Investing has been around for hundreds of years. Over time, trading experts have created a slew of methods that allow investors to diversify their portfolios and increase their chances of earning profits. This article is going to discuss a crypto trading option called ETF or Exchange Traded Fund.
On account of legal implications, this term has been roaming in the crypto circles for a while, and it will help all those who are invested in the crypto space.
What is an Investment Vehicle?
To understand ETFs, the reader must start from the beginning. The story of ETF starts with Investment vehicles. An investment vehicle is a type of investment option that generates money by tracking the performance of other assets or a group of assets.
In most cases, the investment vehicle is organized and managed by a trained and experienced broker. These investment vehicles can pool money from the participants who put their trust in the broker and designate them to purchase in a basket of investment products such as stocks, commodities, certificates of deposits, options, collectibles, artwork, cryptocurrencies, and other tradable goods.
In this manner, the investors try to minimize their risk and diversify their invested capital to earn generous yields.
Types of Investment Vehicles
There are various types of Investment vehicles, and it depends on the broker who is setting up an investment vehicle to put together a unique investment vehicle. Some of the most well-known and common types of investment vehicles are cash equivalents, pooled investment vehicles, venture capital funds, and mutual funds.
Mutual funds are investment vehicles where a broker pools money from the investors and puts it into a basket of trading options such as short-term debt, stocks, bonds, and others. The investors can purchase a share of the mutual fund rather than invest in individual trading products directly.
Mutual funds can be divided further into index funds that generate an investment vehicle based on a specified category of assets. ETFs or exchange-traded funds are considered to be a further classification of index funds.
It is important to note that there are also many types of ETFs such as international, sector, Dividend, Market-cap, etc.
What is an ETF?
The brief genealogy of investment vehicles has created a clear picture of the development and inheritance of ETFs. However, it is best to focus on understanding what an ETF is for now. An ETF is a type of index investing option where investors can track the performance of a particular type of trading product.
It means that rather than buying a given trading product directly from an exchange market, the investors can open a position in an ETF that contains a diverse basket of the said asset class and track their performance. Typically, financial companies and brokers add billions of dollars worth of Assets under Management for a given ETF.
How does an ETF Work?
An ETF is a collection of several variants of a given trading product, such as stocks or cryptocurrencies. If an ETF is intended to track the performance of the stock market, it is going to track the performance of a group of selected stock options that are added to the ETF.
In this manner, the investors can minimize their collective risks and keep benefitting from the accumulating size of their investment on account of the careful management of the ETF. There are several types of trading products added to a single ETF; it means that when the price of one stock goes down, the other listing can keep the ETF value intact.
Therefore, investors must pick their ETF provider carefully and make sure that they are reliable. In essence, ETFs work much like mutual funds and follow the working principles of an index fund.
Types of ETFs
Learning the types of ETFs can help the reader understand them more clearly. Here are some of its most basic classifications:
International ETFs invest in overseas stocks or other trading products. This type of ETF can carry a considerable risk as the investment products added to it may fall out of the jurisdiction of the local financial regulators.
Sector ETFs focus their investment capital on the stocks that belong to a particular sector or industry, such as pharmaceuticals, automobiles, FMCG, etc.
Dividend ETFs invest in the type of stocks where the issuing companies pay out maximum dividend returns to their investors.
Market-cap Index ETFs
Market-cap index ETFs accumulate the shares of companies that are biggest by market cap and the aggregate value of their shares in their respective industry or overall exchange market.
Crypto ETFs add a variety of top cryptocurrency products to track their performance and take advantage of the hedging technique to maintain and increase the value of the respective ETFs.
What is a Crypto ETF?
All the above discussion about ETFs and their classification has helped the reader to navigate to Crypto ETFs. Just as mentioned before, Crypto ETFs track the performance of one or more cryptocurrencies based on their spot price movements.
The investors of a Crypto ETF have the opportunity to generate a position in the pool of cryptocurrencies without directly purchasing them. The Crypto ETF is very much like its TradeFi counterpart, and it is listed on the stock exchange market much like a standard stock listing.
Because Crypto ETFs are listed on the stock exchange markets, they are also regulatory compliant.
How does a Crypto ETF Work?
The way to create a Crypto ETF is for a registered investment enterprise or a certified broker who collects funds to invest in a host of carefully selected cryptocurrencies. The respective broker has to get approval from the financial regulator in their region to get the ETF listed on the stock market.
