What you need to know about cryptocurrency ETFs

September 27, 2021

As cryptocurrencies flash in and out of the business news, fuelled by interest from heavy-hitters like Tesla CEO Elon Musk, a growing number of smaller retail investors have been looking for ways to get exposure to this new, and somewhat mysterious, financial instrument. Short of making the rather considerable – and risky – financial commitment to pure cryptocurrency, investors have had little choice. But now investors have the ability to obtain Bitcoin and Ether exposure through an exchange-traded fund (ETF) vehicle.

The chief attraction for investors when selecting ETFs seems to start at cost or management fees. But when I spoke recently with Elliot Johnson, Chief Investment Officer and Chief Operating Officer at Evolve ETFs, he said investors should not solely focus on cost when selecting cryptocurrency ETFs for their portfolios. “When you are investing in Bitcoin, you are essentially investing in an 80% volatility asset class,” he said. He believes that at that level of volatility, a fund needs to minimize tracking error to maintain a balanced fee range. “This type of investment requires 100% deployment in the asset without affecting exposure as other unitholders buy or sell units of the fund,” he added.

Johnson says that the Evolve Ether ETF (TSX: ETHR) and the Evolve Bitcoin ETF (TSX: EBIT) achieve 100% deployment, through CF Benchmarks, with the underlying price being traded OTC with futures based on spot rates. With this strategy, says Johnson, “you are essentially getting exposure to the underlying cryptocurrency at the best possible price…Basis risk is reduced for the market makers and hence we receive a better price in the end, which helps keep spreads thin.”

ETFs generally follow a standard T+1 (transaction plus one day) settlement process. With this kind of speed, as an investor, you can rest assured that the price of the underlying security is close to the spot price of the asset you might see on cryptocurrency exchanges worldwide. It is important to note the benefits of trading over the counter (OTC), as you may have heard of the outages at exchanges or websites being overloaded with investors being unable to log into their accounts.

When buying directly with an online wallet, you are exposed to vulnerabilities a broker may have. When you deal over-the-counter with futures, you are not exposed to the excess liquidity risk that is characteristic of buying directly through a cryptocurrency exchange. Also, you lower your cybersecurity risk.

Gemini Trust Company LLC has been appointed custodian for nearly all active cryptocurrency ETFs in Canada. Gemini has received the highest level of security ratings in the space and is completely offline. Being specialists in the field, their internal controls are much better equipped to deal with potential breaches than a single investor. In the extreme case of a breach, Gemini also possesses insurance coverage. If you prefer to invest directly through an exchange, due diligence is needed on in-house internal controls and insurance coverage if offered by the broker for these specific tail risks.

Mr. Johnson also believes cyber risk is an important topic. He said, “You as an investor need to ask yourself where the operational risk is. Our team at Evolve uses a cold wallet that needs multiparty participation from Cidel, Gemini, and Evolve and is never connected to the Internet.”

Investment implications

The discussion around cryptocurrency seems to change very swiftly from bearish to bullish in a matter of days. Social media has had dramatic effects on the asset class, as have botched approvals by the U.S. Securities Exchange Commission for an exchange-traded product. As an investor, it’s important to be mindful of the increased risk of holding an asset that trades around the clock 365 days a year.

While the standard 60/40 bond-equity portfolio has slowly included liquid alternatives and other asset classes, it may be time to seek exposure to cryptocurrencies as an asset class. With the low correlation to equities and fixed income, investors stand to benefit from the increased diversification cryptocurrency may provide. The outlook for cryptocurrency remains positive, with institutional interest continuing to rise.

The accompanying table demonstrates that proper execution is key when investing in the cryptocurrency space, which is still in its infancy. The commoditization of the sector should occur with increased adaptation, which should even out the delta in the long-term. For the time being, lowest cost may not equal highest performance net of fees when compared with peers. Consider, too, a currency-hedged version, because with the added protection of a hedge, you lower your currency risk for a small, yet worthwhile, cost.

Building on trail-blazing Canadian ETF innovation, the world’s first cryptocurrency ETF was launched in Canada in early 2021. There are now seven different Canadian fund sponsors offering exposure to either Bitcoin or Ether in a regulated and easily accessible ETF vehicle.

Mr. Johnson says that this year has marked several milestones for both Bitcoin and Ether adoption. He said, “The biggest players in the industry are intrigued and well versed in the space. Bitcoin is being looked at as digital gold and Ether has entered the realms of venture capital.” With micro strategy rollouts at PayPal and Tesla, Mr. Johnson believes this participation rate should increase as more high profile firms and investors enter the space. Investors wishing to enter this market should always discuss their options with their financial advisors before making any decision.

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