Why Bitcoin Investment Trust's Irrational Premium Could Last a Long Time

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Investors are clamoring to invest in bitcoin, and they're looking for any investment vehicle they can find in order to get exposure to the soaring cryptocurrency. The Bitcoin Investment Trust (NASDAQOTH: GBTC) offers one way to own bitcoin indirectly, and the trust's share price has soared along with the price of bitcoin itself. In fact, the cost of shares now dramatically exceeds the value of the bitcoin it owns.

That situation has led investors like prominent short-selling specialist Andrew Left of Citron Research to say that smart investors should bet against Bitcoin Investment Trust. That might be true in the long run, but investors need to understand the challenges involved in reaping profits from the prospect of narrowing investment trust premiums before they simply look at the situation as a way to make some easy money.

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The argument against Bitcoin Investment Trust

The idea of Bitcoin Investment Trust is relatively simple: take investor money and buy bitcoin with it. For its trouble, Grayscale, the management company behind the trust, takes a 2% annual fee. Currently, the trust owns just under 172,000 bitcoin. That means that for each outstanding trust share, the trust owns roughly 0.092 bitcoin. That would imply that the share price should reflect the value of that proportional amount of bitcoin.

However, the trust's share price is actually far higher than that. For instance, on a day when bitcoin traded for around $16,000, shares of the trust were at roughly $2,000. That comes out to about a 35% premium to the $1,472 value of the bitcoin that every trust share arguably represented at that price level.

Why premiums can exist

The reason why Bitcoin Investment Trust started trading at consistent premiums to the value of its underlying bitcoin has to do with supply and demand. Many investors prefer owning a security that they can trade on the open market to direct ownership of bitcoin, which requires a separate relationship with a bitcoin exchange without the consumer protections that stock exchanges generally offer. With many investors preferring trust shares to the cryptocurrency itself, a premium formed.

Ordinarily, such a premium would create an arbitrage opportunity. Indeed, the strategy that Left advocated recently has been available for a long time: sell shares of the trust short, and hedge by buying another investment correlated with bitcoin. Until a couple weeks ago, the only way to do that was to buy bitcoin directly, and even the institutions that generally jump on such arbitrage opportunities seemed reluctant to do that. With the release of bitcoin futures, it became much easier to take a bullish bitcoin position to hedge short bets against the Bitcoin Investment Trust, and that's exactly what Left proposed.

The cost of selling short

If enough professional investors follow Left's guidance, then the premium for the Bitcoin Investment Trust is likely to disappear. However, individual investors shouldn't count on being able to participate in this bet.

The reason: Stocks that are popular targets for short sellers are often classified as "hard to borrow" by brokerage companies. In many cases, that means that a typical broker won't allow you to sell shares of a hard-to-borrow asset short. Even those brokerage companies that do allow short sales for hard-to-borrow stocks will often impose a borrowing fee, and the longer you hold your short position, the larger that fee becomes. Unlike many fund providers in other parts of the ETF market, Grayscale itself hasn't been in a hurry to create new ETF shares, and that has also helped dry up the supply of available shares for short sellers to borrow.

If the cost of selling short is high enough, then it can eat away any advantage that an investor could gain from what looks like an arbitrage opportunity. With institutions shying away from what could be a costly mistake, irrational premiums can persist for a long time.

Closed-end fund investors have seen this play out time and time again. Investors jump into a high-return area, bid funds up to premium levels, and then short-sellers look to come in and take advantage. Yet if they can't borrow shares to sell short, then the premium can survive for months or even years.

Buyer beware

It's understandable why investors hungry for bitcoin investments would turn to Bitcoin Investment Trust, and it's equally reasonable for short specialists like Andrew Left to see trust share-price premiums as an opportunity to profit. Unfortunately, neither strategy is free of risk for individual investors, and structural issues could make it impractical for you to use the same techniques that others hope to use to profit.

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