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Last week, the Securities and Exchange Commission approved the first U.S. exchange-traded funds (ETFs) that can directly invest in bitcoin.
Until now, investors who wanted direct exposure to digital currencies had to trade on crypto exchanges and incur pretty significant transaction fees. Or, there were some ETFs that came out in 2021 that use futures contracts to gain exposure to bitcoin price movements, but owning futures contracts rather than the underlying asset leads to differences in return due to the cost of carry.
The “cost of carry” is something that is probably beyond the scope of this conversation, but you can go back to EP.19 – Should You Invest in a Bitcoin ETF where I talk about how the cost of carry impacts bitcoin futures-backed ETFs.
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These new ETFs that the SEC approved, however, are known as “spot” price bitcoin ETFs. Essentially, the term “spot” indicates the fund’s direct holding of bitcoin rather than a derivative based on bitcoin’s price. And because the funds actually hold bitcoin instead of derivatives, the ETF prices should, in theory, mirror the actual bitcoin price movements in the cryptocurrency market.
So for all of the investors that haven’t wanted to deal with digital wallets, remember complex keys, or register on a cryptocurrency exchange—these ETFs offer an easy way to gain exposure through the same brokerages you would use for trading stocks, bonds, and other ETFs.
In many ways, this development reminds me of when gold ETFs launched in the early 2000s, which offered an accessible avenue to invest in gold via a common brokerage account rather than purchasing actual gold bars.
The only notable difference is in security. Most of the physical gold owned by gold ETFs is held in a giant vault underground in London. With bitcoin, security is a valid concern as there is always a risk of cyber theft. ETF providers won’t have an underground vault, but they do employ third-party custodians to securely store bitcoin in offline “cold storage” locations.
But I think it’s a bit ironic that the SEC’s social media accounts were hacked and a false notice of approval was sent out just a day before the ETF filings were actually approved. There is no doubt that this space is rife with risk.
I’m recording this just one day after the SEC’s announcement because I’m guessing there will be renewed interest from investors that had previously decided against owning cryptocurrencies wasn’t worth it.
Should You Invest in Spot Bitcoin ETFs?
Investing in something simply because it has been going up recently or you fear of missing out on future returns isn’t a good reason to invest in spot bitcoin ETFs. You really should only be investing in bitcoin ETFs if you see value in doing so.
I’ve consistently been publishing content on cryptocurrency since 2017, and what has changed the most over time (in my opinion) has been the complete demise of the case for bitcoin as a currency capable of replacing government money—nearly all of bitcoin’s proponents agree that it is extremely unlikely (if not impossible).
See More: 7 Things to Know Before You Buy Bitcoin
The primary reason it fails as a medium of exchange is that its volatility makes bitcoin impractical to use in most everyday transactions.
People often laugh about the guy who bought two pizzas for 10,000 bitcoin in 2010 because it would now be worth over half a billion dollars. Using any medium of exchange shouldn’t cause potential for regret. My family gets pizza delivered once a week using US dollars and never once have I needed to worry about whether using my currency would be a mistake.
Even worse, exchanging bitcoin for goods and services triggers taxes. The IRS treats Bitcoin as property subject to short and long-term capital gains. If you buy a pizza with Bitcoin that appreciated in value, you will owe capital gains tax.
Even though proponents have seemingly acknowledged bitcoin’s shortcomings as a medium of exchange, I still hear people promote it’s status as a store of value is shaky at best—but that isn’t something that should cause price to soar.
A store of value, by definition, has an expected real rate of return equal to zero.
Regardless, because bitcoin prices are not based on economic fundamentals, but rather depend on speculation about the adoption and use of cryptocurrencies, the uncertainty and resulting high volatility completely undermine the idea of it being a store of value.
The idea of buying cryptocurrency to “buy blockchain” doesn’t really make sense either.
Owning Bitcoin doesn’t give someone any ownership in the underlying blockchain. Even if it did, the blockchain technology that underlies Bitcoin does not power the same blockchains used by the wide range of governments, corporations, and financial institutions utilizing blockchain technology.
The idea that blockchain might revolutionize the world is valid, but “buying blockchain” would be like somehow buying “http” which is the foundation of any data exchange on the Web – it might have been part of the function, but the real commodity was the specific URLs.