Once the broker has listed the ETF on the stock market, the investors can purchase shares and generate new positions in the ETF rather than purchasing cryptocurrencies directly from crypto exchanges. Investors may choose to invest in Crypto ETFs to prevent the loss of their investment capital on account of variable market factors.
By investing in a Crypto ETF, they can lower their risk of sustaining losses and take advantage of the hedging techniques.
Crypto ETFs vs Blockchain ETFs
A Blockchain ETF is particularly different from a Crypto ETF. Blockchain ETFs track the performance of the stock market for companies that are invested in various types of blockchains. It happens because blockchain is a type of innovative technology rather than an investment instrument.
However, some companies use blockchain for their enterprise utilities. Therefore, brokers can create a Blockchain ETF that tracks the progress of these companies based on their stock evaluations. In some cases, Blockchain ETFs may follow the performance of companies that are managing or providing blockchain services.
BLOK is a good example of Blockchain ETF in 2018. 80% of the AUM in BLOK has been taken from the firms that are engaged with DLT services in one way or the other. A recent Blockchain ETF is Schwab Crypto Thematic ETF which debuted in 2022.
Instead of investing in cryptocurrencies, it tracks the performance of the companies that are invested in DeFi, such as MicroStrategy, Coinbase, Riot, etc. Just like Crypto ETFs, Blockchain ETFs also need to get approval from their respective financial regulator in the region.
In the USA, all ETFs need to get a green light from the Securities and Exchange Commission. However, the SEC has maintained a stringent demeanor toward Crypto ETFs.
Types of Crypto ETFs
The financial management companies and named brokers have been trying to get approval for Bitcoin ETFs within the USA for years. However, they have yet to gain some success in this regard. The SEC has created some leverage for a particular type of Bitcoin ETF, but it has remained stringent about other forms of Bitcoin ETFs.
To understand why SEC has approved some Bitcoin ETFs and refrained from registering others, it is necessary to learn about the two main types of Crypto ETFs, namely Bitcoin Spot ETF and Bitcoin Futures ETFs.
Bitcoin Spot ETFs are the type of exchange-traded funds where the broker directly purchases and holds Bitcoin at spot prices. In this manner, the investors can gain exposure to Bitcoin without directly holding the digital currency.
The Grayscale Trust has been trying to convert into a Bitcoin Spot ETF, but the matter is still pending on account of delayed approval from the financial regulators. Other major financial enterprises in the USA have lined up at SEC to get approval for their spot Bitcoin ETF applications, such as Valkyrie and VanEck, among others.
On the other hand, Bitcoin Futures ETF is a type of exchange-traded fund that tracks the performance of the futures contracts for Bitcoin. The SEC has approved several Bitcoin Futures contracts in the USA jurisdiction. Bitcoin Futures ETFs allow investors to track the outcome of future contracts for Bitcoin.
Some popular Bitcoin futures ETFs, such as BITO, have been able to successfully track the prices of the Bitcoin Futures, while others remain widely unsuccessful. BITO is a $1 billion AUM ETF listed on the New York Stock Exchange.
What is an Ethereum ETF?
Bitcoin has been particularly popular among ETF issuers on account of its massive market cap and global popularity. However, there are also some efforts to create an ETF with the second-largest crypto by market cap, namely Ethereum. Investors who do not wish to invest in ETH directly can take advantage of an Ethereum ETF.
On account of the Ethereum Merge Event, the chances of new Ethereum ETFs have increased. Furthermore, Ethereum has also transitioned from PoW to PoS, which is going to affect its mainstream adoption as well as improve its regulatory conductivity.
Another reason for increasing enterprise interest in Ethereum ETFs is the increasing prices of energy products. Due to PoS, Ethereum has broken out of its dependency on fuels which makes it a safer investment bet.
There are some deflationary tactics adopted by Ethereum, such as the EIP-1559 (Ethereum Improvement Proposal), that further increase its enterprise adaptability. However, the SEC has not been very favorable to the Ethereum ETF applicants despite several attempts.
Advantages of Crypto ETFs
Canada is a country that is often exemplified by Crypto ETF advocates as it has approved three Ethereum ETFs and several Bitcoin ETFs. There are currently 9 Crypto ETFs operational in Canada. The government and citizens of Canada are keeping in view all the benefits of the Crypto ETFs, some of these are listed:
TradeFi and DeFi
Crypto ETFs are often touted as the bridge between traditional and digital economies. Since Crypto ETFs are listed on the stock exchange, it means that their penetration among mainstream investors is going to increase.
