What to Know About ETFs and Cryptocurrency ETFs

Over the past two decades, exchange-traded funds (ETFs) have become one of the most popular types of investment products, with more than 7,000 ETFs in circulation and $5 trillion in assets under management (AUM). 

ETFs were originally created as a way for people to have a passive, lower-cost approach to investing. By buying an ETF, you receive exposure to the performance of a basket of stocks or other indexes over time, rather than gaining access to a fund manager who attempts to “beat,” or “time” the market through the purchases of single stocks.  Because this passive strategy was more “hands-off” than mutual funds that were traditionally “actively managed” by fund managers, they also often advertised lower investment fees and offered low-cost means for a diversified portfolio. In 2019, ETFs, along with other passive funds, overtook actively managed funds in assets under management in the U.S. for the first time.

Today, ETFs consist of many different types of investment opportunities in bundles of stocks, bonds, and commodities, or a mixture of these assets. Some now hold alternative assets, including cryptocurrencies. New ETFs come to market every year to serve many different constituencies, providing many accessible opportunities to investors to diversify their portfolio and gain access to new strategies and asset classes. For this reason, ETFs are an investment option that may offer a way to easily diversify your portfolio, without the need to buy individual stocks, bonds, or even alternative assets.

Here’s what you should know about investing in ETFs and cryptocurrency ETFs. 

Why Are Exchange-Traded Funds Important?

ETFs are an important tool for retail and professional investors to gain access to a bundle of assets or strategies that may otherwise be challenging to produce alone. The tool also allows investors to diversify their risk – rather than buying one stock with the expectation it may rise, buying an ETF gives access to a variety, which could reduce the negative impact on your portfolio should a single stock underperform. 

One ETF can hold hundreds or even thousands of assets. For example, the Vanguard Total Stock Market ETF (VTI) consists of 4,124 stocks. It may be prohibitively expensive for a typical investor to acquire every stock, or financially challenging to attempt to mimic exposure in a similar way. It also may be challenging to monitor each individual stock within that universe. 

When you buy an ETF, you also may also gain exposure to one or multiple sectors. VTI, for instance, consists of stocks from nearly every sector, including consumer discretionary, consumer staples, healthcare, technology, telecommunications, and finance, to name a few. Other ETFs, like the SPDR S&P Bank ETF (KBE), hold 100 bank stocks. ETFs may make it easy to diversify, so if banks had a bad year, owning VTI in addition to KBE would help minimize the losses for your portfolio. 

How Does an ETF Work?

ETFs are generally designed to follow a strategy. The fund managers choose what they want to accomplish with the fund.

Many ETFs track indexes, meaning they try to match the returns and movements of an index, like the S&P 500, by choosing assets that match the index’s holdings as much as possible. As the market fluctuates, stocks and other assets within the ETF will experience changes in performance and price.

Some ETFs will seek to reproduce a strategy. The ETFs will select stocks that meet the associated characteristics, like recent price appreciation for a momentum strategy, or shares that are inexpensive on a ratio of price to earnings for a value strategy, as an example. 

You can buy ETFs in many cases just like you buy a stock – through brokerages or investment platforms. That broker will handle the stock allocation for you, and you’ll notice fees, known as expense ratios, which will be debited over time. 

Exchange-traded Funds vs. Mutual Funds

ETFs and mutual funds are often compared with each other. Both ETFs and mutual funds are collections of various stocks, bonds, and other assets, and their performance can be based on individual stocks within the fund and the total number of shares, and how they track indexes. 

However, the ways they are traded and managed, their costs, and designated tax treatments are very different. Here’s a quick comparison of ETFs and mutual funds:

*Not tax advice. Please consult a tax preparation professional for any questions. 

Types of ETFs

An ETF can be made up of any type of security or commodity. 

Choosing ETFs to add to your portfolio should come down to your investment goals and comfort level. As with any investment, you’ll also want to ensure you fully understand the fund's performance, costs, and risk-return profile before moving forward. 

Here are several popular ETF types you could add to your portfolio:

  • Equity ETFs track a basket or index of equities. There are a wide variety of equity funds that range from certain sectors to niche markets to a particular country’s stocks. 

  • Fixed-income and bond ETFs may help provide steady returns at potentially lower risk than other ETFs. Adding these funds to your portfolio may offer balance to other investments that tend to be more volatile. 

  • Commodity ETFs give you access to investments in raw materials, such as gold, silver or energy resources.

  • Sustainable ETFs focus on environmental, social, and governance (ESG) investments. These funds typically hold assets with companies committed to sustainability, social issues, and corporate governance.

  • Currency ETFs may invest in a single currency, like the U.S. dollar, or a basket of currencies. 

Cryptocurrency Exchange-Traded Funds

New ETFs emerge annually and can reflect consumer sentiments, trends, and market opportunities. Today, there are ETFs that offer exposure to alternative assets, like cryptocurrencies. 