Bitcoin isn’t a commodity either, but the idea that it’s a form of “digital gold,” which may be true from strictly a sentiment perspective but couldn’t be further from reality otherwise.
If anything, Bitcoin is more closely aligned with collectibles like art, baseball cards, and Beanie Babies that have aesthetic or emotional value, but that derive their pricing from scarcity in supply and level of demand.
Implementing a Bad Idea vs Missing Out on a Good One
It would be easy to categorize me as anti-Bitcoin or anti-cryptocurrency, but that isn’t necessarily true. I’m simply more concerned about implementing a bad idea than missing out on a good one.
Building a diversified portfolio requires you to combine exposures with various risk and return characteristics that behave differently over time. By combining exposures that zig with others that zag, the volatility of a portfolio’s overall returns is reduced. That, in turn, allows the portfolio’s returns to compound at higher rates.
(If you compare two portfolios with the same average return and different levels of volatility, the lower volatility portfolio will have higher compounded returns and a greater ending value than the portfolio with higher volatility.)
Of course, every new exposure added in the name of diversification comes with a diminishing marginal benefit, so you must carefully weigh the expected net benefits versus the degree of uncertainty.
Bitcoin certainly behaves differently than traditional asset classes such as stocks and bonds, but it doesn’t offer any expected premium for bearing the risk of Bitcoin’s price movements. That increases the already high uncertainty around the net benefit from including such an exposure to a portfolio.
Bitcoin prices depend mostly on speculation about its adoption and use. While the increase in institutional adoption has helped drive price higher, it still lacks an enduring economic rationale that would allow anyone to expect Bitcoin to general positive real returns over time.
Perhaps that will change over time. Or perhaps you don’t care.
Because I’m generally more concerned with implementing a bad idea than missing out on a good one (a preference for minimizing Type I error for all you quant geeks), I’m not a believer in Bitcoin as a strategic diversifier.
Two Reasonable Ways to Think About Bitcoin Investing
If you’re thinking about investing in Bitcoin, I think there are two reasonable ways to go about it:
The first is treating it like an investment in an individual stock.
That actually seems to be the most logical approach. While the risks of owning individual stocks are a bit different, there are some decent parallels between the betting nature of owning an individual coin like Bitcoin or Ethereum or whatever your coin of choice may be.
Carving out some part of your portfolio to actively trade can actually be a good thing if it helps you stay the course with your long-term allocation. If you hit it big with your active portfolio, great. If you don’t, at least you’ve limited your exposure to speculative assets.
The second way to incorporate Bitcoin into your portfolio is as a strategic part of your long-term allocation.
With more products coming to market, I suspect more and more people will be interested in this route.
If that’s the case, here’s how I think about allocating to a new exposure: I start by considering the relative market weight of that exposure compared to the relative weights of your other portfolio assets.
For example, the global stock and bond markets have market capitalizations of roughly $75 trillion and $135 trillion, respectively. Bitcoin’s market value is just over $910 million as of this recording, but let’s round up to $1 trillion. So an asset allocator’s starting point might be 0.50% of a portfolio to Bitcoin ($1T divided by $200T).
If you go either of these routes with Bitcoin or other cryptocurrency exposure, I strongly suggest you follow a set strategy and try to remove emotional decision-making as much as possible.
Eight Questions to Ask Yourself Before Investing In Bitcoin
With something as narrative-driven as Bitcoin, I’d highly encourage you to answer some simple questions, such as:
- What is your time horizon?
- What is your return expectation over that time horizon?
- What are your expected range of outcomes and what probability would you assign to each scenario?
- How does the position fit into your financial plan?
- What is your thesis for making an investment? How will you determine if you are right or wrong?
- Can you tolerate severe losses in the process? (Remember, Bitcoin has already fallen at least 85% on several occasions)
- How will this investment change your life in a bullish scenario?
- How will this change your life if this investment goes to zero?
Answering these questions will help you define the “why” behind your investment and reasonable expectations. Just as important, putting your initial assumptions and strategy in writing guards against overconfidence in your ability to predict the future if your bet pays off for reasons unrelated to your original thesis.
Resources:
- EP 19: Should You Invest in a Bitcoin ETF?
- 7 Things To Know Before You Invest in Bitcoin
- Should You Invest in Bitcoin?
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