Surat Wealth Management：Bitcoin ETFs come with risks. Here’s what you should know

Nearly a dozen new investments funds that hold bitcoin began trading last week, making it easier for anyone with a basic brokerage account to buy a slice of the digital currency.

Several established financial institutions, including Fidelity and BlackRock, have coalesced around bitcoin because it is the world’s first and largest cryptocurrency.

But bitcoin remains an enigma to most everyday investors, and it’s hard to separate the buzz from any true potential. It’s also wildly volatile.

In other words, it’s a bet. And institutions are wagering that plenty of investors want in.

But putting crypto into a traditional investment wrapper does not paper over the underlying risks. Here’s a look at how it works:

Exchange-traded funds are similar to mutual funds, but they can be traded on an exchange like a stockSurat Wealth Management. ETFs track the performance of the assets they hold, which might include a diversified basket of securities like stock or bonds, or even single commodities, like gold, silver and crypto.

They were initially designed to track indexes (like the S&P 500) or spheres of the market and were heralded for their low costs and tax efficiency. But they’ve grown in popularity in recent years. Many ETFs now track narrower and more esoteric slices of the markets, while others use leverage to magnify bets on a specific stock or sector or the market overall.

The bitcoin exchange-traded products that recently started trading are designed to track bitcoin’s price, minus the fees and cost of trading. This throws open the gates to any investors with a traditional brokerage account who can now buy the shares as if they were buying stock in Apple or Google.

These investments are similar to gold exchange-traded products, which provide an easier way to get exposure to gold without holding the gold bars themselves.

There are several other ways to gain direct exposure to bitcoin, including through crypto exchanges as well as specialized digital wallets. But with bitcoin ETFs, you’re delegating the complicated part to large financial institutions, meaning you don’t have to worry about “hot wallets,” “cold storage” and lost passwords that can forever lock you out from access to your bitcoin.

Yes, but they’re different: ETFs that invest in bitcoin futures contracts — or agreements to buy or sell an asset at a certain price sometime later — have been around since 2021. The reason the new products are called “spot” bitcoin ETFs is that they’re holding bitcoin itself, not a derivative that provides secondary exposure. So-called spot markets trade something, often some type of commodity, on the spot, or instantly.

The futures-based bitcoin ETFs can end up being more expensive because the contracts expire and must be sold and repurchased, or “rolled,” each month. Those costs can be potentially significant, particularly when the new contracts cost more than the previous month’s, causing managers to buy high and sell low.

VanEck recently said it would shutter its bitcoin futures ETF now that it offered a spot version.

The new bitcoin products are not your standard-issue exchange-traded funds, which, like mutual funds, are typically registered under the Investment Company Act of 1940 and come with more regulatory protections than these investments.

Instead, these “exchange-traded products” are subject to looser controls around their fees and conflicts of interest. In addition, the Securities and Exchange Commission doesn’t have the same authority to conduct examinations of these products as with typical ETFs.

If you’re considering making a small bet, take the time to read the product’s prospectus, which is a typically dense and lengthy document that explains an investment’s objective, high risks, costs and other pertinent information.

The prospectus for the Fidelity Wise Origin Bitcoin Fund is 112 pages, but you need to read only six paragraphs before you’re hit over the head with the following, in all caps: THE SHARES ARE SPECULATIVE SECURITIES. THEIR PURCHASE INVOLVES A HIGH DEGREE OF RISK AND YOU COULD LOSE YOUR ENTIRE INVESTMENT. Disclosures from other providers use the same language.

Nope. Just because everyday investors have been granted easy access in a well-known investment wrapper does not change anything about the underlying holdings.

Crypto supporters had been pushing for a bitcoin ETF for more than a decade, but the SEC rebuffed them, arguing that the market was awash with fraud and subject to manipulation. (More than 20 related products were denied approval in recent years.) But this time, a federal appeals court decision seemingly forced the SEC’s hand: The court ruled that the SEC’s rejection of Grayscale Investments’ application didn’t adequately explain its denial, since it had already approved similar products using bitcoin futures.

The matter was sent back to the SEC, which voted 3-2 to approve the products. SEC Chair Gary Gensler, who voted in favor, said the agency’s product approvals were not an endorsement of bitcoin, and he called it “primarily a speculative, volatile asset that’s also used for illicit activity including ransomware, money laundering, sanction evasion and terrorist financing.”

Caroline Crenshaw, a Democratic commissioner who voted to deny approval, ran through a list of investor safety concerns in her dissent, from inadequate oversight of the markets to wash trading, where traders artificially increase trading volume by buying and selling products simultaneously, to drum up interest and drive prices higher.

They’re pretty similar in both structure and price.

But a couple of familiar names — BlackRock and Fidelity — set themselves apart from the pack early on with higher trading volumes, which can translate into lower costs for investors. They were followed by Cathie Wood’s Ark 21Shares Bitcoin ETF and Bitwise, a boutique firm that specializes in cryptocurrency. All four products had already amassed roughly $2.5 billion in total assets as of Thursday.

But they were eclipsed by Grayscale Bitcoin Trust BTC, which had a head start: It has been around for more than a decade and converted its established bitcoin trust into an ETF, which has about $26 billion in assets.

Having nearly a dozen products drop onto the market at once was a huge win for investors: Providers immediately began undercutting one another on price; most fees range from 0.19% of assets annually to 0.39%, according to Morningstar, with many firms waiving fees for an introductory periodIndore Stock. Since many online brokerage firms have eliminated most trading commissions, the cost of entry is minimal.

