More ETFs On Horizon — What Are ETFs And How Do They Work?

Anyone, anywhere and at any time can participate in the trading and investing of blockchain-based coins and tokens — so long as they have an internet connection (and a reasonably tolerant jurisdictional authority).

While this current mega rally in the virtual currency market has sparked phenomenal returns — and thus interest among the masses — many on Wall Street are hesitant to engage. Namely, cryptos operate outside of traditional establishments where arbitrary attributes like pedigree and insider connections have little to no sway.

But that doesn’t mean equity investors can’t participate in cryptos. Through exchange-traded funds or ETFs, those who prefer trading in stock exchanges can gain indirect exposure to the fortunes of bitcoin and other virtual currencies. With multiple offerings on the table, ETFs may also provide regular retail investors with diversification options.

What is an ETF?

An ETF represents a basket of securities, commodities or other assets that attempt to parallel the performance of a target benchmark, typically an index like the SP 500 or a market subsegment such as semiconductors. The key advantage to the investor is that an ETF trades just like a stock.

As with any opportunity in the capital markets, an ETF has its set of pros and cons. Generally speaking, index-based ETFs have performed well, in particular because of their popularity. Per the New York Times, these funds trade throughout the day and often replicate mutual fund performance at a much lower cost.

Still, not all ETFs are built equally. Some do a very poor job of replicating their target benchmark. And with cryptos, asset management firms who attempted to replicate the early success of ProShares Bitcoin Strategy ETF (NYSEARCA:BITO) have failed due to higher costs associated with rolling bitcoin futures contracts on a monthly basis, as functionally stipulated by futures-based funds.

Why Buy a Crypto-Based ETF?

Only the individual investor can answer whether he or she wants exposure to a crypto-based ETF. Commonly, however, investors of any ETF category put their money to work in these types of funds because of risk distribution. For instance, if you purchased shares of the SPDR SP 500 ETF Trust (NYSEARCA:SPY), one of its baskets of stocks going sour will not destroy your portfolio’s performance.

For traditional Wall Street investors who want exposure to cryptos, a bitcoin ETF would provide more familiarity. Although an exciting venture, a key drawback for the mainstreaming of virtual currency investments is security protocol. For instance, stakeholders who want direct control of their cryptos must ensure they maintain password discipline at all times.

Of course, any lost passwords or errant transactions conducted through cold wallet infrastructures feature no centralized recourse. And even hot wallet services cannot account for every security concern or negative incident. Thus, crypto ETFs may appeal especially to people who are accustomed to traditional, centralized service platforms.

Pros of Crypto ETFs

Because the crypto surge has enjoyed unparalleled momentum, associated ETFs were an inevitability. Here are a few reasons why you may want to participate.

  • Trades like a stock: Although an ETF represents a basket of securities or assets, each unit is tradable just like any other stock. Therefore, equity investors can jump right in without any learning curve, other than performing due diligence on cryptocurrencies.
  • Possibly more stable: While cryptocurrencies are inherently volatile financial instruments, buying an ETF could be a more stable option than buying individual coins/tokens or specific crypto mining firm. Again, since you’re dealing with a basket of assets, one asset going down isn’t necessarily going to derail the entire portfolio.
  • Multiple ways to play: As the crypto sector matures, the underlying ETF market will probably mature in kind. That means over time, retail investors should see additional ways to participate in the market, including leveraged ETFs and inverse funds (for example, shorting or making money if the target sector falls in value).

Cons of Crypto ETFs

While ETFs bring more color and opportunities to the virtual currency market, you should be aware of these risk factors.

  • Mitigated upside: While ETFs help distribute risk through a broad exposure to cryptocurrencies (or whatever target asset class), this circumstance comes at a cost of upside mitigation. In other words, on any given day, not every asset within the basket will rise. Some will drag down the overall performance of your fund.
  • No 24/7/365 access: Cited as an advantage for certain investors, that ETFs trade like stocks can also be a clear disadvantage to others. That’s because by trading like a stock, you lose the decentralization tailwind that originally helped boost the crypto complex in the first place. Also, you won’t be able to respond to off-hour events if the exchange hosting your ETF is closed.
  • Zombie ETFs: Whether you’re talking stocks or cryptos, assets live or die by liquidity. Simply put, if no one wants to participate in your ETF of choice, the fund will likely languish. At that point, the asset management firm issuing the so-called zombie ETF will probably shut it down. You’ll get your money back but the damage to your portfolio could have already been done by then.

An Intriguing Concept but Do Your Homework

If diversification and risk management are important attributes to your investing strategy, then some exposure to crypto-based ETFs may make sense. For arguably most retail investors, ETFs are simple and intuitive. And years from now, you may be able to exercise multiple financial products, such as leveraged or inverse ETFs.

However, nothing in the capital markets function without risk. Therefore, please perform your due diligence before proceeding with any crypto or ETF investment.

Disclosure: The author holds a long position in BTC.

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