BITO: 2024 May Be Bitcoin's 'Make Or Break' Year

Summary Bitcoin had a strong performance in 2023, rising by roughly 156% and leading to speculation of a new all-time high in 2024. Investor interest in Bitcoin futures ETFs like BITO is surging, with its AUM doubling and total shares outstanding rising by 36% in recent months. BITO differs from Bitcoin as it owns Bitcoin futures without exposure to the spot market, creating inefficient taxation compared to direct long-term ownership. BITO faces liquidity risk because it owns a vast portion of the overall Bitcoin futures market. My outlook for Bitcoin is bearish because its high transaction costs today illustrate its lack of viability as a currency. Bitcoin launched in 2010 and began in an initial price range of around $0.1 to $0.2, surpassing $1 by 2011. Bitcoin is around $43K today, or around 67% of its peak value set in 2021. Bitcoin rose by roughly 156% in 2023, making this year one of the best in its history and encouraging many to speculate that it will reach a new all-time high in 2024. Many investors are clamoring not only for Bitcoin and other cryptocurrencies but also for Bitcoin futures ETFs like ( BITO ) which are a more accessible way to invest in Bitcoin without a cryptocurrency wallet. BITO's AUM has doubled in recent months, with its total shares outstanding rising by around 36%, pointing toward a surge in investor interest. See below: Data by YCharts The ProShares Bitcoin Strategy ETF recently got positive news as ARK's ( ARKW ) Cathie Wood dumped its position in the Grayscale Bitcoin Trust ( GBTC ) for BITO. Of course, given the performance of ARKW in recent years, that may be seen as a positive or negative factor depending on personal perspective. This change was most likely made because BITO trades more similarly to Bitcoin, unlike GBTC, which can have significant premiums or discounts. Going into the new year, I believe it is an excellent time to take a closer look at Bitcoin, given it was one of the best-performing assets in 2023. Further, BITO deserves greater analysis due to its growing interest. In my view, there are many misconceptions surrounding BITO that investors should be aware of, particularly regarding its distribution yield. How Does BITO Differ From Bitcoin? BITO differs from Bitcoin by owning Bitcoin futures without exposure to the Bitcoin spot market. Fundamentally, BITO offers indirect exposure to Bitcoin, which has positive and negative attributes. One issue is the Bitcoin futures market is not very liquid, particularly in futures beyond two months ahead. BITO owns futures and rolls these contracts forward each day. Bitcoin futures usually differ from the spot price slightly. The Bitcoin spot price close on December 31st (the current last record date for futures) was about $42,600. The January futures prices were $42,470, and February's was $42,915. If we look further out in the futures curve, there is a slight increase in contract prices toward later contracts (currently 1.2% higher in June 2024 from January 2024), implying some risk of contango decay. However, there is no clear contango or backwardation in the 1-2 month ahead contracts. Fundamentally, because Bitcoin does not have high storage costs like most commodities, there is a limited need for contango or backwardation in the futures curve. That said, because the long-dated futures are so illiquid, that should cause some slight contango in the curve. While storage and other carry costs are not material for Bitcoin, its futures market liquidity risks are. Hence, its futures market is not very liquid, with a total notional open interest of just $4.8B today, or about one-half of one percent of the entire Bitcoin market cap. BITO's AUM is $1.68B, about 35% of the futures market. Fundamentally, that is not a good position to be in in the event of a market crash because, if ETF owners sell BITO at significant rates, BITO's managers will not have many buyers to sell to. This is a liquidity risk factor, which I believe is underappreciated. Due to BITO's general contango trend, it has underperformed Bitcoin slightly over time. We can compare BITO's price and total returns, which include its dividend, to the price of Bitcoin. See below: Data by YCharts The lower chart shows BITO's total return levels compared to the total return NAV of the Bitcoin Trust. The total return NAV for GBTC is very closely correlated to the spot price of Bitcoin as it measures the value of Bitcoin in GBTC, but not necessarily its price (which is usually discounted). Looking at the ratio of the two, we can see that BITO outperformed Bitcoin briefly in late 2022, directly aligning with its brief period of backwardation. Since then, it has returned to a very slight contango, leading to decay, creating a ~6% decay in 2023 to Bitcoin, even after its distribution. BITO Does Not Pay a True Dividend There is a great deal of confusion around the internet regarding BITO's odd "15%," "monthly paid," and "yield." I purposefully emphasize all of those in quotes because, from a technical standpoint, it is incorrect to say BITO