The craze around MicroStrategy (a company that practically became a Bitcoin holding machine) has highlighted weaknesses in the $15 trillion exchange-traded fund (ETF) market.
The ETF sector has run into trouble with two leveraged funds linked to the volatile MicroStrategy stock. These funds, created to offer twice the daily return of MicroStrategy shares, are giving investors unexpected results.
Defiance’s T-Rex 2x Long MSTR Daily Target ETF (MSTU) and Defiance Daily Target 2x Long MSTR ETF (MSTX) have seen their performances deviate wildly from expectations in recent weeks. On November 21, MSTU fell 25.3%, according to FactSet data.
That’s bad, but it should have been worse: MicroStrategy shares fell 16%, meaning the fund should have fallen 32%. A rare victory for investors. But four days later, the situation changed. MSTU lost 11.3%, while MicroStrategy shares fell only 4.4%.
That’s almost three percentage points worse than the fund’s promised performance. MSTX fared no better, losing 13.4% that same day, a long way from its target.
The problem of size and swaps
Before November, these ETFs did exactly what they were designed to do. But in mid-November cracks began to appear. Funds have become too big, plain and simple.
Enthusiasm for MicroStrategy (and, by extension, Bitcoin) skyrocketed after Trump’s presidential victory, turning these ETFs into massive players almost overnight.
Both funds are supposed to track the performance of MicroStrategy stock using tools like swaps. The exchanges are simple. A broker pays the daily performance of an asset to the fund, less a commission, ensuring accuracy.
But here’s the problem: MSTU manages between $2 billion and $3 billion in assets daily, and MSTX is not far behind. Major brokers can’t keep up and the supply of swaps is drying up.
With swaps maxed out, funds turned to call options. Call options give the right to purchase an asset at a specific price within a certain time. They are a decent backup, but they don’t offer the same accuracy as swaps.
Sylvia Jablonski, CEO of Defiance ETF defended the move to options, calling it efficient for achieving leverage. But critics like Dave Mazza of Roundhill Investments argue otherwise. Options are unpredictable, especially for a stock as volatile as MicroStrategy.
Mazza noted that these ETFs now have exposure worth more than 10% of MicroStrategy’s market cap. This is unheard of in the world of ETFs. “MicroStrategy is too small to handle this level of trading volume and assets under management,” he said.
Leveraged Chaos Meets Bitcoin Hype
MicroStrategy has gone from a software company to a full-fledged Bitcoin proxy. The company owns $43 billion worth of Bitcoin, purchased with mountains of debt. This year alone, its shares are up 430%.
Investors looking to amplify their exposure to Bitcoin have flooded MSTU and MSTX, pushing these funds to the limit. When these ETFs got too big, they hit a wall. The supply of swaps dried up and fund managers had no choice but to turn to options.
This kept the funds alive, but introduced massive tracking errors. Morningstar’s Kenneth Lamont compared the situation to past ETF disasters, such as Leverage Shares’ 3x Tesla ETP. That fund was unable to borrow enough shares to meet demand, leading to performance problems.
Similarly, BlackRock had to review its iShares Global Clean Energy ETF in 2020 after a surge in assets forced a complete portfolio redesign. Lamont called the MicroStrategy ETF situation “a stuttering engine.” Rapid growth, he said, often reveals hidden flaws.
The Securities and Exchange Commission (SEC) discourages ETFs from closing to new investors, even when they run out of swaps. But Kashner suggested that stopping the creation of new units could solve the problem.
This would effectively turn ETFs into closed-end funds, where prices and net asset values ​​do not always match. “Fund companies must choose between growth and precision, and they have clearly prioritized growth,” he said.
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