EP 19: Should You Invest in a Bitcoin ETF?

by Peter Lazaroff | Oct 27, 2021 | Podcast

Listen Now

Cryptocurrency investors have been clamoring for a bitcoin ETF to make it easier for average investors to gain exposure to the crypto market without having to mine bitcoin themselves. The wait is finally over, so now the question is whether the Bitcoin ETF makes sense for you.

In this episode, I share:

How Bitcoin ETF returns will differ from changes Bitcoin prices
Problems with common investment theses for owning Bitcoin
A framework for thinking about adding Bitcoin to your portfolio

Show Notes

Cryptocurrency investors have been clamoring for a bitcoin ETF to make it easier for average investors to gain exposure to the crypto market, and now the wait is finally over. The first Bitcoin ETF launched on October 19 and more are on the way.

I first wrote about Bitcoin in late 2017, and much of the commentary still holds up. But one main thing has changed for me from the time I wrote that article to when I wrote about it again in April 2021.

Whenever possible, I try to think in range of outcomes and probabilities. In 2017, I felt like the two most probable outcomes for Bitcoin was it would be worth a ton or nothing.

Fast forward to 2021 and I’d now assign an extremely low probability that Bitcoin is worth nothing.

That makes the more interesting question, I suppose, is whether or not today’s price qualifies as the “being worth a ton” outcome I assigned a probability to back in 2017. It’s hard for me to imagine Bitcoin returns over the next four years will match those of the previous four years, a time in which the price of Bitcoin has gained roughly 1,150%.

But in reality, as a long term investor, I’m less concerned about the next four years and more concerned about the next 20 or 30.

While I’m not against Bitcoin or cryptocurrency exposures, the most common investment theses are highly flawed and I believe a true long-term investor, someone who intends to hold these types of investments for multiple decades, needs to have realistic return expectations.

In this episode, I’m going to dig into the common investment theses for Bitcoin and discuss a framework for someone thinking about adding Bitcoin to your portfolio. But first, let’s talk a little bit about the new Bitcoin ETFs coming to market.

The first Bitcoin ETF to launch was ProShares Bitcoin Strategy ETF (BITO) and there are many similar ETFs on the way.

One important thing that needs to be clarified is that these ETFs aren’t backed by actual Bitcoin – they’re backed by futures tied to Bitcoin.

This is important because the returns from a futures-backed ETF will be very different than the returns of direct Bitcoin ownership because of what is referred to as the cost of carry.

I’ve found that it’s easier to explain this concept using commodities.

Most commodity funds are futures-based because the actual physical storage of most commodities is impractical. Plus, there is basically no liquidity and trading in physical commodities — that really all happens in the futures market.

The challenge with a futures-based commodity exposure is that futures prices and spot prices differ. For example, when a commodity price is expected to rise over time, the futures price will be higher than the actual spot price for that commodity.

When this is happening, the market is said to be in “contango.” This is a technical term that I watch a lot of people struggle with, even financial advisors, but contango simply means that investors are willing to pay more for a commodity in the future than they are today.

The premium above the current spot price for a particular expiration date becomes the cost of carry — or in plain English the cost of maintaining a long position in the commodity.

So when you have an ETF that provides exposure to a commodity like oil, it uses futures contracts to provide that exposure to price movements. When an oil ETF’s futures contracts expire, new contracts must be purchased to continue giving investors exposure to oil prices.

But if the market is in contango — again, meaning futures prices are higher than spot prices — the fund loses money by rolling forward its contracts at a higher cost than what the expiring futures contract is worth.

Commodities futures frequently trade in contango, which has historically been one of my primary complaints about the use of commodity funds in general, but it is possible for a market to be in the opposite of contango— spot prices can be higher than future prices— this is referred to as “backwardation;” and in this case, investors earn a positive roll yield.

Back to Bitcoin, these futures-based ETFs that are coming to market are going to provide different returns than direct ownership of Bitcoin. Bitcoin is currently in contango, so the cost of carry is likely to have adverse impacts on these funds.

Perhaps someday there will be a spot Bitcoin ETF, but probably no until the crypto markets have a more robust regulatory framework.

But there are funds today that hold Bitcoin directly. For example, Grayscale Bitcoin Trust (GBTC) is a closed end fund that has direct ownership of Bitcoin. A closed-end fund is a little different than an ETF in that there is a set number of shares, so the demand for those set number of shares can cause the price of the fund to differ quite a bit from the value of underlying holdings. This fund also comes with a 2% expense ratio. There is a cheaper closed end fund on the market, but GBTC seems to be the product with the most traction.

You can always buy Bitcoin directly through a number of different exchanges, but should you?

It really depends. I don’t think you need to. When I think about my own financial plan, there is no mention of needing to invest in an asset that goes completely bonkers in order to create the wealth necessary to reach my goals.

