Cryptocurrency ETF: What It Is And How It Works

Cryptocurrencies are again outperforming the majority of stocks, while offering, in general, very attractive risk/return parameters. True, many investors are still sitting on the fence in terms of mixing their existing portfolios with straightforward coin investments. One of the reasons is the difficulty of mark-to-market for tax purposes, as well as the lingering presumption of excessive, non-alignable with traditional investments, risks. Whether true or not, for many of us it’s really worth considering to bolster their portfolio performances by including a handful of crypto ETFs.

A cryptocurrency ETF is an exchange-traded fund that seeks to track the price of one or more digital currencies. Cryptocurrency ETFs do not directly hold cryptocurrency. Instead, they are either backed by physical cryptocurrencies or they may hold derivatives, such as futures contracts, which enable the fund to gain exposure to crypto prices without taking possession of the digital currency.

The first cryptocurrency ETF, ProShares Bitcoin Strategy ETF (BITO), was launched on October 19, 2021. Although there are many more of them in the pipeline, so far the U.S. SEC had only approved ETFs that hold Bitcoin cryptocurrency futures, as the United States still waits on the sidelines for a physically backed cryptocurrency ETF. On top of that, we can enjoy a relatively liquid Grayscale Bitcoin and Ethereum tradable trusts – two funds whose eligible shares are quoted on the OTCQX®, the top marketplace operated by OTC Markets.

Some ETFs provide indirect or limited exposure to cryptocurrency by holding equity positions in blockchain miners or in businesses that may profit from blockchain technology in some way. These funds are generally referred to as "blockchain ETFs." Many ETFs seeking to replicate the performance of a single commodity or currency are structured as grantor trusts. That enables them to allow the funds to hold few assets without violating the usual fund rules about diversification. Some cryptocurrency ETFs are structured as corporations for tax-efficiency purposes, while others are structured as Registered Investment Companies.

ProShares Bitcoin Strategy ETF (BITO) is an actively-managed exchange-traded fund that seeks capital appreciation by investing in Bitcoin futures contracts. BITO was the first futures-based cryptocurrency ETF launched and is also the largest, as measured by assets under management. Like other cryptocurrencies ETFs that hold Bitcoin futures contracts, BITO significantly underperformed the S&P 500 index year-to-date in 2022, but since recently started to demonstrate an increasingly attractive positive momentum.

Valkyrie Bitcoin Strategy ETF (BTF) is an actively managed ETF available through Nasdaq that also invests primarily in Bitcoin futures contracts. Although this particular ETF does not have the lowest expense ratio among its peers, its active management strategy was able to outperform many category rivals.

Bitwise 10 Crypto Index (BITW) is different because it offers exposure to a basket of 10 leading cryptocurrencies, including Bitcoin and Ethereum. More specifically, BITW seeks to track the performance of a mix of the 10 most highly valued cryptocurrencies, weighted by market capitalization, and rebalanced monthly, which are actively managed with hedging certain risks in mind.

BITW is an alternative crypto ETF, in that it does not purchase Bitcoin futures contracts. Investors should be sure to understand the tax implications of an investment in the fund. Additionally, expenses of 2.50% are high for such an ETF.