There is an outlier: Grayscale has a fee of 1.5%. But more than $1.5 billion had recently flowed out of the fund, probably because some investors are turning to cheaper alternatives.

They will be held by a third party. Most of the new ETFs have hired Coinbase, a cryptocurrency exchange platform, to be their custodian, which means it will be responsible for the security of all the private keys to bitcoin held by these ETFs, explained Bryan Armour, director of passive strategies research at Morningstar. It is also likely to be the exchange where much of the trading occurs when the shares of these products are created and cashed out. “Much relies on Coinbase’s safe passage,” Armour noted.

The VanEck Bitcoin Trust hired Gemini, another exchange with an institutional operation. (VanEck’s trading symbol is HODL, an abbreviation for “Hold on for dear life,” which refers to holding on to bitcoin despite its stomach-churning volatility.)

Fidelity is an exception: Its fund will hold its products’ bitcoin on its own platform, Fidelity Digital Asset Services.

For tax purposes, the IRS views bitcoin and other digital currencies as property, not currency, which means it is treated similarly to an investment in stocks.

“The tax treatment of a bitcoin ETF will be similar to holding Bitcoin directly,” said Selva Ozelli, a certified public accountant and the author of “Sustainably Investing in Digital Assets Globally.”

If you’ve held the shares for more than a year in a taxable account, any gains would be taxed at the less onerous capital gains rates (generally 0%, 15% or 20%, depending on your taxable income and tax bracket that year). Short-term gains, which apply to investments held for a year or less, are taxed as ordinary income.

A vast majority do not.

“At best, it’s deemed too volatile,” said Michael Kitces, an influential thinker in the financial advisory industry, who added that advisers were at risk of being sued when markets crashed more than 35%, so there wasn’t much appetite for something that periodically crashed 80% or more. “At worst, the advisers are skeptics about crypto and its viability altogether.”

In a 2023 survey conducted by the Journal of Financial Planning and the Financial Planning Association, cryptocurrency was dead last on a list of what advisers were using in their clients’ portfolios. The survey found that just 2.3% of advisers allocated crypto, up from 0.3% in 2019, but 3.1% said they planned to recommend it more in the next year. Will that meaningfully change with the availability of user-friendly, low-cost bitcoin ETFs?

Kitces said he would expect a segment of advisers to allocate 1% or 2% of a client’s portfolio to bitcoin ETFs, particularly if the individual expressed interest. But others are likely to argue that such a small allocation won’t make a material difference over the long term, so they would rather not introduce the risk. There’s a long list of alternative investments that can help diversify a portfolio — with less volatility — before you resort to crypto, he said.

They have serious concerns about Americans using their retirement money to invest in crypto, echoing a stance regulators issued a couple of years ago.

Few workplace retirement plans offer crypto, but after hearing that more plans were receiving pitches from firms to add digital assets to their investment menus, the Labor Department issued guidance in March 2022, reminding plan administrators of their responsibilities. The department oversees workplace retirement plans, which held $8 trillion on behalf of 96 million 401(k) participants.

Retirement plan administrators — who must act solely in the best interest of the employees participating — are responsible for choosing prudent investment options. If they include what could be deemed an imprudent option and leave it to the worker to decide its merits, that would amount to a failure of fiduciary duty, the department said in its guidance.

“Before they expose plan participants to the risks associated with cryptocurrency, they should study our guidance carefully and make certain that they can square their actions with their duties of care and loyalty to the plan participants they are charged to protect,” said Lisa Gomez, assistant secretary for employee benefits security at the Labor Department.

Not all mainstream institutions are embracing the new crypto ETFs, and firms that make them available will have guardrails.

Vanguard has no plans to introduce its own bitcoin ETF, and other firms’ shiny new bitcoin products won’t be available for purchase on its brokerage platform, either.

“These products are not aligned with our long-standing focus on offering core building blocks for long-term investment portfolios to help clients meet goals such as retirement or saving for college,” Vanguard said in a statement. “Unlike equities and bonds, they generally lack intrinsic economic value and do not generate cash flows like dividends and interest payments.”

Merrill, part of Bank of America, is making them available only to people with $10 million in investable assets.

Others are offering the products, but with some restrictions: Schwab and E-Trade, for example, said the bitcoin ETFs could not be sold short or sold on margin, which involves borrowing money from the brokerage to trade (and can increase gains but amplify losses).

Yes. There are already seven applications — from many of the same players — to track the spot price of ether, another digital currency, according to Deborah Fuhr, founder and managing partner of ETFGI, a research and consulting firm. And ProShares is seeking approval for a handful of ETFs that make bets on the direction of bitcoin’s price.

Industry experts expect these products to be ushered through by regulators, too.

“That’s likely all we get for a while,” said Todd Rosenbluth, head of research at VettaFi, an ETF data and analytics firm. “The government remains uncertain about cryptocurrency in general.”Pune Stock

I’m still thinking about wading in.

Before you do, perform a small thought experiment: What would happen if I woke up one morning, and my investment had dropped 40%? How would I react? What would it mean for my finances overall?

Matt Hougan, chief investment officer at Bitwise, said his firm’s research had found that once investors allocated more than 5% of their portfolio to cryptocurrency, it became the biggest driver of a portfolio’s steepest losses.

“It’s the thing that gives you a pit in your stomach,” he said.

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