What is a Crypto Index Fund -- a Crypto ETF?

SEC approves, Finally! 

On October 15, the world woke up to the news that the United States Securities and Exchange Commission (SEC) has finally approved Bitcoin Exchange Traded Funds (ETFs) for the American financial market. On the strength of that news, the price of Bitcoin went on a rally that saw it reach an all-time high of $66,930. 

The US SEC had been hesitant for quite a while over approving Bitcoin ETFs, but it now looks like the regulatory giant is gradually warming up to the fact that cryptocurrency is the way to go. Though Bitcoin ETFs were already trading legally in some countries such as Sweden and Canada etc before coming to the US, the US is the world's biggest financial market. As such, getting approved in the US marks a new milestone in the growing legitimacy surrounding the use of cryptocurrencies and their derivatives.

While a good number of people know about Bitcoin and other cryptocurrencies, Crypto ETFs are a new concept to many others. In this article, we take a look at Crypto ETFs (of which Bitcoin ETF is an example) to help our readers understand the subject better.

What is a Crypto ETF?

A Crypto Exchange Traded Fund (ETF) is an investment fund that enables people to invest in a particular cryptocurrency or a group of cryptocurrencies without a need to own or keep the actual crypto assets. However, the price of a Crypto ETF follows the price of the particular cryptocurrency on which the fund is based.

We will use a scenario to try and make it clearer: let us say that a company owns a cache of Bitcoin, Ethereum, Solana, and Binance Coin. The company then desires to set up ABC ETF to track the price of those 4 crypto assets. To do so, the company will split the ownership of its crypto assets into shares. These shares of ABC ETF are then listed on a stock exchange. An investor could purchase, say 100 shares at $20 per share. Assuming that in 2 years the crypto assets held in the company's portfolio experienced growth in market value. At the end of the 2 years, the value of each ABC ETF share may have risen to say, $60, and the original investment of $2,000 would then be worth $6,000.

We can see that the investor in the above scenario is not in custody of the crypto assets even though his investment is affected by what goes on in the crypto market. The investor simply outsources the custody and management of the crypto assets to the company. 

Keep in mind that cryptocurrencies can be very speculative and there is no guarantee that the valuation will always go up. If a crypto asset loses market value, the price of the shares of any ETF that is based on that particular crypto asset will go down as well.

Crypto ETFs are regulated instruments like shares/stocks and can be bought or sold on traditional exchanges such as New York Stock Exchange, Toronto Stock Exchange etc

Brief History

Though it took the US quite a while before licensing Crypto ETFs, they have been around for some time in a few countries. 

According to PRNewswire, In October 2015, CoinShares floated the world's first publicly traded Bitcoin ETF on NASDAQ Stockholm and followed it up with the listing of an Ethereum ETF - the Ether Tracker One, in 2017. Earlier in 2021, Canada approved the listing of Purpose Investments' Bitcoin ETF and Evolve's Bitcoin ETF on the Toronto Stock Exchange.

United States financial regulators have been much more conservative and hesitant to approve Crypto ETFs. In a May 7th CNBC report, the SEC stated that the potential for fraud and manipulation in the Bitcoin market was a major reason why the regulatory watchdog was cautious.

But then, in August the SEC's posture towards Crypto ETFs began to turn positive. Finally, after turning down many applications over the years, the first Bitcoin ETF in the US market - ProShares Bitcoin Strategy ETF, got SEC-approved and commenced trading on the New York Stock Exchange on October 19. Other Crypto ETFs that have gotten SEC approval and are trading include Valkyrie Bitcoin Strategy ETF and VanEck Bitcoin Strategy ETF.

Classes of Crypto ETFs

Presently, all crypto ETFs fall into one of three categories:

• Physical-backed

In this type, the company that issues the ETF units first buys the actual cryptocurrency. It then creates a fund that equates the value of the crypto. The fund is broken up into shares that are listed on a stock exchange. Investors who subscribe to this type of ETF get exposed to the price movement of the crypto without the hassles associated with owning and managing it. 

