The Wall Street Journal: Behind the Bitcoin Frenzy, the Risks of MicroStrategy's Stock Leverage Are Gradually Emerging
Leveraged ETFs amplify the gains of the Bitcoin frenzy, but they also hide the huge risks that could lead to investors being "liquidated."Original Title: "Bitcoin Euphoria Threatens to Break These ETFs"
Author: Jack Pitcher, WSJ
Translated by: zhouzhou, BlockBeats
This article analyzes the leveraged funds launched by Tuttle Capital and Defiance ETFs, focusing on MicroStrategy stock to amplify its returns associated with Bitcoin. These funds use swaps and options for leverage but face liquidity issues, leading to underperformance. Investors are disappointed with the funds' deviation from expectations, and critics warn that these funds exacerbate the volatility of MicroStrategy's stock and pose risks that could lead to losses.
Below is the original content (reorganized for readability):
Investors are flocking to funds that aim to amplify the daily returns of MicroStrategy stock, but these ETFs have recently failed to perform as expected.
MicroStrategy founder Michael Saylor, whose software company has turned into a Bitcoin buying machine. Image source: LIAM KENNEDY/ BLOOMBERG NEWS
Investors are rushing into a pair of highly leveraged exchange-traded funds (ETFs) trying to profit from Bitcoin's momentum, but these funds carry hidden risks that are not widely understood. These ETFs aim to amplify MicroStrategy's daily returns, as the company has transformed itself into a Bitcoin buying machine. By using complex derivatives trading, they aim to provide double the daily returns of the stock, whether it goes up or down.
These funds, launched by asset management companies like Tuttle Capital Management and Defiance ETFs, are inherently high-risk, as MicroStrategy itself is a leveraged bet on Bitcoin, holding about $35 billion in Bitcoin. However, optimistic investors have pushed its market capitalization to nearly $90 billion, more than double 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 launches in August and September, the total assets of these two funds have ballooned to about $5 billion.
Some analysts say these funds are driving the wild rise in MicroStrategy's stock price. They warn that if the stock drops 51% in a single day, these ETFs could completely collapse, similar to the blow-ups of some volatility-related ETFs after the 2018 market volatility event known as "Volmageddon."
Worse yet, the recent performance of these two 2X leveraged ETFs has not met expectations. On Wednesday, MicroStrategy's stock rose 9.9%, but the T-Rex fund only increased by 13.9%, falling short of the 19.8% target. When the stock declines, the T-Rex fund's performance is also disappointing. On Monday, when MicroStrategy fell 1.9%, the fund's price dropped by 6.2%.
This has sparked widespread discussion among investors on social media, with many questioning this discrepancy and feeling misled.
Jesse Schwartz, a 36-year-old wine merchant and day trader from Washington State, has been using these funds to amplify his exposure to the stock, and he is particularly surprised to see the stocks not performing as advertised. Schwartz called his brokerage firm Charles Schwab to inquire about the discrepancy, but he was not satisfied with the company's explanation and ultimately sold all his shares before the week ended.
"At the very least, it's disappointing," Schwartz said. "I took on more risk on the downside without getting the returns on the upside."
Since regulators approved single-stock ETFs in 2022, dozens have been launched by small fund managers. So far, these funds have mostly operated as expected. Popular funds aimed at doubling the daily returns of Nvidia and Tesla typically track their targets closely, thanks to financial contracts known as total return swaps.
Supporters of these funds argue that they provide ordinary investors with investment strategies that Wall Street has used for a long time. Critics, however, contend that they can be dangerous because they do not offer diversified investments. Taking the MicroStrategy fund as an example, these funds expose investors to highly volatile stocks through leverage, and that stock is associated with unpredictable cryptocurrency price movements.
Critics warn that this hype is part of a broader investor frenzy targeting speculative assets that could ultimately collapse.
MicroStrategy holds about $35 billion in Bitcoin. Image source: KEVIN SIKORSKY
Managers of the MicroStrategy funds say they may struggle to achieve their 2x return targets because their primary broker—who provides securities lending and other services to professional investors—has reached the limit of swap exposure they are willing to offer.
Leveraged ETFs typically achieve their intended effects by using swaps, which are widely available for the largest and most liquid stocks. The payments on swap contracts are directly tied to the performance of the underlying asset, allowing the funds to precisely double the daily performance of the stock or index.
Matt Tuttle, manager of the Tuttle Capital and Rex Shares 2x leveraged MicroStrategy fund, stated that he is unable to obtain enough swaps to support his rapidly growing fund. He said his primary broker is currently offering him swap limits of $20 million to $50 million, while at one point last week he could have used $1.3 billion in swaps.
Tuttle and Sylvia Jablonski, CEO of competitor Defiance ETFs, both indicated that they are turning to the options market to achieve leveraged results for the MicroStrategy fund. Traders can effectively use options to double the daily returns of an asset, but analysts say this is a less precise method.
Options prices fluctuate, and large buyers like ETFs can influence the market. Tuttle noted that using options is a primary reason for increased tracking error.
The Defiance ETF fell nearly three times the decline of the underlying stock on November 25. Last Friday, when MicroStrategy only dropped 0.35%, the ETF fell by 1.76%.
Analysts believe that the launch of leveraged MicroStrategy ETFs has accelerated the stock's volatility. These ETFs must increase or decrease their exposure daily to achieve leveraged effects. Market makers providing swaps and options typically buy and sell actual MicroStrategy stock to hedge their risks.
"It's like driving with a weight tied to your foot; you can still control the gas, but the default mode is to floor it," said Dave Nadig, a veteran in the ETF industry who has worked at VettaFi and FactSet.
