The popularity of bets on Bitcoin-buying giant MicroStrategy is causing rare growing pains in one corner of the $15 trillion global exchange-traded fund industry.
The rapid growth of the ETF sector (with assets surging 30% in the past year alone) has so far caused few structural problems, with the majority of funds working perfectly as planned.
But investors in two leveraged U.S.-listed MicroStrategy ETFs are targeting double the daily return of the popular software company, which has raised about $20 billion from investors to buy Bitcoin this year. However, in many cases they have received significantly different returns than they expected. Expected in recent weeks.
For example, on Nov. 21, the Tyrannosaurus 2x Long MSTR Daily Target ETF (MSTU) fell 25.3%, according to FactSet data. That may sound bad, but given that MicroStrategy fell more than 16 percent on the day, the actual decline was 7 percentage points smaller than expected.
This was a partial reprieve for investors, but some days they suffered losses. For example, on Nov. 25, MSTU fell 11.3 percent, according to FactSet data. On this day, MicroStrategy was only supposed to be down 4.4 percent and MSTU was only supposed to be down 8.7 percent.
Its rival fund, the Defiance ETF Daily Target 2x Long MSTR ETF (MSTX), also showed significant tracking errors on certain days, the most notable of which was November 25th, when it received a 13.4 %, which was 4.7 percentage points higher than the original value. I have it.
As the first graph shows, both MSTX and MSTU, launched in August and September respectively, tracked their expected returns fairly accurately until mid-November, after which they experienced significant tracking errors. I snuck in.
The central problem appears to be that the size of these ETFs has increased to take advantage of the growing enthusiasm for Bitcoin since Donald Trump’s presidential election victory.
MicroStrategy is a strategy that leverages Bitcoin. Given that the company is the world’s largest corporate owner of Bitcoin, and its debt-powered $43 billion stash of cryptocurrencies has contributed to a 430% rise in its stock price this year.
Enthusiasm for leveraged play in volatile cryptocurrencies led to a flurry of buying, with MSTU’s daily assets in the range of $2 billion to $3 billion, and MSTX around the same size.
This appears to have exceeded the supply of total return swaps that ETF prime brokers are willing to offer. These swaps involve the broker paying the exact daily return of the asset in exchange for a commission and provide highly accurate tracking.
For this reason, we have also introduced a call option. This gives the buyer the right to purchase an asset at a specific price within a specific time period, but this does not necessarily closely track the desired exposure.
Tuttle Capital Management, MSTU’s advisor and portfolio manager, declined to comment, but Sylvia Jablonski, chief executive officer of Defiance ETF, told the FT that MSTX has used a mix of swaps and options since its inception. “We use the most efficient products,” he said. to achieve target leverage. ”
“It’s not necessarily true that options are less trackable than swaps,” Jablonski argued.
However, some people disagree. “Swaps are good, even one-for-one,” said Elizabeth Kashner, director of global funds analysis at FactSet and a former options trader. The greater the volatility, the more imperfectly the option hedge. ”
Dave Mazza, CEO of Round Hill Investments, a rival issuer of ETFs that include the leveraged Magnificent Seven Fund and covered call strategies that also use derivatives, said the issue is that the MSTU We believe this is due to the large scale of MSTX.
“This is not an ‘ETF’ issue or a ‘leveraged ETF’ issue. This is a MicroStrategy ETF issue,” Mazza argued.
“These two ETFs indirectly own exposure equal to more than 10 percent of MicroStrategy’s market capitalization, something we have never seen before in a leveraged ETF, let alone a traditional ETF. ”
“Simply put, MicroStrategy is too small a company to support the AUM and volume of these products. At this point, these ETFs have already reached their ‘breaking point’.”
Mazza also attributed the increase in the level of risk inherent in volatile stocks such as MicroStrategy.
“If a leveraged fund is unable to achieve 2x exposure through swaps, it indicates that the trading community views accumulating additional swap exposure for the fund as a poor risk-reward decision,” he said. “
“Long options are a much less precise tool for achieving exposure, but they are also a tool that does not require the counterparty to bear credit risk to the fund. It could happen, but to our knowledge it doesn’t because most are index-based or focused on larger-cap securities.
Kenneth Lamont, Morningstar’s head of research, hinted that two previous issues in the ETF landscape similarly revolved around size. Last year, Leverage Shares was unable to generate full leverage for its popular 3x Tesla ETP for a short period of time because it was unable to borrow enough funds to purchase the necessary shares.
Two years ago, BlackRock was forced to switch the underlying index of its iShares Global Clean Energy ETF (ICLN) to a broader index due to a surge in assets, forcing a fundamental overhaul of its portfolio. Ta.
Lamont said MicroStrategy-related failures were “more about engine wander than wheels falling off.”
Still, he added, “I hope that incidents like this will improve future products, send a warning to other players in the industry, and perhaps make things better for everyone.”
If the ETF’s rapid growth causes problems in the future, “that means the ETF was not well-built for success,” Lamont added.
But Kashner proposed one simple solution to the problem. That said, even though it’s not recommended by the U.S. Securities and Exchange Commission, these ETFs may only end up creating new units each time their swap line is completely exhausted.
“If they choose to move closer to creation, they will track perfectly. At that point, they will act more like a closed-end fund,” Kashner said, adding that this is due to stock price and net worth. This means that values do not necessarily match.
“The fund companies, T-Rex and Defiance, are forced to make a choice, but it is a suboptimal choice. They can limit their growth, they can live with limited precision, but this So far they have chosen to prioritize growth over precision,” Kashner added.