%.
The performance caused an uproar among investors on social media who questioned the discrepancy and said they felt cheated.
Jesse Schwartz, a 36-year-old winemaker and day trader in Washington state, has been using the funds as a tool to amplify his exposure to the stock.
He was surprised to see the shares weren't performing as advertised. Schwartz called his broker, Charles Schwab, to ask about the discrepancy and wasn't satisfied with the explanation. He sold all of his shares by the end of the week.
"It's disappointing to say the least," Schwartz said. "I'm getting more than the full risk to the downside and then not getting rewarded on the upside."
Niche fund managers have launched dozens of single-stock ETFs since they were first approved by regulators in 2022. Until this point, the funds have largely worked as advertised. Popular funds that aim to double the daily return of Nvidia and Tesla tend to track closely to their target, thanks to their use of financial contracts known as total return swaps.
Proponents of the funds say they give regular investors access to strategies long used by Wall Street. Critics argue they can be dangerous because they don't offer diversification. In the case of the MicroStrategy funds, they add leveraged exposure to a volatile stock that moves in relation to an unpredictable cryptocurrency. They warn the hype is part of a broader investor euphoria for speculative assets that will eventually collapse.
MicroStrategy holds some $35 billion of bitcoin. Photo: Kevin Sikorsky
The managers of the MicroStrategy funds say they might be struggling to hit the 2x targets because their prime brokers -- firms that provide securities lending and other services to professional investors -- have reached the limit of the swap exposure they are willing to offer.
Leveraged ETFs typically achieve their desired result through the use of swaps, which are widely available for the biggest, most liquid stocks. Swap contract payments are tied directly to the performance of an underlying asset and allow a fund to double the daily performance of a stock or index with precision.
Matt Tuttle, who runs the Tuttle Capital and Rex Shares 2x long MicroStrategy fund, said he can't get anywhere close to the amount of swaps he needs for his booming fund. He says his prime brokers are offering him $20 million to $50 million in swaps when at one point last week he could have used $1.3 billion.
Both Tuttle and Sylvia Jablonski, the chief executive of competitor Defiance ETFs, said they are turning to the options market instead to achieve leveraged outcomes for their MicroStrategy funds. Traders can effectively use options to double the daily return of an asset, but analysts say it is more of an inexact science. Options prices fluctuate, and big buyers like the ETFs can move the market.
The use of options is the primary reason tracking has worsened, Tuttle said.
The Defiance ETF dropped nearly three times as much as the underlying stock on Nov. 25. On Friday, it fell 1.76% when MicroStrategy was down just 0.35%.
Analysts say the introduction of the leveraged MicroStrategy ETFs has accelerated moves in the stock. The ETFs have to increase or decrease their exposure every day to achieve a leveraged outcome. The network of market makers offering swaps and options often buys or sells actual MicroStrategy shares to hedge their exposure.
"It's like putting a lead weight on your foot when you're driving a car. You can still deal with the gas, but the default mode is going to be floored," said Dave Nadig, an ETF industry veteran formerly at VettaFi and FactSet.
Comments