On the other hand, there are some financial giants, such as Black Rock that have made headlines by adding Coinbase services to the Aladdin platform. It is important to note that Aladdin has a massive AUM standing of $10 trillion as of January 2022.
The Crypto ETFs are also going to grant more legitimacy to Bitcoin and the remaining crypto market, which is still smaller in comparison to the multi-trillion dollar mutual funds, hedge funds, and other investment sectors.
The main advantage of an ETF is that it can hold more than one type of investment product. For example, the Ethereum ETF has the potential to own several different types of Ethereum futures, and it may also invest in a host of other cryptocurrencies or tech stocks.
As long as the ETF generator can gain approval from the financial regulators, they are free to add or subtract any trading products from their Crypto ETFs.
Therefore, with ETFs, investors are better protected against the high volatility of the crypto assets, and they are also more diversified than individual investment positions.
ETFs are easier to handle, and they save time, money, and effort for investors. By design, ETF investments are cheaper in comparison to mutual funds. They save the investors from the hassle of investing their time in formulating an expert trading strategy.
At the same time, the investors do not have to perform micro calculations to account for all the transaction fees and broker commissions at every level. They are simple, economic, and suitable for beginners.
Cryptocurrencies can be a challenge when it comes to taxation. There are still many gray areas for filing taxes and reporting returns to the government when it comes to cryptocurrencies. On the other hand, adding cryptocurrencies to pension funds or other types of investment vehicles can expose users to considerable trading risks.
Crypto ETFs can remedy all these issues. Because Crypto ETFs are intrinsically regulated, they are safer and more practical. Regulatory compliance is why corporate investors feel more confident about Crypto ETFs rather than cryptocurrencies.
Limitations of Crypto ETFs
It is time to examine the mindset of the SEC in the United States that has remained unseemly towards Crypto ETF applicants in the country. Here are some of the main limitations that SEC officials argue made Crypto ETFs risky:
Crypto ETFs are centralized and regulated even when cryptocurrencies tout to be decentralized. Since digital assets are unregulated, banks are not allowed to interact with them, but Crypto ETFs are regulated, and it can create a compliance dilemma for banks to provide custodial services for them.
It also means that financial regulators are constantly clashing with Crypto ETFs and pose a threat of regulatory backlash at any moment.
The maintenance costs for Crypto ETFs are subject to highs and lows on account of the trading duration. For some investors, it can be expensive to buy in on account of the inflated gas transactions for certain cryptocurrencies on account of the massive increase in trading volume. Therefore, depending on variable time duration, Crypto ETFs can become more costly.
There is always a massive liquidity risk associated with Crypto ETFs. If the ETF fund manager decided to short-sell the ETF, the investors of the Crypt ETF would have to suffer the consequences.
The reigns of the Crypto ETF are in the hands of the fund manager. Additionally, the fund managers can also adopt tactics to dramatically impact the prices of the ETF to defraud the investors and make away with spoils. Since regulatory clarity is still underway for Crypto ETFs; investors may not be able to turn to the law for protection and recovery of their lost funds.
There are many challenges in measuring the correct value of a Crypto ETF accurately. Investors may not be able to understand all the complex factors that may contribute to decreasing or increasing the overall value of a Crypto ETF that is not in line with the changes in the stock market.
Therefore, investors must invest in understanding the performance requirements for Crypto ETF beforehand. The ETF can contain tech stocks, cryptocurrencies, shares, and other trading products, but its total value is not always the accumulated reflection of all the changes in the main stock market.
Investors can exchange one cryptocurrency for another using DEX or CEX platforms. However, when it comes to Crypto ETFs, there are no options to exchange them with other crypto trading products.
The investors have one-way investment exposure with Crypto ETFs, and they are also unable to use their Crypto ETFs as payments for other goods and services.
When it comes to the cryptocurrency market, it is great that there are other options, such as ETFs. Investors who wish to diversify their trading portfolio can take advantage of Crypto ETFs on account of their regulated nature.
However, it is best to consider all the pros and cons and understand the market dynamics before creating a new ETF position. Investors must always research in depth about the Crypto ETF fund managers to ascertain whether they are trustworthy and qualified to manage their investment capital.