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examining the benefits and drawbacks of cryptocurrency exchange-traded funds

Many investors are interested in holding bitcoins, ether, or other cryptocurrencies. However, investing in crypto is complex for people who are unfamiliar with the technology. To ease the process of investing in crypto, fund managers have been offering crypto exchange-traded funds (ETFs). These enable everyday investors the chance to get into crypto through their normal brokerage accounts without having to buy and store the digital tokens themselves. While they offer convenience, it's important to consider the risks and benefits of these ETFs while weighing adding them to your portfolio.

Key Takeaways

  • Cryptocurrency has gained in popularity as an asset class in the past decade, especially among younger investors.
  • For many investors, buying crypto directly and keeping it safe is complicated.
  • Crypto ETFs make it easier for investors to gain exposure to crypto.
  • In the U.S., crypto ETFs are limited to being crypto futures ETFs that seek to mimic the price moves of the cryptocurrency they hold.
  • Fund managers purchase these crypto futures contracts, bundle them into a fund, and then sell shares in the ETF.
  • There are drawbacks to these ETFs, such as fees and reduced control.

Introduction to Crypto ETFs

A crypto ETF is one that enables investors to add crypto exposure to their investment portfolios. Like other ETFs, they are traded on the open market and held in traditional brokerage accounts.

The Securities and Exchange Commission (SEC) has so far denied applications for spot cryptocurrency ETFs, saying they haven’t yet demonstrated how they would safeguard investors from market manipulation. However, many analysts expect SEC approval soon. Spot crypto ETFs directly purchase and hold the cryptocurrency.

In the meantime, the regulator has given the green light to ETFs that own futures contracts tied to the price of cryptocurrencies. For example, a Bitcoin futures ETF leverages futures contracts to simulate the rise and fall in the price of Bitcoin. A futures contract is a standardized agreement where two parties arrange to exchange a specific quantity of assets on a specific day for a particular price. The ETFs buy the futures contracts and bundle them into a fund. Then, the ETF sells shares in the fund to investors on an exchange.

There are snags to investing this way. Futures contracts don’t always provide the same returns as their target assets. In addition, ETFs for complex investments like crypto futures contracts often have higher fees that can eat into your potential returns.

Some crypto ETFs bet against crypto's rise in value, shorting specific cryptocurrencies. For example, the ProShares Short Bitcoin ETF enables investors to short Bitcoin, meaning the price of the ETF rises when Bitcoin falls and vice versa.

Pros of Crypto ETFs

Crypto ETFs offer advantages to investors who are interested in gaining exposure to cryptocurrency in their portfolio:

  • Diversification: Crypto is a unique asset class, so adding crypto to a portfolio offers diversification. Crypto ETFs also make gaining exposure to several cryptocurrencies easier than a single type of crypto, enabling you to diversify within the crypto world.
  • Simplicity: For most investors, buying shares in an ETF is far simpler than buying and holding crypto directly. To invest in crypto directly, you need to create a wallet, find an exchange to use for trading, connect it to your bank account, and use the crypto exchange to buy and sell cryptocurrency. You can skip much of this and trade shares in crypto ETFs from your existing brokerage account—many times in a manner of seconds.
  • Security: While you don't technically have cryptocurrency in your wallet, you have security keys to safeguard if you own most cryptocurrencies. If you buy your cryptocurrency through an exchange, you can choose to have your keys stored on that exchange if it offers that service. However, wallets and exchanges can be hacked and keys stolen—which means your cryptocurrency can be stolen. An ETF doesn't require you to own any cryptocurrency, store keys safely, or move the keys back and forth between different types of storage—you own shares of the fund, which doesn't own any cryptocurrency either, but derivatives based on crypto price moves.

The complexity of buying and holding crypto directly means that many investors either can't be bothered or won't have the technical knowledge required. Crypto ETFs open investments in cryptocurrency to a wider range of investors.

