Behind the surge in MicroStrategy: the unknown “2X MSTR ETF”

Original title: Bitcoin Euphoria Threatens to Break These ETFs

Author: Jack Pitcher, The Wall Street Journal; Compiler: 0xjs@jinsecaijignore

Investors have flocked to a pair of turbocharged ETFs to ride on Bitcoin's momentum, but they carry hidden risks that are not widely understood.

These ETFs are designed to amplify the daily returns of MicroStrategy, the software company that has turned itself into a Bitcoin buying machine. They use complex derivatives bets designed to deliver double the daily returns of stocks - whether they're up or down.

The ETFs, managed by asset manager Tuttle Capital Management and Defiance ETFs, are inherently risky. MicroStrategy itself is a leveraged bet on Bitcoin, holding about $35 billion in the cryptocurrency. But bullish investors have pushed its market value to nearly $90 billion, more than double the value of its Bitcoin holdings. Skeptics say that's unsustainable.

The Defiance Daily Target 2X Long MSTR ETF and T-Rex 2X Long MSTR Daily Target ETF are designed for investors who want a more aggressive bet on the stock. The two funds have swelled to about $5 billion in total assets since their launches in August and September, respectively.

Some analysts say these ETFs have driven MicroStrategy’s big gains. They warn that the ETFs could be wiped out if the stock drops 51% in a single day, a crash similar to what happened to some volatility-linked ETFs after the 2018 market event known as Volmageddon.

Importantly, the two 2X ETFs haven’t performed as expected in recent days. MicroStrategy shares rose 9.9% on Wednesday, but the T-Rex fund rose only 13.9%, rather than the expected 19.8% target gain. The fund’s performance has also been disappointing when the stock has fallen. On Monday, when MicroStrategy shares fell 1.9%, the fund fell 6.2%.

The performance sparked an outcry on social media from investors who questioned the discrepancy and said they felt cheated.

Jesse Schwartz, a 36-year-old Washington state winemaker and day trader, had been using the funds as a vehicle to expand his exposure to the stock.

Schwartz was surprised to find the shares weren't performing as advertised. Schwartz called his broker, Charles Schwab, to ask about the discrepancy but wasn't satisfied with his broker's explanation. He sold all his shares over the weekend.

"It was disappointing, to say the least," Schwartz said. "I took on more than all of the downside risk and got none of the upside reward."

Since the first regulatory approval in 2022, niche fund managers have launched dozens of single-stock ETFs. So far, the funds have performed largely as advertised. Popular funds designed to double the daily returns of Nvidia and Tesla tend to track their targets closely, thanks to their use of financial contracts known as total return swaps.

Backers of these funds say they give regular investors access to strategies long used on Wall Street. Critics say the funds can be dangerous because they don’t offer diversification. In the case of the MicroStrategy ETFs, they’ve added leveraged exposure to volatile stocks that are tied to unpredictable cryptocurrencies. They warn that the hype is part of a broader frenzy among investors for speculative assets that will eventually crash.

Managers of MicroStrategy ETF funds said they may have trouble reaching their 2x target because their top brokers (companies that provide securities lending and other services to professional investors) have reached the limits of swap exposure they are willing to provide.

Leveraged ETFs typically achieve their desired effect through the use of swaps, which are widely used for the largest and most liquid stocks. Swap contract payments are directly tied to the performance of the underlying asset, allowing the fund to precisely double the daily performance of a stock or index.

Matt Tuttle, who manages Tuttle Capital and Rex Shares 2x Long MicroStrategy funds, said he simply can’t get the amount of swaps his thriving funds need. He said his prime broker offered him $20 million to $50 million in swaps, when he could have used $1.3 billion last week.

Both Tuttle and Sylvia Jablonski, CEO of rival Defiance ETFs, said they are turning to the options market to realize leveraged gains on MicroStrategy ETF funds. Traders can effectively use options to double an asset’s daily returns, but analysts say it’s more of an inexact science. Options prices fluctuate, and big buyers like ETFs can move the market.

Tuttle said the use of options is the main reason for the deterioration in tracking.

On Nov. 25, the Defiance ETF fell nearly three times as much as the underlying stock. On Friday, the ETF fell 1.76%, while MicroStrategy fell just 0.35%.

The launch of the leveraged MicroStrategy ETF accelerated the move in MicroStrategy's stock price, analysts said. To achieve leveraged results, the ETF must increase or decrease its exposure every day. The network of market makers that offer swaps and options often buy or sell actual MicroStrategy shares to hedge their exposure.

“It’s like putting a lead weight on your foot while driving. You still have control over the accelerator, but the default mode is flooring,” said Dave Nadig, an ETF industry veteran who previously worked at VettaFi and FactSet.