Bitcoin Rockets to New Highs, But Beware of This…

It’s Thursday, mercifully.

One more day to go.

Hope this week has been great for you, and it has been if you own the Big Coin.

Let’s talk about the latest development in the crypto world.

New All-Time Highs

Bitcoin has surged to new highs after the first regulator-approved ETF started to trade yesterday.

The ProShares Bitcoin Strategy ETF (ticker: BITO) debuted as the second-biggest traded ETF of all time, by volume.

There’s clearly some appetite for Bitcoin amongst institutional investors and their clients who range from retail all the way to pension funds.

It’s an interesting development for Bitcoin, but there are a few reasons why I think you should invest in Bitcoin itself rather than the ETF.

First, let me explain what an ETF is.

ETFs Have Their Uses

An ETF or exchange traded fund is a fund that is designed to mimic an index, a sector or basket of securities or some underlying asset.

They can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities.

ETFs are great for passive investors.  They’re also great for those who employ a “core-satellite approach” to their portfolios.

Core-satellite is a method whereby an index-based ETF will form 70-80% of the portfolio holdings.  That means you’ll get a broad exposure to the market and earn that return.

Sometimes, that’s pejoratively called “riding the beta train,” as beta represents the market return in finance.

The remaining 20-30% of the portfolio will be placed in strategic or opportunistic investments, where an investor may have an edge.

For instance, if someone has worked in oil and gas their whole life, they can place bets in that space for the satellite part of their portfolio.

Hopefully, those investments will lead to an outsized return, known as alpha.

What’s the Problem with ETFs, Then?

The problem with a lot of ETFs is that they are built using the futures of those underlying assets, and not the underlying assets, themselves.

To remind you, futures contracts are an obligation to buy or sell a specified quantity of a specified asset at a price agreed today at some point in the future.

The difference in price between the underlying and a futures contract is what we call the net cost of carry.

That can vary wildly from contract to contract.

For instance, the cost to carry on oil will be quite different than the cost to carry on a stock index future. The net cost of carry causes price discrepancies between the underlying asset and the futures contract.

In short, the ETF, which is based on futures, may not track the Bitcoin price exactly. We saw this with the USO ETF.

USO is the oil futures-based contract that is supposed to track the price of West Texas intermediate oil.

The USO did nothing of the sort when oil last rallied.

In fact, I went all the way back to 2006 – the furthest I could – to compare the two.

You can see it in the chart here. There lies the inherent danger of piling into ETFs instead of buying the underlying.

Since April 2006, the price of oil is up 21.36%.  The USO is down 89.32%.

Why does this happen?

Contango and Backwardation

Way back in April, I wrote about this very subject here:

Contango simply means the futures price of an asset is greater than the spot or cash price of the asset.  Although a futures price is not a prediction, contango usually occurs when price rises are expected over time.

Backwardation is the opposite of contango.  That’s when the spot price of an asset is greater than the futures price.

I have no idea how they came up with these terms.

Never mind, because the important part is the roll yield.  “Yield,” in finance, is synonymous with “return.”   (We usually use “yield” in fixed income and commodities, and “return” with equities, but there are exceptions.)

The roll yield is the amount of return generated after an investor rolls a short-term contract into a longer-term contract.  The managers of commodity funds have to do this every month to attempt to mimic the underlying asset.  Unfortunately, it doesn’t work out like that.  The roll yield is the reason.

Most futures markets are in contango.  As futures prices aren’t a prediction, the reason why they’re higher is because of the costs associated with storage, insurance, and foregone interest.  All are a function of time.  So the longer out you go, the more expensive the contract is.

Since most futures are in contango, the commodity ETFs based on them lose big money on the roll yield, despite the spot and futures prices going up!  That’s because they’ve got to roll every month, and the farther out contracts are more expensive.

If you look at the Bitcoin futures price on the CME, you’ll see they get more expensive as time goes on.  That’s a contango market.  That means you lose on the roll yield every time.

This is not good for the investor.  It may change.  But right now, it’s a no-go for me.

What To Do

My advice remains the same.  I hope you’ve taken it because Bitcoin is now trading at $66,000. 

Own Bitcoin itself by learning how to use wallets.

Don’t take this easy route into the ETF world because your results may vary wildly from the actual Bitcoin price.

Why?  Because this ETF is built on the Bitcoin future not on Bitcoin itself.

Please keep this in mind whenever you’re thinking about investing in commodities.

China’s Reaction Versus the USG’s Reaction to BTC

Geopolitically speaking, it’s interesting that China has now outlawed Bitcoin while the United States seems to have embraced Bitcoin.

What’s up with this discrepancy?

Well, China clearly just doesn’t want any competition with its currency.

And we get that, from a political perspective. No government wants currency competition because all government currencies are proven to be worthless eventually.

The United States government, while looking quite benevolent now, is rubberstamping the legality of Bitcoin because the Biden administration is looking at ways at taxing and regulating the crap out of it.

The administration is looking at how it can regulate companies that issue ICOs.  It’s also exploring even more onerous ways to regulate crypto exchanges.

That would mimic the way they regulate securities exchanges, as well.

At the end of the day, the USG is broke, and it needs to raise funds in the name of protecting investors.

Funnily enough, BTC investors are only trying to protect themselves from the Fed’s insanely inflationary monetary policy and the USG’s recklessly expansionary fiscal policy.

Keep protecting yourself!

Until tomorrow, have a wonderful day.

All the best,

Sean

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