But I understand the allure and excitement that comes from owning an asset like Bitcoin, so let’s talk about some of the investment theses before talking about how someone might incorporate it into a portfolio.

For much of the past decade, the primary case for owning Bitcoin was that it would replace fiat currency. Nowadays, nearly all of Bitcoin’s proponents agree that is extremely unlikely, but I still hear what I’ll refer to as “fanatics” still mention this as a reason to invest in Bitcoin.

The Three Purposes Currencies Fulfill

Let’s consider the three purposes currencies fulfill:

Medium of exchange (instrument or system used to facilitate the sale, purchase, or trade of goods between parties)
Unit of account (standard monetary unit of measurement of value, cost of goods, services, assets, liabilities, etc)
Store of value (function of an asset that can be saved, retrieved, and exchanged at aa later date, and be predictably useful when retrieved; a store of value is anything that retains purchasing power into the future)

Bitcoin fails as a medium of exchange for a number of reasons. For starters, it’s wildly volatile, which makes it 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 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 worried 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. Not exactly something you would associate with a good medium of exchange.

Bitcoin is also not a viable unit of account because it’s not effectively used to quote prices or contracted amounts. You don’t see companies releasing financial statements demoninated in Bitcoin nor do you see commodities contracts quoted in crypto.

As for store of value, the case here is shaky at best, yet it’s one of the more common reasons I hear Bitcoin bulls cite. The thing is, a store of value shouldn’t be volatile.

Think about the US dollar…I need the US dollar to be a store of value from the time I earn it to the time I spend, invest, or pay my taxes with it. It does that remarkably well. The same can’t be said of Bitcoin. It is wildly volatile to the point that it completely undermines the purpose of a store of value.

And by the way, it’s also worth pointing out that a store of value, by definition, has an expected real rate of return equal to zero. So everyone using “store of value” as a thesis for why Bitcoin will deliver big returns is contradicting themselves because saying it’s a store of value means they expect to earn zero return net of inflation over the long run. There’s nothing wrong with that, but usually these same people have much higher return expectations than that.

Another popular narrative for Bitcoin buyers in the past decade, but less so these days, is Bitcoin represents a bet either on blockchain or an early-stage investment in emerging technology that would change the way people buy and sell goods or transfer money internationally.

This is compelling until you consider Bitcoin is simply far too inefficient. It’s capacity to process payments is less than ten per second, which falls far short of realistically being the next Visa or PayPal.

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 blockchain used by the wide range of governments, corporations, and financial institutions utilizing blockchain technology.

The idea that blockchain might revolutionize the world is certainly valid, but “buying blockchain” would be like somehow buying “http” which is the foundation of any exchange on the Web – it might have been part of the function, but the real commodity was the specific URLs.

The idea of Bitcoin as a commodity is a newer investment case.

On one hand, it’s understandable. Both bitcoin and commodities values are determined by demand, acceptance, and usage.

However, Bitcoin is not a physical raw material that carries any useful value (whereas traditional commodities like gold and oil do).

The idea that Bitcoin is a form of “digital gold” seems to be gaining traction, but this couldn’t be further from reality. That would have to be an entirely separate episode to go into those nuances, so I’ll leave it at that for now except to say that even if Bitcoin was the new gold, that’s not exactly the greatest investment.

Deeper reading: Want to Invest in Gold? Here’s What You Should Know First

Although it isn’t a thesis I hear much, the way I see Bitcoin is that it most closely resembles collectibles like art, baseball cards, and Beanie Babies — all of which have aesthetic or emotional value, but that derive their pricing from scarcity in supply and level of demand.

Now, after listening to me question the reasons people say they are bullish on Bitcoin, you would probably categorize me as anti-Bitcoin or anti-cryptocurrency, but that isn’t necessarily true.

Building a diversified portfolio requires you combine exposures with various risk and return characteristics that behave differently over time. By combining exposures that size 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 weight 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.

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 $70 trillion and $130 trillion, respectively. Bitcoin’s market value is roughly $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.

One of the practices I incorporate in making investment decisions is writing down the reasoning behind my investment decisions. This forces me to clearly define my beliefs about a particular exposure. It also provides me with honest feedback about my abilities as a prognosticator.

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.

What do you think about Bitcoin? Let me know in the comments section. I’d love to hear from you.

Resources

Get Your Finance Questions Answered

Do you have a financial or investing question you want answered? Submit your question through the “Ask Me Anything” form at the bottom of my podcast page.

If you enjoy the show, you can subscribe wherever you listen to podcasts, and please leave me a review. I read every single one and appreciate you taking the time to let me know what you think.

Until next time, to long-term investing!

About the Podcast

Long term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.

Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.

Support the Show

Thank you for being a listener to The Long Term Investor Podcast. If you’d like to help spread the word and help other listeners find the show, please click here to leave a review.

Free Financial Assessment

Do you want to make smart decisions with your money? Discover your biggest opportunities in just a few questions with my Financial Wellness Assessment.