WSJ: Risks of MicroStrategy's Leveraged Stock Behind BTC Craze Gradually Emerging

Leveraged ETF has amplified the frenzy of BTC gains, but also hides the enormous risk of potentially 'Get Liquidated' for investors.

Original Title: "Bitcoin Euphoria Threatens to Break These ETFs"

Written by: Jack Pitcher, WSJ

Compiled by zhouzhou, BlockBeats

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

The original text is as follows (for ease of reading and understanding, the original content has been reorganized):

Investors have poured into funds seeking to amplify the daily returns of MicroStrategy stock, but these ETFs have recently failed to perform as expected.

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

Investors are flocking to highly leveraged exchange-traded funds (ETFs) in an attempt to profit from the momentum of BTC, but these funds come with 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 BTC buying machine. Through the use of complex derivatives trading, their goal is to provide double the daily returns of the stock, whether it's a pump or a drop.

These funds were inherently high-risk when launched by asset management companies such as Tuttle Capital Management and Defiance ETFs. MicroStrategy itself is a leveraged bet on BTC, holding about $35 billion worth of BTC. However, optimistic investors have pushed its market capitalization to nearly $90 billion, more than twice the value of its BTC holdings, so skeptics believe this situation is unsustainable.

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, the total assets of these two funds have inflated to about 5 billion dollars.

Some analysts say that these funds are driving the crazy pump of MicroStrategy's stock price. They warn that if the stock falls 51% in a single day, these ETFs may completely collapse, similar to the 2018 market Fluctuation event 'Volmageddon' when some ETFs related to Fluctuation got Liquidated.

What's worse is that the recent performance of these two 2X leveraged ETFs did not run as expected. On Wednesday, MicroStrategy's stock pump by 9.9%, while T-Rex Fund only pump by 13.9%, failing to reach the target of 19.8%. The performance of T-Rex Fund was also disappointing when the stock fell. On Monday, when MicroStrategy fell by 1.9%, the fund's stock price dropped by 6.2%.

This has sparked widespread discussions among investors on social media, with many questioning this discrepancy and expressing a feeling of being 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. 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, so he sold all his shares before the end of the week.

"At the very least, it's disappointing," Schwartz said, "I took on more downside risk without getting rewarded on the pump."

Since being approved by regulators in 2022, dozens of ETFs focusing on individual stocks have been launched by small fund managers. So far, these funds have mostly operated as expected. Popular funds designed to double the daily returns of Nvidia and Tesla often track their targets closely, thanks to the use of financial contracts known as total return swaps.

Supporters of these funds argue that they provide ordinary investors with investment strategies that Wall Street has been using for a long time. Critics, on the other hand, believe that they may be risky because they do not offer diversification. Taking the MicroStrategy fund as an example, these funds expose investors to highly volatile stocks through leverage, which are associated with unpredictable cryptocurrency price fluctuations.

Critics warn that this speculation is part of a broader investor frenzy targeting speculative assets that could eventually collapse.

MicroStrategy holds about $35 billion worth of BTC. Image source: KEVIN SIKORSKY

The manager of MicroStrategy Fund states that they may have difficulty achieving the goal of a 2x return because their primary broker, a company that provides securities lending and other services to professional investors, has reached the limit of the available swap exposure they are willing to provide.

Leveraged ETFs typically achieve their desired effect through the use of derivatives, which are widely available for the most liquid stocks. The payment of derivative contracts is directly linked to the performance of the underlying assets, allowing the fund to accurately double the daily performance of stocks or indices.

Matt Tuttle, manager of Tuttle Capital and Rex Shares' 2x leveraged MicroStrategy fund, said he couldn't get enough swaps to support the rapid rise of his fund. He said his main broker currently offers him a swap limit of $20-50 million, while at some point last week he could have used $1.3 billion worth of swaps.

Tuttle and competitor Defiance ETFs' CEO Sylvia Jablonski both said they are turning to the Options market to achieve leveraged results for the MicroStrategy fund. Traders can effectively double the daily returns of assets using Options, but analysts say it is a less precise method.

Options price Fluctuation, while large buyers like ETFs can impact the market. Tuttle stated that the use of Options is a major cause of tracking error exacerbation.

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

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

"Just like tying a lead weight to your feet while driving, you can still control the accelerator, but the default mode is to step on it," said Dave Nadig, a veteran in the ETF industry who has worked at VettaFi and FactSet.