Bitcoin is fast becoming a mainstream alternative investment to stocks and bonds, and there are now a variety of ways to invest in Bitcoin.

The Major Drawback of Buying Bitcoin Itself

Many will prefer to invest in Bitcoin directly by holding Bitcoin itself. There are reputable exchanges like Coinbase, FTX, and Gemini where you can buy Bitcoin. However, you will be charged small fees and many experts recommend holding your own Bitcoin in an offline, cold wallet rather than with the exchange itself (many exchanges have been hacked and millions of dollars of bitcoins stolen). There is a small learning curve to handling digital assets, but anyone who puts forward the effort can quickly learn.

The main drawback to buying Bitcoin itself is that you cannot hold Bitcoin in a tax-sheltered retirement account like a Roth IRA.

Hence, if you want to profit from Bitcoin’s rise in a Roth IRA, you will have to explore other options such as various types of “Bitcoin ETFs.”

Three Types of “Bitcoin ETFs”

The most popular way of investing in Bitcoin in a retirement account is through exchange-traded funds (ETFs). There are three types of “Bitcoin ETFs”:

(1) An ETF that directly holds bitcoin

The United States Securities and Exchange Commission (SEC) has not yet approved an ETF that directly holds Bitcoin itself, but there are many European and Canadian ETFs that directly hold bitcoin.

Any fund that directly holds Bitcoin has issues with the custody of the bitcoins: What if the custodian is hacked? Where will physical, offline cold wallets be stored and what if they are stolen? What sort of insurance does the custodian have?

There is also the problem of market manipulation, fraud, and illegal activity on the bitcoin exchanges that operate outside of the United States. The SEC will likely not approve a direct Bitcoin ETF until these issues are adequately addressed.

(2) An ETF that holds bitcoin futures contracts

This type of ETF trades commodity futures contracts on Bitcoin. A futures contract is a financial derivative that derives its value from the underlying asset. The contract forms a legal agreement to buy or sell a commodity at a predetermined price at a specified time in the future (the expiration date). Depending on market conditions, futures contracts may reasonably well track the price of the underlying asset. In the current Bitcoin market environment, Bitcoin futures contracts have tended to underperform Bitcoin itself and thus poorly track the price of Bitcoin.

As of February 2022, the SEC has approved three Bitcoin futures ETFs: the ProShares Bitcoin Strategy ETF (BITO), the Valkyrie Bitcoin Strategy ETF (BTF), and the VanEck Bitcoin Strategy ETF (XBTF). ProShares and Valkyrie have a 25% allocation to Bitcoin futures contracts and a 75% allocation to other money-market instruments such as U.S. Treasury Bills. VanEck is unclear on its exact breakdown of holdings. ProShares and Valkyrie have a 0.95% management fee, while VanEck has a 0.65% management fee.

All three funds trade on the highly regulated Chicago Mercantile Exchange (CME), which is why the SEC was comfortable with approving such an ETF. Since the CME is highly regulated, the SEC considers Bitcoin futures to be safer from market manipulation than the “Wild West” of direct Bitcoin exchanges such as Binance, Coinbase, Kraken, and Gemini.

(3) An ETF that invests in the Bitcoin industry

Bitcoin is the leading member of the new class of digital assets, or cryptocurrencies. As of February 7, 2022, the market cap of the entire cryptocurrency space is about $1.7 trillion, while Bitcoin accounts for $836 billion of that total market cap (roughly 49%).

Bitcoin is supported by an underlying infrastructure and industry. This is a two-way relationship: the price of Bitcoin affects the valuation of this industry, while good or bad developments in the Bitcoin industry can also affect the price of Bitcoin.

For example, China’s crackdown on bitcoin mining in May/June/July 2021 sent the price of Bitcoin crashing down because China accounted for about 50% of all bitcoin mining worldwide in early 2021. But this Chinese crackdown also had the effect of boosting American bitcoin mining companies, thus investment into these American companies has and will pay off as bitcoin mining shifts from China to the US. For example, according to the Cambridge Bitcoin Electricity Consumption Index, in May 2021, American mining companies accounted for about 17.77% of worldwide bitcoin mining, while in July 2021, American mining companies accounted for about 35.40% of worldwide bitcoin mining and China was down to zero.

Rather than directly holding bitcoin or buying futures contracts, a Bitcoin industry ETF attempts to capture Bitcoin’s upside by investing in “Bitcoin Industry Revolution Companies”:

  1. Companies that derive a majority of their revenue/profits from mining, lending, transacting in bitcoin, or manufacturing bitcoin mining equipment. Most notable here are bitcoin mining companies such as Riot Blockchain, Marathon Digital Holdings, and Hut 8 Mining. Volt Equity’s strategy is especially focused on Bitcoin mining companies that hold onto the bitcoin they mine, as opposed to selling it for fiat currency.
  1. Companies that hold a majority of their net assets in bitcoin on their balance sheet, such as MicroStrategy, Tesla, and Square. The assumption here is that as the price of Bitcoin rises and falls, the valuation of these companies will correlate to a certain extent.

