WSJ: Behind Bitcoin Fervor, MicroStrategy Stock Leverage Risk Emerges
Leveraged ETFs have amplified the gains of the Bitcoin frenzy, but they also carry a significant risk of causing investors to “liquidate” their positions
Original Article Title: Bitcoin Euphoria Threatens to Break These ETFs
Original Article Author: Jack Pitcher, WSJ
Original Article Translation: zhouzhou, BlockBeats
Editor's Note: This article analyzes the leveraged funds launched by Tuttle Capital and Defiance ETFs, focusing on MicroStrategy stock to amplify its Bitcoin-related returns. These funds use derivatives and options for leverage, but they are facing liquidity issues, leading to underperformance. Investors are disappointed by the funds' deviation from expected performance, and critics warn that these funds exacerbate the volatility of MicroStrategy's stock price, posing a risk of loss.
The following is the original content (slightly reorganized for better readability):
Investors have flooded into funds seeking to amplify the daily returns of MicroStrategy stock, but these ETFs have recently failed to perform as expected.
MicroStrategy founder Michael Saylor, this software company has turned into a Bitcoin buying machine. Image Source: LIAM KENNEDY/ BLOOMBERG NEWS
Investors have flocked to a pair of highly leveraged exchange-traded funds (ETFs) seeking to profit from Bitcoin's momentum, but these funds carry hidden risks, and these risks are not widely understood. These ETFs are designed to amplify the daily returns of MicroStrategy, a company that has transformed itself into a Bitcoin buying machine. Through complex derivative trading, their goal is to provide double the daily return of the stock, whether it goes up or down.
These funds, launched by asset management companies such as Tuttle Capital Management and Defiance ETFs, inherently carry high risk as MicroStrategy itself is a leverage bet on Bitcoin, holding about $35 billion in Bitcoin. However, optimistic investors have driven its market value to nearly $90 billion, more than twice the value of its Bitcoin holdings, leading skeptics to believe this situation is unsustainable.
The Defiance Daily Target 2X Long MSTR ETF and T-Rex 2X Long MSTR Daily Target ETF are designed for investors looking to make more aggressive bets on the stock. Since their respective launches in August and September, the total assets of these two funds have ballooned to around $5 billion.
Some analysts suggest that these funds are driving the frenzied surge in MicroStrategy's stock price. They caution that if the stock were to drop by 51% in a day, these ETFs could potentially collapse entirely, similar to the scenario where some volatility-related ETFs blew up after the 2018 market event known as "Volmageddon."
What's worse is that recently, the performance of these two 2X leveraged ETFs has not been operating as expected. On Wednesday, while MicroStrategy's stock rose by 9.9%, the T-Rex fund only saw a 13.9% increase, falling short of the 19.8% target. Similarly, when the stock dropped, the T-Rex fund's performance was disappointing as well. On Monday, when MicroStrategy fell by 1.9%, the fund's share price dropped by 6.2%.
This has sparked widespread discussions among investors on social media, with many questioning this disparity and feeling misled.
36-year-old wine merchant and day trader Jesse Schwartz in Washington State has been leveraging these funds to amplify his exposure to the stock. He was particularly surprised to see the stock not performing as advertised. Schwartz called his brokerage firm Charles Schwab to inquire about the discrepancy, but he was unsatisfied with the company's explanation, eventually selling off all his shares before the week's end.
"It's safe to say it's been disappointing," Schwartz said. "I took on more risk on the downside, only to not be rewarded on the upside."
Since regulatory approval in 2022, dozens of ETFs targeting individual stocks have been launched by smaller fund managers. So far, most of these funds have been operating as expected. Popular funds aiming to double the daily returns of Nvidia and Tesla usually closely track their targets, thanks to the use of financial contracts known as total return swaps.
Supporters of these funds argue that they provide ordinary investors with an investment strategy Wall Street has long used. Critics, on the other hand, argue that they could be risky as they do not offer diversification. Taking the MicroStrategy funds as an example, these funds expose investors to highly volatile stocks through leverage and tie that stock to unpredictable and cryptocurrency price movements.
Critics warn that this frenzy is part of a broader investor mania targeting speculative assets that could ultimately crash.
MicroStrategy holds about $35 billion in Bitcoin. Image Source: KEVIN SIKORSKY
The managers of the MicroStrategy fund say they may struggle to achieve their goal of 2x returns as their primary broker— a company that offers securities lending and other services to professional investors— has reached the limit of the swap exposure they are willing to provide.
Leveraged ETFs typically achieve their desired effect through the use of swaps, which are widely available for the largest and most liquid stocks. The payouts of swap contracts are directly linked to the performance of the underlying asset, allowing funds to accurately double the daily performance of a stock or index.
Matt Tuttle, manager of the Tuttle Capital and Rex Shares 2x leveraged MicroStrategy fund, says he cannot access a sufficient amount of swaps to support the rapid growth of his fund. He mentioned that his primary broker currently offers him swap exposure of $20 to $50 million, whereas at one point last week, he could have had access to $1.3 billion in swaps.
Tuttle and his competitor, Sylvia Jablonski, CEO of Defiance ETFs, both stated that they are turning to the options market to achieve leveraged outcomes for the MicroStrategy fund. Traders can effectively use options to double the daily returns of an asset, but analysts note that this method is less precise.
Options prices fluctuate, and large buyers like ETFs can impact the market. Tuttle mentioned that using options is a major reason for tracking error exacerbation.
On November 25th, the Defiance ETF dropped almost three times the magnitude of the underlying stock. Last Friday, while MicroStrategy only fell by 0.35%, the ETF dropped by 1.76%.
Analysts believe the launch of a leveraged MicroStrategy ETF has accelerated the stock's volatility. These ETFs must adjust their exposure daily to achieve the leveraged effect. Market makers providing swaps and options typically trade the actual MicroStrategy shares to hedge their risks.
“It’s like driving with a cinder block strapped to your foot; you can still control the accelerator, but the default mode is full throttle,” said Dave Nadig, a veteran of the ETF industry who has worked at VettaFi and FactSet.
Disclaimer: The content of this article solely reflects the author's opinion and does not represent the platform in any capacity. This article is not intended to serve as a reference for making investment decisions.