Why New Bitcoin ETFs Could Be the Riskiest Crypto Plays Yet

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Bitcoin has never been more popular. Momentum-seeking investors have sought ways to take advantage of the cryptocurrency revolution, and the advent of bitcoin futures from established exchanges has given some investors a way to bet on bitcoin's success that they never had before. Still, countless investors remain on the sidelines, hoping for a more familiar-looking investment that will give them exposure to the cryptocurrency market.

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Now, it looks like investors might get their wish. A recent move to make two bitcoin-related exchange-traded funds (ETFs) available to the general public could be the game-changer that invites a surge in interest in investing in the cryptocurrency. Yet the risks involved with these vehicles could be dramatically higher than even existing ways to bet on bitcoin's success, and ETF investors will need to be careful in evaluating whether bitcoin ETFs belong in their portfolios.

A rush for new bitcoin ETFs

Just after futures contracts on bitcoin became available, the New York Stock Exchange requested that the U.S. Securities and Exchange Commission allow it to list two exchange-traded funds related to bitcoin. The ProShares Bitcoin ETF and ProShares Short Bitcoin ETF aren't yet available to investors, but if ProShares and the NYSE have their way, they could start trading early in 2018.

ProShares, which is among the top 10 ETF providers in the market, actually filed for its ETFs back in September. That was long before bitcoin futures began trading, but the fund company anticipated that major exchanges would begin futures trading in the cryptocurrency as expected by the end of 2017.

Several other fund providers have also renewed their filings for their own ETFs. Companies including VanEck, First Trust, and REX Shares have sought to open ETFs that also use futures contracts to track the bitcoin market.

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What bitcoin ETFs could bring to the crypto table

How the ProShares bitcoin ETFs would work would be similar to how many other ETFs that track futures contracts operate. ProShares' management team would take positions in bitcoin futures contracts that were consistent with each ETF's investment objective. For ProShares Bitcoin ETF, the objective would be for the value of the portfolio to rise in conjunction with rises in the underlying bitcoin futures that the fund took. ProShares ambitiously believes that it would seek "both for a single day and over time" to match the performance of its underlying bitcoin return benchmark.

For the ProShares Short Bitcoin ETF, the objective would be the opposite: Make the value of the portfolio rise proportionately to declines in bitcoin prices. For this ETF, ProShares is careful to say that it intends to produce the inverse of benchmark performance only for a single day, with the potential for deviation from long-term returns of bitcoin.

Having an ETF available will dramatically increase the number of investors who feel comfortable taking positions in bitcoin. Current vehicles like the Bitcoin Investment Trust exist, but they have structural problems of their own that make it hard for them to track the performance of bitcoin. Similarly, investments in crypto stocks don't always move in lockstep with underlying cryptocurrencies.

The big risk in bitcoin ETFs

Unfortunately, bitcoin ETFs will have huge risks that will likely make them unsuitable for most investors. ETFs that track futures contracts already have problems tracking the price of the underlying commodity, because futures markets themselves don't always match up to spot prices. For instance, at the time of this article, bitcoin futures for March 2018 traded at a price $500 higher than the January futures contract. Similar deviations in other commodities markets are common, and they can hurt returns of futures-based ETFs compared to the underlying investment.

Moreover, the bitcoin futures market itself isn't nearly as big as most of the commodities markets that have established ETFs tracking them. Just a few thousand futures contracts have been trading hands each day in the bitcoin market, compared to totals of several hundred thousand contracts in popular markets like crude oil. Light volume means that prices can move abruptly, a risk that already exists in the underlying bitcoin price.

Should you buy bitcoin ETFs?

The appeal of bitcoin ETFs is that they'll offer a chance to own a bitcoin investment without going to the trouble of acquiring bitcoin itself. For many who believe in the future of the cryptocurrency, that will be impetus enough to buy a bitcoin ETF. Prudent investors should wait until the ETFs are available and have traded for a while in order to see whether they do a good job in tracking bitcoin prices. Unless they do, investors will want to steer clear of bitcoin ETFs for good and seek better ways to profit from cryptocurrency.

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Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.