Most investors know what an exchange-traded fund (ETF) is, as over the past several decades, ETFs have become an integral part of many portfolios. But what is a Bitcoin ETF? And how does the relatively new world of cryptocurrencies intersect with an established investment vehicle like an ETF? We’ll go into it in this article.
Key takeaways
- A Bitcoin ETF is a fund that tracks the price of Bitcoin by either buying actual bitcoin or by purchasing assets that are related to Bitcoin’s price.
- ETFs can be a good way to get exposure to Bitcoin in a portfolio without the steep learning curve involved in owning actual Bitcoin.
- Not all Bitcoin ETFs are created equal. Spot Bitcoin ETFs are the best analogues to owning actual Bitcoin.
How a Bitcoin ETF works
Bitcoin ETFs come in different shapes and sizes. So, there isn’t a one-size-fits-all answer for how they work. However, we can talk about the most common versions of Bitcoin ETFs and outline the architecture behind them. This way, you can have a strong foundational understanding of how they operate.
At a high level, a Bitcoin ETF is simply a fund that is meant to track the price of Bitcoin. A fund does this by buying actual bitcoin or bitcoin derivatives, and then selling shares representing the value of these holdings to investors. These shares operate just like any other ETF or stock, which means Bitcoin ETFs can be convenient, tidy, and easy ways to get exposure to bitcoin in your portfolio, without the headache of buying and storing it yourself.
There are two main types of Bitcoin-specific ETFs currently available: spot Bitcoin ETFs and Bitcoin futures ETFs. In the former option, a fund will buy and hold actual bitcoin. In the latter option, a fund will buy and hold Bitcoin futures contracts.
We will go into the differences between the two types of Bitcoin ETFs below.
How a spot Bitcoin ETF works
A spot Bitcoin ETF issues investors fractionalized shares of actual bitcoin that it has or will purchase. In practice, what this means is that when somebody invests in a spot Bitcoin ETF, money will be used by the fund to buy bitcoin at whatever the market price is. So, the shares that an investor receives from the fund will closely track the spot price of Bitcoin.
Because spot Bitcoin ETF shares derive their value directly from the market price of Bitcoin, they are generally regarded to be the best option for anybody looking for a traditional investment product that closely mirrors the performance of actual Bitcoin.
As a familiar vehicle to invest and trade, spot Bitcoin ETFs also reduce any friction that retail and institutional investors might have accessing the crypto space, giving them a way to securely invest in Bitcoin without worrying about what crypto are reputable or figuring out digital wallets.
Bitcoin Futures ETFs
As of the publishing of this article, Bitcoin futures ETFs are the only type of Bitcoin ETF currently allowed to operate in the United States. And, therefore, they are an incredibly important player in the crypto fund space.
Bitcoin futures ETFs track the performance of Bitcoin futures contracts. For those who are unfamiliar with what futures contracts are, they are essentially an agreement between two parties to buy or sell an asset (in this case bitcoin) at a specified price and on a pre-determined date. So, they are effectively a way to speculate on the future price of Bitcoin. A Bitcoin futures ETF buys and holds these futures contracts and sells shares that derive their value from these futures contracts to investors.
An ETF like this allows investors to bet on the price of Bitcoin without having to actively participate and trade in the futures market. However, because Bitcoin futures ETFs track future contracts and not the spot price of Bitcoin, many investors believe that they aren’t the ideal way to get exposure to bitcoin in a portfolio.
Benefits and drawbacks of Bitcoin ETFs
Like any other investment, Bitcoin ETFs have their benefits and drawbacks. We will go into them below:
Benefits of Bitcoin ETFs
- Convenience: Bitcoin ETFs operate and trade like any other ETF or stock. This means you don’t need to figure out how to use a crypto exchange or crypto wallet to invest in Bitcoin. So long as you have access to a financial advisor or a traditional investment platform or app, you can invest in these ETFs.
- Tax efficiency: Again, because ETFs are an investment tool that have been broadly integrated into our financial system, it’s easy for people to incorporate them into their tax-advantaged investment accounts like TFSA, RRSP, and RESP. This can obviously be very desirable if you aim to reduce the amount of taxes you pay on your investments.
- The trust factor: This can’t be overstated. In theory, buying actual crypto and holding it yourself or with a “trusted” third party can be an appealing idea. What has been highlighted in no uncertain terms during 2022, though, is that many of crypto’s on and off ramps are operating without strict regulatory oversight. This has resulted in billions of dollars of investor funds being lost through malpractice or poor balance sheet management. Crypto ETFs, on the other hand, are subject to very strict and stringent regulatory oversight that ensures they operate at the highest and most trustworthy standards possible.
- Institutional-grade pricing: By the standards of the average retail investor, Bitcoin ETFs buy, sell, and trade massive amounts of bitcoin every day. This allows them to benefit from economies of scale, and from favourable rates when they purchase bitcoin from their crypto partners. In contrast, as an individual investor, you could be paying anywhere from 1.5-3% in fees every time you make a trade on a retail crypto exchange. This means that unless you are a very advanced trader, you are often getting more bang for your buck when purchasing a share in a Bitcoin ETF.
Drawbacks of Bitcoin ETFs
- Fees: Like any other ETF or mutual fund, Bitcoin ETFs will have fees associated with. This means when you buy a share in a Bitcoin ETF, some of the money you spend will be allocated to the people or company that manages the fund, not just towards buying bitcoins.
- No actual bitcoin ownership: When you buy crypto on an exchange you fully own and control it and can move and use it as you see fit. With an ETF, you never have direct access to actual bitcoin. Though this is not particularly problematic for many investors, there are people who view this lack of flexibility in an unfavourable light.
- Rigid trading hours: Unlike crypto which you can buy and sell 24 hours a day, ETFs trade like stocks between Monday to Friday within set hours. This means buying and selling ETFs can potentially not happen as fast as if you were trading crypto directly.
Final thoughts
Bitcoin ETFs can be an excellent way to gain portfolio exposure to cryptocurrencies. They offer a user-friendly alternative to crypto self-custody and, depending on your needs, could be the right fit for you.
At Purpose, we believe that spot Bitcoin ETFs provide the most accessible, transparent, and secure way for investors to get exposure to Bitcoin in their portfolios. That’s why we launched the world’s first Bitcoin ETF in 2021.
Just like anything else, there are drawbacks to using this type of investment product. Ultimately, whether a Bitcoin ETF makes sense to incorporate into your investment planning, will depend on your risk tolerance, investment goals, and belief in the underlying asset.
—Purpose Investments
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