Spot Bitcoin ETFs Are Driving A Fresh Rally. They May Not Be All That They Seem.

Bitcoin lovers have a lot to look forward to these days. The next halving date is months away, and now there’s a rising expectation that a bunch of spot bitcoin ETFs might soon come to market. If approved by the US Securities and Exchange Commission (SEC), these proposed funds – potentially from firms like BlackRock, Fidelity, Invesco, Grayscale, and WisdomTree – would bring to the scene a whole new way to invest in bitcoin, and that could drive up the value of the crypto itself. So, whether you’re invested in bitcoin or not, that makes this very much worth a look…

What is the spot bitcoin ETF?

This is something Wall Street’s big fund companies have been trying to get approved for years: an ETF that would give investors exposure to the cryptocurrency by buying shares, just the way they would with a stock.

Already, there’s more than one way to invest in bitcoin. The two most common methods are to own the crypto yourself in a digital wallet or invest in a bitcoin futures ETF. Bitcoin futures ETFs, which have been around since 2021, allow you to invest in the crypto without owning the underlying asset. Essentially, you’re betting on the price of bitcoin futures, i.e. contracts that let investors buy or sell an asset for a set price at a later date. Bitcoin futures track the price of bitcoin closely, but not perfectly.

Like bitcoin futures ETFs, spot bitcoin ETFs would allow you to invest in bitcoin without directly owning it. (That’s the job of the ETF provider). That means you do away with digital keys and the hassle of securely storing your bitcoin. Yeah, but on paper, the difference between investing in a spot bitcoin or bitcoin futures ETF isn’t massive.

So what’s the big fuss?

Regulators have consistently rejected spot bitcoin ETF applications on concerns that they’d be vulnerable to fraud and market manipulation. The high volatility of bitcoin and its unsuitability for retail investors are another concern. But more importantly, the SEC hasn’t been convinced that the funds will have the necessary information to value tokens like bitcoin, or that they can validate who owns the underlying coins.

Nonetheless, proponents of these ETFs have high hopes, and some analysts estimate they could unleash $30 trillion of wealth onto the token.

What could this mean for bitcoin?

If those folks are right, the more obvious impact is a short-term rally in the price of bitcoin. The OG crypto shot up about 20% this summer in the weeks after BlackRock filed its spot bitcoin ETF application back. Some of that rally eventually faded, but there’s still a lot of optimism that these new ETFs might encourage fresh investments from institutional and retail investors who want to gain exposure to bitcoin's price without having to buy actual bitcoin. There’s also a sense that they’d bring more liquidity to bitcoin, making it easier for investors to trade the coin.

Not everyone is sold, though. Analysts at JPMorgan have said the potential impact of the ETF is overstated. They note that bitcoin funds haven’t drawn a ton of investor attention since 2021 and say that’s unlikely to change with the marginal difference that spot bitcoin ETFs would offer.

Why bother with this ETF then?

There are certain advantages to the concept, particularly these two:

Convenience and tax benefits. The ETF would allow you to have all your investments in one place, because you could invest in bitcoin through your existing investment account without having to create an account on a crypto exchange or set up a digital wallet. That also means doing away with the technical challenges that you may face learning how to buy, store, and secure bitcoin. A spot bitcoin ETF would also be eligible for tax-advantaged accounts, such as IRAs or 401(k)s in the US, or ISAs in the UK.

Lower commissions. Trading bitcoin on crypto exchanges can be a lot more expensive than buying an ETF. The platforms are less liquid than a stock exchange, which means you pay higher transaction fees. And those fees can vary widely depending on which crypto platform you use. As more spot bitcoin ETFs are approved over time and competition increases, you could expect commission fees to fall.

Are these spot bitcoin ETFs for you?

That’s the big question. Before you consider investing in the spot bitcoin ETF, you first need to understand the role of bitcoin in your portfolio, and how it contributes to your risk and return profile.

If you believe in the notion that cryptocurrencies will thrive as an asset class outside of the control of governments and traditional financial institutions, then you might be better off holding the digital keys to bitcoin, as opposed to investing in an ETF.

If you’re not overly concerned with that notion but are still interested in adding some bitcoin to your investment mix, then it’s worth keeping in mind that bitcoin is a high-risk asset with a lot of volatility. So unless you’ve got a really high risk tolerance, you typically wouldn’t want it to comprise more than 5% to 10% of your portfolio.

Bitcoin’s Sharpe ratio – this is a measure of its excess return after accounting for its volatility – is at 0.92, and that’s slightly higher than the S&P 500’s ratio of 0.89. Now, it’s true that the higher the ratio, the better, but that outperformance only applies if you’d held the coin from its inception in 2010. Over any shorter three-year rolling period from 2010, the coin’s performance has disappointed compared to the S&P 500.

Bitcoin’s median rolling three-year Sharpe ratio since July 2010. Source: Bloomberg.

Although cryptocurrencies can help improve your portfolio diversification, a spot bitcoin ETF would give you exposure only to bitcoin, not any of its peers. And that’s a difference between these ETFs and the usual stock ETFs you may be familiar with: those usually hold a basket of stocks, giving you a diversification benefit. So if you think this ETF is interesting, it’s still best to proceed with caution and make sure you have a well-diversified portfolio.