Bitcoin ETF’s Success Could Come at Fundholders’ Expense

By October 24, 2021Bitcoin Business
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There are signs that the bitcoin futures market isn’t big enough for a planned wave of crypto exchange-traded funds.

Since launching Tuesday, the ProShares Bitcoin Strategy ETF has amassed $1.2 billion in investor assets, the quickest billion-dollar fundraising on record.

But that success is almost certain to come at fundholders’ expense, analysts say, because the gains make the ProShares ETF an outsize target for traders who seek to exploit futures-based ETFs’ Achilles’ heel: their need to take large positions in near-term futures and frequently “roll” them into the following month, rather than taking cash at expiration.

The ProShares ETF, which buys bitcoin futures contracts rather than the cryptocurrency itself, now controls more than a fifth of outstanding bitcoin futures contracts expiring this month and nearly a third of next month’s. The scale of those holdings will pressure returns of the futures-based ETFs that have been launched and slow the pace of further introductions, analysts said.

“For us, it creates more trading opportunities,” said James Koutoulas, chief executive of Typhon Capital Management, a nearly $200 million hedge fund that trades futures, including bitcoin.

ProShares says its fund offers investors an opportunity to gain exposure to bitcoin. To maintain that exposure, ProShares takes investors’ cash from ETF purchases and uses some of it to buy bitcoin futures, primarily the closest month’s futures contract, since that typically offers the closest correlation to the cryptocurrency’s spot price.

That is when it gets complicated. When the contract expires, the fund must roll its existing contracts into next month’s. Other investors know this, so they buy the next month’s futures first—an act that drives up the price and allows traders to profit by selling into the demand created when the fund rolls. The higher price that the fund pays comes out of investors’ pockets.

“It can cost you a lot of money to roll your bitcoin futures,” said Francisco Blanch, an analyst at Bank of America. “There’s an element of traders taking advantage of it, and an investor potentially losing out.”

Another wrinkle: Position limits imposed by CME Group Inc. have already led ProShares to invest into the next month, analysts said—a decision that could reduce the stress of rolling this month’s contracts into the next one but that risks expanding the gap between the fund’s performance and bitcoin’s. Those limits double next month, potentially somewhat alleviating that issue.

“This is an evolving market,” said ProShares Chief Executive Michael Sapir. “We expect the market to continue to grow on both sides of the trade and become more and more efficient.”

In its prospectus, the fund highlights the lack of liquidity in the bitcoin futures market, adding that large positions increase the risk of illiquidity, might make positions more difficult to sell and may affect the price of bitcoin futures. Doing so “may increase the losses incurred,” the prospectus added.

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The price of the ProShares ETF declined 1.2% between the 9:30 a.m. market opening on Tuesday, its first trading day, and Friday’s 4 p.m. close. Bitcoin fell 2.4% over the same span.

Asset managers and futures traders say the prospect of other ETFs buying the same contracts stands to exacerbate the problem. The Valkyrie Bitcoin Strategy ETF that was launched Friday will ultimately push roll costs higher and hit performance at both funds, analysts added.

One of the biggest ETF issuers in the country, Invesco Ltd. IVZ 0.48% , has already said it is backing off for now from following ProShares with its own bitcoin futures ETF. The firm didn’t elaborate on the decision, but people familiar with the matter said capacity issues within the bitcoin futures market were a factor.

Over the past year, the annualized roll yield on bitcoin futures—reflecting the gap between the front-month futures and bitcoin’s price—has averaged 8.4%, said Charlie Morris, founder and chief investment officer of ByteTree Asset Management.

That means an investor in a futures ETF would net $91.60 annually before fees for every $100 in gains made by bitcoin. The gap stands to widen with volatility, which has picked up recently following large price gains in bitcoin. Annualized roll yield was as high as 17% Thursday, he added—meaning investors in a futures-based fund would net $83 for every $100 in bitcoin gains.

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That isn’t unprecedented. A popular ETF known as the United States Oil Fund, known as USO, has grown so big that it often controls a significant portion of the most-active oil-futures contracts. Though that market is much deeper and more liquid than the futures market for bitcoin, oil traders routinely came to buy the next-month futures before USO could, a practice known as front-running that had the effect of increasing the costs that the fund paid for its futures and punishing returns for the fund’s investors.

This isn’t an isolated issue. Over the past 10 years, USO has lost nearly 80% of its value, while crude-oil prices have risen and fallen sharply but ended essentially where they started.

Unlike USO, the funds run by ProShares and Valkyrie are both actively managed, giving fund managers greater latitude and potentially limiting the impact of the front-running trades. “Our objective is to reduce any possibility of friction there might be in carrying out the roll,” said ProShares’ Mr. Sapir.

Still, both ETFs publish their daily holdings, just like USO and most other ETFs, allowing traders a clear line of sight into how they are positioned.

“It’s like poker,” said Mr. Koutoulas of Typhon Capital Management. “You lose an edge when the whole market knows your position.”

Write to Michael Wursthorn at Michael.Wursthorn@wsj.com

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