Cons of Crypto ETFs

Though crypto ETFs offer benefits, there are drawbacks to consider:

Fees: Investing in a crypto ETF is likely to be more expensive than buying cryptocurrency directly. When buying crypto, you only need to make a one-time payment to the exchange, which can be as low as a few hundredths of the value traded. When investing in an ETF, you pay your brokerage's trade fees, if any, and the fund's expense ratio. Crypto ETFs have expense ratios from 0.39% to 0.95%, much higher than the transaction fees charged by crypto exchanges.

Lack of ownership: Investing in a crypto ETF means not owning the crypto directly. Even the fund won't hold the currency directly if it's a crypto futures ETF.

Deferring to the ETF management's strategy: A drawback all ETFs share is that you give up some control. You rely on the fund manager's strategies, so more complex or precise strategies are unavailable.

No 24/7 trading: Finally, you are more limited when you can trade crypto ETFs. Typically, you can only buy and sell ETFs during normal market hours. Crypto exchanges often run 24 hours a day, seven days a week, 365 days a year.

Crypto ETFs vs Direct Investment in Cryptocurrency

Crypto ETFs vs. Buying Crypto Directly

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Crypto ETF

  • More convenient for most investors

  • Higher fees

  • Less control

Buying Crypto Directly

  • More complicated for many investors

  • Lower fees

  • More control

Investing in crypto ETFs and directly buying crypto both enable investors to gain exposure to cryptocurrency through their portfolios. However, it's essential to understand the differences between the two.

For many investors, the simplicity of using crypto ETFs will offset its drawbacks, such as higher fees and less control. It is a significant advantage to buy and sell crypto ETFs like any other fund and hold them in the same brokerage account as your other investments.

However, crypto enthusiasts likely prefer to buy crypto directly. Many coins can be divided into tenths, hundredths, thousandths, or even more granularly, allowing direct investors to buy or sell precisely the amount of each coin they select. Direct investment also has lower costs and the ability to trade at all hours of the day.

Regulatory Considerations

A critical concern for anyone interested in cryptocurrency is regulation. The regulatory environment for crypto can change rapidly, and these changes can affect the value of crypto or how funds pegged to their value operate.

Front and center is the SEC's review of spot Bitcoin ETFs. These funds would directly invest in crypto rather than relying on derivatives to simulate the price movement of Bitcoin.

Another matter is that in some jurisdictions, the legality of cryptocurrency is still not settled. Virtual currencies are commonly used in criminal activity, such as smuggling or money laundering, and certain jurisdictions have taken steps to curtail or ban them outright. Increasing regulation could lead to a significant drop in crypto's value.

How Do You Invest in Crypto ETFs?

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One of the benefits of crypto ETFs is that you can invest in them in the same way as any other ETF. Once you know which ETF you'd like to invest in, you can use your brokerage account to place an order to purchase shares.

What Is the Largest Crypto ETF?

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As of mid-October 2023. The largest crypto ETF is the ProShares Bitcoin Strategy ETF with about $850 million in bitcoin under its management.

How Are Crypto Investments Taxed?

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The Internal Revenue Service considers crypto a digital asset, not currency, for tax purposes, meaning crypto is taxed like any other investment. Transactions involving cryptocurrencies can trigger capital gains and losses. Thus, investing in crypto ETFs would likely involve similar tax obligations to investing directly in cryptocurrencies. However, it's always prudent to consult a tax advisor for advice that covers your individual situation for more exact information on your tax situation, especially with the rapidly moving regulatory environment for cryptocurrencies.

The Bottom Line

Crypto ETFs enable institutional and everyday investors to speculate on the price of these currencies. Nevertheless, it's important to understand the differences between crypto ETFs and direct investment in crypto, such as higher fees and the lower amount of control you'll have over the digital assets. Before investing in crypto ETFs, it's important to note that crypto is a relatively new and significantly volatile asset class. Before plunging into these investment waters, it's always prudent to first get professional advice.


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