BITO: Why Bother?

Summary When it launched, ProShares Bitcoin Strategy ETF created a unique way for the public to get involved with Bitcoin, using a novel underlying futures strategy to gain exposure in a regulated context. The Fund has underperformed Bitcoin due to distributions and contract rolling costs and charges a high annual fee of 0.95%. On the other hand, Spot Bitcoin ETFs offer lower expenses, less tracking error, and better tax efficiency, rendering BITO an inferior choice for most investors. We rate BITO a 'Sell' on tracking concerns and a high expense structure and think most would be better served by the new crop of ETFs recently approved by the SEC. Launched in October of 2021, the ProShares Bitcoin Strategy ETF ( BITO ) has the unique claim of being the first-ever publicly-listed ETF with focused exposure to Bitcoin. With a novel approach that uses CME Group ( CME ) Bitcoin Futures as the underlying instrument, the ETF began trading to tremendous fanfare in late 2021, near the top of the previous crypto cycle. In that time, the ETF has done its job, tracking the price of Bitcoin accurately over the last few years. That is; if you count the distributions. This may surprise some investors who haven't held the fund before, but due to the complex nature of using futures as the underlying holding, BITO pays a large distribution as a result of the futures contract rolling process, which skews returns a little bit. Without these distributions, BITO has been a poor tracker of Bitcoin over time, underperforming the target asset by a significant margin: TradingView However, even with the distributions, BITO has underperformed due to contract rolling costs, which cause a 'decay' effect, slowly but steadily losing bits and bobs of performance over time. On top of that, BITO charges a hefty fee for what it does, raking in 0.95% annually from investors for the privilege of holding it. With the recent advent of a number of popular spot Bitcoin ETFs that avoid these problems entirely, one has to wonder why anyone would still hold BITO in its current format. Today, we'll take an in-depth look at how BITO works, why it's worse than its spot competitors, and why you should consider dumping it for one of the new SEC-approved funds. Sound good? Let's jump in. How BITO Works At its core, BITO invests its assets in Bitcoin Futures, which are a derivative instrument that tracks the price of Bitcoin. The CME Group contracts are cash-settled, which means that they track the price of Bitcoin and then settle for a cash price at expiry that is fed by a price feed called the "BRR", or ' Bitcoin Reference Rate' . In theory, this makes sense, as the contracts should provide a perfect proxy to Bitcoin, as they settle with the BRR. This incentivizes market makers to statistically arbitrage away any price discrepancies over time. Thus, for all intents and purposes, there's very low tracking error when it comes to Bitcoin Futures vs. Spot Bitcoin. However, in practice, futures expire. This means that every month, BITO managers have to sell out of their expiring futures positions in order to buy into the next month's futures contract. If prices have risen, then this means that the fund books profit on its trades, which it then has to pay out to shareholders for tax reasons. Additionally, futures trading costs, including commissions, fees, and slippage, are also realized by the fund due to the consistently expiring nature of the fund's main holding. This stands in contrast to simply purchasing bitcoin outright and holding it for as long as one wants. Why It's Worse There are a number of reasons why BITO's futures strategy is worse than simply holding Spot Bitcoin. Here are the top 3 keys to know: 1.) Expenses First and foremost, BITO is more expensive than other Spot ETFs that are now live in the market. With an expense ratio of 0.95% annually, the fund is undercut significantly by many new funds that are aiming to achieve the same thing - Bitcoin exposure. Here's where the other funds sit (A big thank you to Mike Fay for putting this table together in his recent article ): Mike Fay As you can see, Bitwise's BITB ETF is currently the cheapest from an expense standpoint, only charging 0.20% per year. That said, other funds, including the iShares Bitcoin Trust ETF ( IBIT ) and the ARK 21Shares Bitcoin ETF ( ARKB ) are still in this general range, charging less than 0.30% annually. It's common knowledge at this point, but fees can really eat into long-term returns, especially when compounded over decades. Being more than 3x as expensive as the cheapest spot Bitcoin ETF is a serious disadvantage to staying in BITO. 2.) Decay While the expenses associated with BITO mar the fund somewhat, another key issue is the tracking error that BITO's returns show vs. the return profile of Bitcoin itself. Since inception, the BITO fund, inclusive of distributions , has underperformed by more than 1,000 basis points: TradingView This difference can be attributed to the commissions, fees, and slippage costs associated with the futures contract rolling process. This is a key issue for futures-based funds, but Spot funds should see less impact from this phenomenon. This is because liquidity for Spot Bitcoin is significantly higher than it is for Bitcoin futures, which have a thin book and only trade in $5 increments. We expect this will continue into the future, which should only exacerbate this condition. 3.) Taxes Finally, BITO is a worse option than a Spot Bitcoin ETF at the moment due to the tax issue. Right now, as we mentioned, BITO pays a healthy 'dividend' from the profits of its trading & rolling operations that occur when BTC's underlying price increases. This shouldn't lead to much in the way of capital decay, like what happens in other 'income' funds like QYLD , but functionally, it does mean that the fund has to pay back its assets to shareholders in the form of a dividend every so often. This would be the equivalent of investors in an S&P 500 ETF receiving distributions due to the fund's managers selling out of, and then buying back into, positions, once a month. Clearly, realizing profits creates tax implications for BITO, which means that you're functionally getting paid back your own capital as a 'dividend', which means that you have to pay taxes on it yourself. If you've got BITO in a non-tax advantaged account, this is a massive inefficiency. It's also functionally worse than Spot ETFs, which can hold Bitcoin for as long as they like, without realizing profits & thus needing to engage in the same behavior. Risks While there are some serious risks associated with keeping BITO in a portfolio when we believe that any of the Spot ETFs would likely be a better choice, there are also some risks that you're avoiding by using BITO when compared to a Spot ETF. The key risk for a Spot ETF, like IBIT, is the custody of their digital assets with centralized exchanges, like Coinbase ( COIN ). This makes sense, as Coinbase has done the work to abstract away a lot of the security & cryptographic key management for customers & clients, reducing the risk of errors or unintentional asset losses that could happen if Blackrock tried to create a new, first-party solution for custody. However, it also means that when you invest in IBIT or any of the other Spot ETFs, that your funds are essentially in Coinbase's hands. If Coinbase, or any of the other, smaller exchanges that have been chosen to custody customer funds end up getting hacked, then it could be a serious hassle trying to get your money back. In the event of a hack like this, BITO and its investors would likely sidestep the issue, due to the regulatory status of the underlying futures contracts which are not exposed to this risk. Custody-compromised risk shouldn't be overlooked, but we think that it's ultimately a trivial concern when compared with the advantages that Spot ETFs bring. Summary BITO will go down in history as an incredibly pioneering ETF for its time, one that used a novel strategy to give everyday investors access to Bitcoin without any of the custody, security, or legal risks of buying it yourself. However, as time has gone on and the SEC has allowed the existence of regular Spot ETFs, there are very few reasons why one should consider BITO at the present moment, as we've laid out. Thus, we rate BITO a "Sell". Cheers!