WSJ: Behind the Bitcoin frenzy, the risks of leveraged MicroStrategy stocks are gradually emerging

Original Title: Bitcoin Euphoria Threatens to Break These ETFs

Original author: Jack Pitcher, WSJ

Original Translation: zhouzhou, BlockBeats

Editor's note: This article analyzes the leveraged funds launched by Tuttle Capital and Defiance ETFs, which focus on amplifying the returns associated with MicroStrategy stock and Bitcoin. These funds engage in leverage operations through swaps and options, but face liquidity issues, resulting in underperformance. Investors are disappointed with the deviation in fund performance, and critics warn that these funds exacerbate the volatility of MicroStrategy's stock price and carry risks that may lead to losses.

The following is the original content (for ease of reading comprehension, the original content has been edited):

Investors have flocked to funds that seek to amplify the daily returns of MicroStrategy stock, but these ETFs have recently not performed as expected.

MicroStrategy founder Michael Saylor has turned his software company into a Bitcoin buying machine. Photo credit: LIAM KENNEDY/ BLOOMBERG NEWS

Investors are flocking to leveraged exchange-traded funds (ETFs) in an attempt to profit from the momentum of Bitcoin, but these funds have hidden risks that are not widely understood. These ETFs aim to amplify the daily returns of MicroStrategy, a company that has transformed itself into a Bitcoin buying machine. Through the use of complex derivative trading, their goal is to provide double the daily returns of the stock, whether it's going up or down.

These funds were born with high risk when they were launched by asset management companies such as Tuttle Capital Management and Defiance ETFs. MicroStrategy itself is a leveraged bet on Bitcoin, holding about 35 billion US dollars worth of Bitcoin. However, optimistic investors have pushed its market value close to 90 billion US dollars, more than twice the value of its Bitcoin holdings, so skeptics believe that this situation is unsustainable.

The Defiance Daily Target 2X Long MSTR ETF and T-Rex 2X Long MSTR Daily Target ETF are designed for investors who want to make more aggressive bets on stocks. Since their launch in August and September respectively, the assets of these two funds have expanded to about $5 billion.

Some analysts say these funds are driving the crazy surge in MicroStrategy stock price. They warn that if the stock falls 51% in a day, these ETFs could collapse completely, similar to the situation where some volatility-related ETFs blew up after the 2018 market volatility event 'Volmageddon'.

Even worse, the performance of the two 2X leveraged ETFs has not been operating as expected recently. On Wednesday, MicroStrategy's stock rose by 9.9%, while the T-Rex fund only rose by 13.9%, falling short of the 19.8% target. The performance of the T-Rex fund was also disappointing when the stock fell. On Monday, when MicroStrategy fell by 1.9%, the fund's stock price also fell by 6.2%.

This has triggered widespread discussion among investors on social media, with many questioning this discrepancy and feeling deceived.

36-year-old wine merchant and daytime trader Jesse Schwartz in Washington state has been using these funds to leverage his exposure to stocks, and he was particularly surprised to see that these stocks did not perform as advertised. Schwartz called his brokerage firm Charles Schwab to inquire about the discrepancy, but he was not satisfied with the company's explanation, and eventually sold all his shares before the end of the week.

"At the very least, it's disappointing," Schwartz said, "I took on more risk on the downside and didn't get rewarded on the upside."

Since regulatory approval in 2022, dozens of ETFs focusing on individual stocks have been launched by small fund managers. So far, most of these funds have operated as expected. Popular funds aiming to double the daily returns of Nvidia and Tesla typically closely track their targets, thanks to the financial contracts they use known as total return swaps.

Supporters of these funds say they provide ordinary investors with investment strategies that Wall Street has been using for a long time. Critics argue that they can be risky because they do not offer diversified investments. Take the MicroStrategy fund as an example, these funds expose investors to highly volatile stocks through leverage, and these stocks are associated with unpredictable and cryptocurrency price movements.

Critics warn that such speculation is part of a broader investor frenzy targeting speculative assets that could ultimately crash.

MicroStrategy holds approximately $35 billion worth of Bitcoin. Image source: KEVIN SIKORSKY

MicroStrategy fund managers say they may struggle to achieve their goal of doubling their returns because their main broker, a company that provides securities lending and other services to professional investors, has reached the limit of the swap exposure it is willing to provide.

Leveraged ETFs typically achieve their desired effects by using derivatives, which are widely available for the most liquid stocks. The performance of the derivative contracts is directly linked to the underlying assets, allowing the fund to precisely double the daily performance of stocks or indices.

Matt Tuttle, manager of Tuttle Capital and Rex Shares' 2x leveraged MicroStrategy fund, said he was unable to obtain the necessary swaps to support the rapid growth of his fund. He said his primary broker currently offers him a swap limit of 20 to 50 million dollars, while at some point last week he could have used swaps worth 1.3 billion dollars.

Tuttle and competitor Defiance ETFs' CEO Sylvia Jablonski both said they are turning to the options market to leverage the results for the MicroStrategy fund. Traders can effectively use options to double the daily return on assets, but analysts say this is a less precise method.

Option prices fluctuate, and large buyers like ETFs can influence the market. Tuttle said that the use of options is the main cause of tracking error exacerbation.

The Defiance ETF fell nearly three times as much as the underlying stocks on November 25th. Last Friday, while MicroStrategy fell only 0.35%, the ETF fell 1.76%.

Analysts believe that the launch of leveraged MicroStrategy ETFs has accelerated the volatility of the stock. These ETFs must increase or decrease their exposure daily to achieve the leverage effect. Market makers providing swaps and options typically trade actual MicroStrategy stocks to hedge their risks.

“Just like tying a lead block to your feet while driving, you can still control the throttle, but the default mode is to step on it,” said Dave Nadig, a seasoned professional in the ETF industry who has worked at VettaFi and FactSet.

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