Part 4

What about leveraged ETFs and crypto ETFs? Why do ETFs sometimes deviate from underlying assets?

Leveraged ETFs give investors a way to augment returns or insulate against the downside more cheaply in principle. However, you should NEVER assume that these correlations will be good. The nature of the derivatives instruments necessary to create a double or triple leveraged ETF will inherently create more risk than funds that mimic an asset on a one-to-one basis generally.

So, it is extra important to monitor the correlations here. The results are achieved using equity swaps, futures, rebalancing, and re-indexing. All these methods are prone to human error or other risks in execution that can cause prices to deviate. Market conditions, excessive demand or supply, and regulatory action can all cause the price to differ from NAV. In the case of crypto, extreme enthusiasm for an exchange-traded way to access this exciting new asset class likely causes significant premiums that can sometimes get into the triple digits.

The crypto example is an excellent allegory for how ETFs help investors expand access. As demonstrated by the overwhelming demand for cryptocurrency trusts formed by both Grayscale and bitwise, traditional investors are taking a serious interest in making digital assets a part of their portfolios. Many investors would not be able to get access to these sometimes-cumbersome assets otherwise.

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However, a key component still missing from the crypto investment landscape is an SEC-approved crypto ETF. Crypto-adjacent ETFs in the US offer exposure to companies that operate within the crypto ecosystem, but none are directly tied to an underlying digital asset such as Bitcoin or Ether. IT is essential to note that while crypto ETFs are restricted on a domestic basis, a shortlist including Canada and Brazil has led to getting Ethereum and Bitcoin ETFs approved.

While trusts and direct asset purchases from crypto exchanges have partially satiated the considerable appetite of investors, the benefits of ETFs we have previously outlined seem particularly suited to give retail investors access to this high-alpha asset. ETFs, simplify access for market participants since they trade on significant indexes and remove custodial and security issues of directly holding cryptocurrency. While some brokerages offer access to crypto trusts, it seems that crypto ETFs in the United States would provide better and broader access for investors if approved by the SEC.

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For a crypto ETF to move forward, it would require SEC approval. Issues cited by the regulatory body include limited market hours that traditional exchanges offer compared to an asset class traded 24 hours a day. Limited liquidity for large-scale transactions has been cited as a concern, and regulators have even brought up financial stability concerns which should be construed as a backhanded compliment for a previously fringe asset class.

The Winklevoss twins have submitted an ETF application and had it rejected in 2013, and since then, the SEC has denied a long list of bids. There were 16 active Bitcoin ETF applications pending review and 2 Ethereum ETFs pending review at the time of this writing. Many asset managers are cautiously optimistic about SEC approval within the next 12-18 months. However, timelines are always ambiguous and opaque regarding regulatory developments.

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