Gaining exposure to bitcoin through a Futures ETF comes with significant drawbacks. Here’s what advisors need to know.:
Estimated reading time: 10 minutes
Summary:
Gaining exposure to bitcoin through a Bitcoin Futures ETF comes with significant drawbacks in comparison to direct ownership:
- There is a significant risk that a Bitcoin Futures ETF will underperform direct bitcoin ownership because of the high premium at which futures trade relative to the current price of bitcoin
- The bitcoin futures market is small compared to other established futures markets, which may result in even greater underperformance due to the market impact of a Bitcoin Futures ETF
- The tax treatment of a Bitcoin Futures ETF is substantially different from that of direct ownership
Direct ownership of bitcoin is a more efficient way of gaining exposure to this new asset class compared to a Bitcoin Futures ETF. With tens of millions of Americans already investing directly, advisors should carefully consider whether a significantly less efficient form of access makes sense for their clients—particularly with the emergence of direct ownership solutions built for RIAs.
Introduction
On Friday, October 15, the SEC approved the first Bitcoin Futures ETF,1 coinciding with the price of bitcoin exceeding $60,000 for the second time in history. While the approval of a Bitcoin Futures ETF is an important moment for the cryptocurrency industry, we believe that futures are an inefficient way for advisors and their clients to gain exposure to bitcoin—particularly with the introduction of more efficient direct ownership solutions built for RIAs, such as Flourish Crypto.2
All else equal, advisors virtually always prefer direct ownership of any asset class over indirect ownership through futures. After all, it is unheard of for an advisor to invest in an S&P 500 futures fund if they are looking for exposure to the S&P 500—and bitcoin is no different.
When do futures make sense? Investors might reasonably prefer to access commodities like crude oil or lean hogs via futures, since the alternative of renting an oil tanker or a pig farm is likely out of the question. As a fully digital asset, however, bitcoin falls squarely in the category of assets that can be held directly.
Here’s what advisors need to know about Bitcoin Futures ETFs.
How will a Bitcoin Futures ETF work?
A futures contract is an agreement traded on an exchange to buy or sell assets (such as commodities or shares) at a fixed price, to be paid for and delivered at a later date.3 For every futures contract buyer there must be a futures contract seller.
A futures ETF does not take possession of the underlying asset; instead the ETF purchases and holds a number of futures contracts. Since all futures contracts eventually expire, in order to maintain price exposure, the ETF must periodically sell futures contracts before expiration (or hold them to expiration) and simultaneously replace the sold (or expired) contracts by buying new contracts that have a longer dated expiration. This process is commonly referred to as “rolling.”
A Bitcoin Futures ETF uses cash-settled bitcoin futures to gain exposure to bitcoin. The first approved Bitcoin Futures ETFs will purchase futures contracts traded on the Chicago Mercantile Exchange (CME); the fund “does not invest directly in bitcoin.”1
What are potential drawbacks of a Bitcoin Futures ETF?
1) Underperformance due to contango
Using futures to gain bitcoin exposure can lead to significant underperformance compared with holding bitcoin directly. This underperformance is often attributed to “contango,” which occurs when the price of futures contracts is higher than the current price of the underlying asset.4 To illustrate this simply, if futures are in contango, an investor will lose money if they hold a futures contract to expiration and the underlying asset doesn’t sufficiently increase in price by the time the contract expires. Contango is particularly common with anticipated future price increases and limited capacity.
Bitcoin futures are currently in contango. If this condition persists, when a bitcoin ETF buys a bitcoin future, it will be buying at a price that is higher than the then-current price of bitcoin (known as the “spot price”). As the futures contract approaches expiration, the futures price will generally converge towards the bitcoin spot price until, at expiration, it is equal to the price of bitcoin at the time of expiration. This drop in price is called “negative roll yield,” and can result in negative performance relative to the performance of the underlying asset itself; in fact, it can even result in the strategy losing money even when the underlying spot price has increased. As noted by SEC staff, “a rise in Bitcoin prices may not result in a similar increase in the value of a fund holding positions in Bitcoin futures contracts.”5
This risk isn’t just hypothetical. As of October 15, 2021, the October 2021 futures contract settled 3.4% higher than the spot bitcoin price,6meaning an investor who purchased that contract would lose 3.4% in 17 days if they held the contract to expiration and the price of bitcoin did not change. A fund that invests primarily in front-month bitcoin futures contracts (i.e., contracts with the shortest time to maturity) must roll its futures position to the next contract every month, so this negative roll yield can add up throughout the year (if the same underlying conditions persist). While it is impossible to predict how both spot and futures pricing may change going forward, it is readily apparent that premiums of this magnitude can create a significant drag on returns to a futures investment strategy going forward in comparison to spot ownership.
If a Bitcoin Futures ETF increases demand for futures even further, the premium on futures prices could increase further, which could increase this negative drag.