As the name implies, a cryptocurrency ETF is a fund that is designed to track cryptocurrencies. While most ETFs track an index, a crypto ETF tracks the price of one or more digital tokens. There are other crypto-inspired ETFs that hold stocks of companies that have tied their fortunes to either the price of bitcoin – by holding the cryptocurrency on their balance sheet – or larger adoption of cryptocurrencies broadly by facilitating mining operations, crypto trading or other development and business practices in the sector. 

A critique of cryptocurrencies is that they are neither backed by anything physical (like gold) nor regulated by official agencies. In addition, they are anonymous by design, which raises concerns around protecting consumers from certain harmful trading practices in the crypto markets.  U.S. exchanges that facilitate trading in other assets typically employ anti-fraud and other protective measures for participants.

One way to mitigate those concerns in the U.S. was for the SEC to approve a cryptocurrency ETF to track futures contracts. The SEC has not yet approved ETFs that explicitly hold crypto .  Some of the rationale for that decision is outlined above, along with potential market manipulation worries. 

Futures, including cryptocurrency trade in the U.S. on markets that are subject to regulatory oversight. Cryptocurrencies have been declared commodities by the Commodities Exchange Act. This means cryptocurrency futures contracts  trade on commodities exchanges, not stock exchanges. Cryptocurrency ETFs in the U.S. are currently linked to cryptocurrency futures contracts and traded on the Chicago Mercantile Exchange. 

How Does a Cryptocurrency ETF Work?

In October 2021, the ProShares Bitcoin Strategy ETF (BITO) became the first cryptocurrency ETF to be listed on an exchange. But it’s important to note that it does not track nor hold the actual cryptocurrency but the futures contract associated with it. 

Futures contracts are agreements between two parties to buy and sell an asset at a predetermined price, at a set time and date in the future. Derivatives of the contracts are then securitized — or turned into securities — and made available for investors so they can gain exposure to, but are not responsible for, taking physical control of the underlying asset when the contract expires.

For example, traders create and sell a contract for five Bitcoins, and agree on a price, and the contract expires six months later. In the meantime, traders and investors can buy and sell derivatives of the contract and speculate about Bitcoin price changes. In the BITO example, shares are created based on cash-settled Bitcoin futures contracts and are then bundled into ETFs.

Futures contracts, in general, can be volatile investments. If you add the risks of Bitcoin and other cryptocurrencies, such as valuation risk and futures capacity risk (the risk that the fund may not obtain future contract exposure), you’ll notice there is a very high risk tolerance required for investing in BITO, and the understanding that it may not perfectly match Bitcoin’s day-to-day movements.

Differences between Cryptocurrency ETFs and Traditional ETFs

The key difference between a cryptocurrency ETF and other ETFs is the underlying assets. Non-cryptocurrency ETFs invest in traditional asset classes such as stocks, bonds, non-crypto commodities such as oil or gas, and even real estate. Cryptocurrency ETFs can track cryptocurrency prices and futures contracts.

Advantages for Investors

Investing in crypto ETFs comes with risks, just like investing in any other asset. That’s why it’s crucial to use smart investing practices and only invest money you don’t absolutely need for necessities or emergencies. 

Cryptocurrency ETFs and crypto-inspired ETFs provide investors with relatively easy access to the sector through their regular brokerage accounts, without needing to understand the more technical aspect of cryptocurrency. To obtain cryptocurrency directly, one usually needs to create a wallet, and will need to select specific currencies in which to invest. Many individual currencies are volatile, and to obtain the individual currency, it often involves a large financial commitment – at least for Bitcoin and other closely followed currencies which cost thousands of U.S. dollars. 

While you can purchase fractional portions of cryptocurrencies, doing so only provides you access to the one cryptocurrency — which means you may be subjected to wild price swings vs the ownership of a basket of currencies or crypto-exposed publicly-traded companies. 

Diversified exposure is a key tenet behind funds and ETFs. For example, the Bitwise 10 Crypto Index Fund (BITW) is an instrument that gives investors access to the 10 most valuable cryptocurrencies by market capitalization. Its holdings are rebalanced monthly depending on certain factors and risks. BITW holds assets in Bitcoin and Ethereum, as well as altcoins such as Algorand and Uniswap. It is an open-ended statutory trust, rather than an ETF, but is publicly tradable over-the-counter (OTC).  

Investing directly in cryptocurrency can also come with added costs. For example, cryptos may charge custody charges and some digital wallets impose annual fees. Other hidden costs may include transaction and network fees. When you invest in cryptocurrencies using an ETF, the ETF providers typically handle these expenses.

Alternatives to Cryptocurrency ETFs

Gaining exposure to cryptocurrency can be challenging if you don’t mine or purchase it on cryptocurrency exchanges. That said, mining and purchasing are the only alternatives currently available. Cryptocurrencies are available from a variety of cryptocurrency exchanges and platforms, like Domain Money. 

You can buy portions of coins or entire coins on many exchanges. Many cryptocurrency investors use them as a store of value. Still others expect price appreciation over time, assuming wider adoption and interest within the economy.  

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