The sheer popularity of betting on the bitcoin-buying juggernaut MicroStrategy has led to rare growing pains in a corner of the $15tn global exchange traded fund industry.
The rapid growth of the ETF sector — with assets surging by 30 per cent in the past year alone — has thus far led to precious few structural problems, with the vast majority of funds working entirely as planned.
However, investors in two US-listed leveraged MicroStrategy ETFs targeting twice the daily return of the white-hot software company — which has raised almost $20bn from investors this year to buy bitcoin — have often received returns markedly at variance from what they might have expected in recent weeks.
On November 21, for instance the T-Rex 2x Long MSTR Daily Target ETF (MSTU) lost 25.3 per cent, according to data from FactSet. As bad as that might sound, the fall was actually 7 percentage points less than it should have been, given that MicroStrategy tumbled more than 16 per cent that day.
While this was a partial reprieve for investors, on other days they have lost out. On November 25, for example, MSTU lost 11.3 per cent, on a day when MicroStrategy only fell 4.4 per cent and MSTU should only have been down by 8.7 per cent, according to FactSet data.
Its rival fund, Defiance ETFs’ Daily Target 2x Long MSTR ETF (MSTX), has also exhibited noticeable tracking error on particular days, the most glaring of these being November 25, when it lost 13.4 per cent — 4.7 percentage points more than it should have.
As the first chart shows, both MSTX and MSTU, which launched in August and September, respectively, tracked their expected returns fairly accurately until mid-November, since when significant tracking error has crept in.
The central issue appears to be the growing size of these ETFs, which have piggybacked on rising enthusiasm for bitcoin since Donald Trump’s presidential election victory.
MicroStrategy is a leveraged play on bitcoin, given the company is the world’s largest corporate owner of bitcoin, with its debt-fuelled $43bn stash of the cryptocurrency helping send its shares spiralling 430 per cent this year.
Enthusiasm for a leveraged play on a leveraged play on a volatile cryptocurrency had led to a flood of buying, with MSTU’s daily assets in the $2bn-$3bn range and MSTX almost as large.
This in turn appears to have exceeded the supply of total return swaps that the ETFs’ prime brokers are willing to offer. These swaps — which involve a broker paying the exact daily return of an asset in return for a fee — offer very precise tracking.
This has led them to also deploy call options — giving the buyer the right to buy an asset at a specified price within a specific period — which do not always track the desired exposure as closely.
Tuttle Capital Management, the adviser and portfolio manager of MSTU, declined to comment, but Sylvia Jablonski, chief executive of Defiance ETFs, told the FT that MSTX had used a combination of swaps and options since launch, utilising “the most efficient product that allows us to achieve our target leverage”.
Jablonski argued that “it is not necessarily the case that options would provide less accurate tracking than swaps”.
Some disagree, though. Elisabeth Kashner, director of global fund analytics at FactSet and a former options trader, said “swaps are preferable: they can be one to one. The greater the volatility the less perfect the options hedge.”
Dave Mazza, chief executive of Roundhill Investments, a rival issuer of ETFs, including a leveraged Magnificent Seven fund and covered call strategies that also utilise derivatives, believed the problems stemmed from the sheer size of MSTU and MSTX.
“This isn’t an ‘ETF’ problem or even a ‘leveraged ETF’ problem — this is a MicroStrategy ETF problem,” Mazza argued.
“The two ETFs indirectly own exposure worth upwards of 10 per cent of MicroStrategy’s market cap, which is something we’ve never seen before in levered ETFs, let alone traditional ETFs.
“Simply put, MicroStrategy is too small a company to accommodate the AUM and trading volume in these products. At this point, these ETFs have already reached the ‘breaking point’.”
Mazza believed the elevated level of risk inherent in a volatile stock such as MicroStrategy was also a factor.
“If a leveraged fund is unable to achieve 2x exposure via swaps, it’s an indication that the trading community views it as a poor risk-reward decision to write additional swap exposure for the fund,” he said.
“Long options are a much less precise tool for achieving exposure, but they are also a tool that doesn’t require a counterparty to take on credit risk to the funds. While this could theoretically happen for any leveraged or inverse ETF, to our knowledge it has not because most are index based or focused on larger securities.”
Kenneth Lamont, principal of research at Morningstar, drew allusions to two previous hiccups in the ETF landscape that also revolved around size. Last year Leverage Shares was unable to generate the full leverage for its popular 3x Tesla ETP for a short period due to an inability to borrow enough money to buy the necessary shares.
Two years earlier, BlackRock had been forced to switch the underlying index for its iShares Global Clean Energy ETF (ICLN) to a broader measure following a surge in assets, forcing it to radically revamp the portfolio.
Lamont said the MicroStrategy-related glitch “is not a case of the wheels falling off, it’s more of a stuttering engine”.
Nevertheless, he added “we would hope it’s incidents like this that would improve products in the future, send out a warning to other players in the industry, and perhaps improve things for everyone”.
If any ETFs in the future run into problems because of their rapid growth, “it means that they were not well built for success”, Lamont added.
Kashner suggested one simple solution to the problem, however: these ETFs could simply close to the creation of new units whenever their swap lines are fully exhausted, even though this is discouraged by the US Securities and Exchange Commission.
“If they had chosen to close to creation they would track perfectly. They would act more like a closed-end fund at that point,” Kashner said, meaning that the share price and net asset value would not necessarily align.
“The fund companies, T-Rex and Defiance, face a choice and it’s a suboptimal choice. They can limit their growth or they can live with the limited accuracy and so far they have chosen to prioritise growth over accuracy,” Kashner added.
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