pays a yield; it paid a temporary distribution needed due to its tax status. Investors who clamor over this "yield" are mistaken in viewing it as a source of income, such as in dividend stocks and bonds. For one, consider that even after BITO's distribution, it still underperformed Bitcoin over the past year by ~6%. It underperformed by around 22% if the distribution is not included. This distribution results from short-term gains from realizing appreciation on Bitcoin futures. It is not from roll gains because there were no backwardation gains on Bitcoin in 2023. For the most part, it is also not from its Treasury Bill positions, which, for one, would not pay 15%, and additionally, are against the cash liability from its futures position. As the price of Bitcoin increases, BITO is realizing market-to-market gains on its position and must pass some of that onto investors due to the tax status of futures. From that standpoint (see ProShares FAQ for more ), BITO's "dividend" is a taxable (non-qualified) return of capital. BITO's distribution is likely one of its worst qualities because direct holdings of Bitcoin are not subject to short-term capital gains taxes if held for less than a year. This distribution does not come from actual income but from realized appreciation of Bitcoin. Hence, roughly 40% of the potential appreciation in Bitcoin from BITO will be paid as a non-qualified distribution. This is akin to selling 40% of a position in Bitcoin at The Outlook For Bitcoin in 2024 is Questionable In my view, 2024 will be a critical year for Bitcoin, potentially one of the most significant years in its history. The supply of Bitcoin nears its maximal level, meaning the ability to mine more of it will become increasingly difficult. Bitcoin transactions per day and transaction fees are also very high today. See below: Data by YCharts Bitcoin Transaction levels and fees have not been this high since 2021. A significant reason is the resurgence of NFT Ordinal inscriptions, which embed data into the Bitcoin blockchain. Fundamentally, this has become a potential real-life use case for Bitcoin. Of course, with Bitcoin transactions taking $20-$30, there is a minimal use case for small transactions such as in a currency. I view the high Bitcoin transaction fees as a negative for Bitcoin's future because it shows how the cryptocurrency cannot handle sufficiently high transaction volumes to make it a usable currency. That stems from the high energy costs of operating the Bitcoin blockchain. Fundamentally, it is neither a currency nor a store of value due to immense transaction costs. Of course, many other cryptocurrencies have far superior transactability (in time, cost, and energy needs) and privacy . Indeed, among the many cryptos on the market, I argue many could easily be far superior to traditional currency as a means of exchange due to these efficiencies. Bitcoin is perhaps among the worst for privacy transactability. Bitcoin's only positive is its widespread popularity, but it can never be a currency or long-term value store if it cannot handle a relatively small volume of transactions . While I view many cryptocurrencies as a hedge against inflation, I do not believe that is true for Bitcoin. In the short term, if gold rises in value or other inflation factors grow, then Bitcoin may also rise because people believe it is a hedge against inflation. However, if it cannot be used as a currency or is not a valuable store of value, then it is fundamentally not a hedge against inflation. To me, its only advantage is being the first-mover, which is likely a cost in the long term because it is built upon highly outdated technology. The Bottom Line Overall, I am bearish on BITO for two reasons. For one, BITO is a comparatively poor way to invest in Bitcoin due to its nearly 1% expense ratio and inefficient tax status compared to outright Bitcoin ownership (held for over one year). BITO is also generally subject to contango decay, and its temporary gain distribution does not offset that factor. BITO is also subject to potential liquidity risk because it owns many Bitcoin futures markets. I am secondarily bearish on BITO because I am bearish on Bitcoin, which is its primary performance driver. I would not short Bitcoin or BITO because it could quickly rise higher over the coming months due to decent speculative momentum. Bitcoin may also benefit from bearish volatility in the US dollar, which is growing again . However, I believe any "inflation hedge" Bitcoin benefits will be short-lived because it is fundamentally a poor hedge against inflation due to its inability to handle sufficient transaction volumes and tremendous energy costs . Unlike Bitcoin, other transaction-efficient and private cryptocurrencies (huge benefits for capital-control countries ) are potential alternatives to fiat currencies. Thus, in the event of an actual collapse of some fiat currencies (see Africa ), I expect Bitcoin will eventually lose value and be replaced by a more viable alternative. Of course, investors should do their research on these cryptocurrencies.