It’s been seven months since the first ETF to give exposure to bitcoin prices, the ProShares Bitcoin Strategy ETF (BITO), launched. However, BITO, and the two ETFs that followed—the Valkyrie Bitcoin Strategy ETF (BTF) and the VanEck Bitcoin Strategy ETF (XBTF)—do not hold bitcoins; they hold bitcoin futures. The SEC has not allowed a physical bitcoin ETF.
Many investors tend to view these ETFs as a poor second choice. Those three ETFs combined have only about $1 billion in AUM despite the interest in bitcoin. Should investors curious about bitcoin take a second look?
Investors tend to dislike futures-based ETFs because their returns compared to spot price movements are affected by the price relationship between the contract that’s about to expire, the front month and the contracts that expire later.
The price relationship is described as a “backwardated” market if the front month trades at a higher price than the second month, and as “contango” if the front-month price is lower. When in contango, the futures-based ETF will underperform the spot price. In backwardation, it will outperform, but backwardated markets are less common.
When BITO, BTF and XBTF launched, the degree of contango in the bitcoin futures market suggested that their returns would lag the spot price movement of bitcoin by anywhere between 7-10% a year. But that level of contango in bitcoin futures is not a certainty over time.
Most physical commodities swing between various levels of backwardation and contango as production, consumption and inventories move around. But historically, one major commodity did not: gold.
Production of gold, as a percentage of gold inventory, is low. “Consumption” of gold is also low. It’s gold that gets lost or destroyed. When you look at buying gold today—either as spot or futures contracts—you pretty much know how much gold there is both now and later.
If swings in production, consumption and inventory aren’t going to impact the relationship between gold futures prices for the front month versus the second month or a six-month contract, what does? The answer is interest rates.
If you buy 100 ounces of physical gold, or the front-month gold futures contract today for $1,900 an ounce, or you can buy today the six-month gold futures contract for the exact same $1,900 price, everybody would always buy the six-month futures. If you buy the gold now, you owe $190,000 now. If you buy the six-month future, you pay the $190,000 then. You get both the price movement of gold and six months’ worth of interest on your cash.
Gold markets understand this, and the price of the second-month or six-month futures will actually trade at the price of the front month plus interest. Gold futures trade in contango all the time. The degree of contango is determined by short-term interest rates. When interest rates go up, so does contango, and also the cash yield that a futures ETF earns on its unspent cash. The two factors largely cancel each other out.
If you look at a physical gold ETF, such as the SPDR Gold Trust (GLD), and one that owns futures, like the Invesco DB Gold Fund (DGL), over the last 10 years, the difference in annual returns between the two gold ETFs—once you adjust for expenses—is less than 1% despite their different approaches. Contango averaged more than that over this time frame, but DGL also collected interest on its cash. In total, contango had a negative impact on the fund of less than 1% a year.
A Parallel With Bitcoin
Bitcoin is like gold. There’s a small and predictable increase in inventory over time. There’s no real consumption except for people forgetting their passwords. You really know how much bitcoin there is now and later. In theory, bitcoin futures should always be in contango. The exact degree of contango should reflect some sort of short-term interest rates.
But bitcoin is a very new investment. Bitcoin futures are even newer. Those futures did not trade like the theory would suggest. In their first year or so, bitcoin futures even traded in backwardation, which is not what you’d expect. When the bitcoin futures ETFs came out, they faced steep contango markets.
But that’s no longer the case.
The degree of contango in bitcoin futures has steadily fallen from last year’s nosebleed levels to levels near that of gold futures.
In 2021, the degree of contango between the front-month and the second-month gold futures would work out to be an annualized -1.33%. This year it’s running more like -2%. By comparison, last year, the degree of contango between the front-month bitcoin future and the second-month futures was averaging -8.3% annually, but this year it’s averaging closer to -2.3%. And remember, the bitcoin ETF is collecting interest on its unspent cash.
We asked Senior VP/Portfolio Manager Chris Mullen at Cboe Vest, an asset management firm that specializes in derivative-based strategies, about this development. Cboe Vest manages more than 75 ETFs and mutual funds, including a risk-managed mutual fund that invests in bitcoin futures.
“Over the last year or so, the daily trading volume in bitcoin futures, both the front-month and the second-month contracts, has risen by a lot—up to two or three times as much as early last year,” Mullen said. Over this same span, so have the open interest levels, meaning that at any given time, more contracts are outstanding.
The contracts have now been around for longer, and more major players—both investors and futures liquidity providers—have joined in. More trading and more contracts help makes markets more liquid, and pricing becomes more rational.
When asked if this new state of affairs will continue, he added, “It is possible that trade volume and open interest could drop back down and contango would go back up. However, the bitcoin futures market is maturing, and more and more players are using it. That should act to help keep contango closer in line with interest rates.”
A Question Of Size
One question that’s been asked about BITO is the issue of its current size relative to the overall size of the bitcoin futures market. BITO owns around 25-30% of all of the contracts. Does the fund’s bulk make it more difficult or expensive for it to buy and sell contracts?
If BITO’s size is a detriment, its returns should be lower than that of BTF and XBTF after you adjust for management fees. If you start your measurement from when the last of the three launched until last week, what you find is that all three ETFs’ total returns are within 0.50% of each other.
Asking Mullen about BITO, he said, “BITO’s size is an issue for their managers. However, although I am sure they feel the strain of dealing with potential capacity limits, as far as we can tell, they have been able to successfully get their trading done at or near market prices. Of course, if they were to get larger as a percentage of the futures market, they may start having bigger problems.”
All three bitcoin futures ETFs trade fairly tightly in the market. BITO tends to trade about one cent wide. The smaller two trade two to five cents wide. Trading costs are not the only thing for investors to consider. XBTF has a much lower expense ratio, and it may be worth paying a higher spread if an investor plans to keep the investment for long periods of time.
Since inception, all three bitcoin ETFs are currently down more than 50%, but so is the price of bitcoin. The decline in the ETFs is not a design flaw. It’s what they’re supposed to do here.
With lower levels of contango in the market, should investors really view the futures-based ETFs as “a poor second choice”? Should they wait, for however long, for an actual physical bitcoin ETF if the result is only seeing a fairly small improvement in tracking?
We don’t know what the future holds, but the experience with gold suggests that many investors should give futures-based bitcoin ETFs a second look.
John Hyland, CFA, is a retired ETF executive and longtime investment industry professional who has contributed articles to ETF.com. He currently sits as an independent director on the board of the Esoterica NextG Economy ETF (WUGI). Hyland also is a director of Matthews International, the investment advisor to the Matthews Asia family of mutual funds.