Three Concerns with Bitcoin Futures ETFs

While an ETF that allocates 25% of the fund to Bitcoin futures might track the movements of bitcoin well, there are three problems with Bitcoin futures ETFs:

  1. “Contango bleed,” leading to underperforming bitcoin itself
  2. Front running by others drives up the cost of futures contracts
  3. Low interest U.S. Treasury Bills make up 75% of these ETFs

#1: “Contango bleed,” leading to underperforming bitcoin itself

Contango is a situation with futures contracts where the price of longer term contracts is higher than the price of shorter term contracts. In this situation, an ETF is forced to sell expiring contracts at a lower price than the new contracts it must buy, so the fund is forced to accept a loss every time it rolls over contracts.

Image: Investopedia

Bitcoin futures are currently in contango, so bitcoin futures ETFs are experiencing “contango bleed”: March 2022 contracts are priced about $100 higher than February 2022 contracts, so the bitcoin futures ETFs will experience about $500 loss for each contract rolled from February to March (since each futures contract is for 5 bitcoins). When the ETFs first debuted in October 2021, November 2021 contracts were priced about $1,000 higher per contract, so the ETFs experienced about $5,000 loss for each contract rolled from October to November.

CME Group Bitcoin Futures Quotes (Feb 7, 2022)

As of Feb 7, 2022, BITO holds 3,795 FEB 2022 contracts and 1,250 MARCH 2022 contracts.

One contract is 5 bitcoins and the margin requirement is about 30% right now ($65,024 for FEB 2022 contracts and $65,144 for MARCH 2022 contracts), which gives the funds roughly 3 to 1 leverage.

Contracts expire on the last Friday of each month, so both funds must finish rolling contracts by Friday, February 25, 2022.

BITO will absorb a roughly $1.897 million loss in rolling forward its February 2022 contracts.

When BITO first launched in October 2021, the spike in Bitcoin a few days before BITO started trading actually hurt the fund by forcing it to buy more expensive futures contracts.

Charlie Morris of ByteTree Asset Management observed:

Overall, he expects BITO to underperform bitcoin itself by 8.4% annually, before factoring in the 0.95% expense fee. Simeon Hyman of ProShares (which launched BITO) pushed back and estimated a 2.5% underperformance based on September 2021 data.

Regardless of what the precise underperformance will be, even ProShares itself admits that they will underperform bitcoin itself because of current market conditions (contango).

#2: Front-running by others drives up the price of futures contracts

Because these ETFs publish their holdings at the end of each trading day, other investors can take advantage of such public knowledge and front-run to drive up the price of Bitcoin futures contracts and make a profit by forcing ProShares and Valkyrie to buy contracts at even higher prices. This works because the Bitcoin futures market is very small and illiquid, so any one company that holds a large amount of contracts may find it difficult to find buyers at a good price.

Michael Wursthorn of the Wall Street Journal makes this same point: “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” (Oct 24, 2021, Bitcoin ETF’s Success Could Come at Fundholders’ Expense)

#3: U.S. Treasury Bills make up 75% of these ETFs

25% of the funds are allocated to Bitcoin futures contracts. The remaining 75% of the funds are allocated to U.S. Treasury Bills. The current yields on 3- and 6-month U.S. Treasury Bills are 0.27% and 0.58% respectively.

This means that 75% of the Bitcoin futures ETFs will only yield about 0.5% return, which will not even outpace rising inflation of more than 7%.

A more aggressive investment into Bitcoin mining companies, other bitcoin funds (such as Grayscale’s GBTC), or publicly traded companies holding large amounts of bitcoin (such as MicroStrategy or Tesla) would allow the remaining 75% of the funds to perform better, but such a strategy is not part of these ETFs’ investment mandate. Therefore, the entire upside to these Bitcoin futures ETFs is dependent on the futures contracts themselves, which are currently experiencing “contango bleed” and therefore, will likely underperform bitcoin itself between 2.5% and 9.6% annually.

Summary: Bitcoin futures ETFs have launched in bad market conditions: low interest rates, contango bleed in futures contracts, and possible front-running of futures contracts will cause Bitcoin futures ETFs to underperform bitcoin itself in this upcoming year.

In light of these problems with bitcoin futures ETFs, we discuss four reasons to invest in bitcoin mining companies.