• Stocks-based

Stocks-based crypto ETFs gives indirect exposure to the cryptocurrency industry. It is based on the stocks of publicly listed blockchain companies such as Coinbase, or companies whose treasury includes a significant amount of cryptocurrencies (such as Tesla). A good example of this class is Bitwise Crypto Industry Innovators ETF. This type of ETF only gives partial exposure to crypto price movement because its value does not necessarily track the value of a particular crypto.

• Futures-based

Futures is a type of crypto derivatives. It speculates on the future price of a commodity without a need to purchase the actual crypto. This type of Crypto ETF is based on a futures contract which is an agreement to buy or sell an asset at a specific time in the future and for a specific price. The fund can thus be set up such that an investor can make a profit when the market is in both upward and downward trends, that is, bull and bear markets. 

Advantages of Crypto ETFs

Here are some of the reasons why people may prefer investing in crypto ETFs instead of directly buying and owning crypto:

• Low entry barrier

The prices of some cryptocurrencies such as Bitcoin and Ethereum may be beyond the reach of many people. At the time of writing, 1BTC costs around $57,000 while 1ETH is around $4,000. However, the price of 1 share of a Bitcoin or Ethereum Crypto ETF is far less than those prices. Thus, investors with much less capital can easily invest in a Crypto ETF and still benefit from the price movements of the actual coin. 

• Involves much less 'trouble'

Many people find investing in Crypto ETFs more convenient than getting involved with the actual crypto. Buying crypto means having accounts on a crypto exchange, needing to set up wallets, and a real-time need to always protect one's private keys etc. Some people would rather prefer to delegate the trouble involved with crypto ownership to fund managers while still enjoying the benefits of crypto investment.

• Better diversity

There are Crypto ETFs that follow the price of more than one crypto asset. Investing in such a multi-asset ETF will give an investor exposure to multiple markets with just one investment. It offers an easy way to diversify one's investment portfolio.

• More Secure

Hackers and thieves are an ever-constant threat to any crypto bought and kept on a crypto exchange or wallet. No such risk exists with Crypto ETFs because the investor does not own or keep any cryptocurrencies.

Associated Risks

All that glitters is not gold, you would say. Yes, crypto ETFs have their downsides too. Some notable downsides include:

• Volatility

Perhaps the most famous attribute of cryptocurrencies is volatility. Prices of crypto can swing wildly. Crypto ETFs are not immune to volatility. Any direction the price of the underlying crypto swings, the value of the Crypto ETF will follow it. 

• Fewer options

Crypto ETFs are still an emerging market. There are not many to choose from. However, with the recent approval from the world's largest financial market - the US, many more Crypto ETFs are likely to spring up throughout the world. 

• Extra Cost

Crypto ETFs are convenient, but the investment company will charge some management fees for the convenience it offers investors. These fees, which are compounded into the cost of 1 ETF share, have to be borne by investors.

• Rigid trading time

The stock exchanges where crypto ETFs are traded do not operate round the clock, unlike crypto exchanges that operate 24hrs each day. Choosing to invest in a Crypto ETF means that the investor will potentially miss out on any positive and profitable price movements that happen outside traditional market hours. 

• Limited utility

Apart from the value of the investment, there may not be much utility associated with crypto ETFs. Buying a Crypto ETF instead of the actual crypto will mean the loss of several exciting utilities which crypto offers such as yield farming, DeFi, GameFi etc

Which one should you go for: Crypto or Crypto ETF?

It all depends on the preference and goal of each individual. An investor who is only concerned about the long-term investment potential of crypto could choose to invest in ETFs. On the other hand, if an investor prefers to profit from the real-time and short-term benefits of crypto such as means of payment, DeFi, swing trading, etc, buying the actual cryptocurrencies and being in the custody of them would probably be the way to go.

Closing Thoughts

SEC's approval of Bitcoin ETFs is a significant turning point in favour of the global adoption of cryptocurrencies and their derivatives. In the coming months, we are likely to witness rapid growth in the investment niche of crypto ETFs.

As the dust of the excitement crypto ETFs settles, it is important to note that the crypto ETF market is still developing and there is room for amendment in its regulatory framework. Also bear in mind that the value of crypto ETFs is still prone to the volatility of the crypto market. Hence, it may be necessary to avoid allocating a huge percentage of your investment portfolio to such a market still in its regulatory and operational infancy.