How Do Cryptocurrency Exchange-Traded Funds (ETFs) Work?

Cryptocurrency exchange-traded funds (ETFs) track the price performance of one or more cryptocurrencies by investing in a portfolio linked to their instruments. Like other ETFs, crypto ETFs trade on regular stock exchanges, and investors can hold them in their standard brokerage accounts.

Crypto ETFs can track the value of cryptocurrencies by investing in futures contracts for digital currency, or by investing in digital currencies directly. This makes it possible to gain exposure to cryptocurrency prices without having to do business on a crypto exchange or deal with the costs and complexities of directly owning digital assets. However, crypto ETFs can be more expensive than other ETFs.

A growing roster of ETFs—a type of exchange-traded product (ETP)—gives investors the chance to engage in an ever-expanding list of market segments and commodities. After about a decade of regulatory wrangling, the Securities and Exchange Commission (SEC) authorized the first crypto spot ETFs in early 2024. These investment vehicles make it possible for retail investors to gain direct exposure to crypto prices without having to own the assets directly.

How Does a Cryptocurrency ETF Work?

While most ETFs replicate how indexes work by holding a basket of the underlying assets, crypto ETFs have a couple of ways of tracking the performance of a digital currency. Spot ETFs directly hold the cryptocurrency, building a portfolio that naturally replicates the performance of the digital assets it contains. Other crypto ETFs invest in futures contracts, agreements to buy or sell crypto at a predetermined date and price.

Given the structure of their portfolios, these ETFs have share prices that mimic changes in the price of derivatives instead of the cryptocurrencies themselves. Therefore, the price of shares in a given cryptocurrency ETF rises and falls in line with crypto futures contract prices. Like other derivatives, synthetic cryptocurrency ETFs have an additional risk because their operations are not always transparent.

While U.S. regulators refused to approve crypto ETFs for several years, they were readily available to investors in Europe and Canada. The SEC approved the first crypto futures ETFs for the U.S. market in October 2021, and the first crypto spot ETFs in January 2024.

Cryptocurrency Futures ETFs

An analysis of the ProShares Bitcoin Strategy ETF, the first crypto ETF on U.S. markets, shows how crypto futures ETFs work. As of January 2024, the fund assigns about 44% of its portfolio to CME bitcoin futures that expire at the end of the current month, and another 54% in CME bitcoin futures expiring the following month.

As the expiration of the contracts in the portfolio approaches, the fund rolls over its investments, selling the expiring contracts and buying contracts for the coming month. The costs associated with rolling over the contracts may account for some of the differences between the performance of the ETFs and their underlying cryptocurrencies.

After ProShares entered the crypto ETF market, VanEck followed closely behind, launching the VanEck Bitcoin Strategy ETF in November 2021. In addition to investing in CME bitcoin futures contracts, this ETF holds U.S. Treasurys as collateral.

ProShares also offers an ether futures ETF like the one it offers for bitcoin. The Ether Strategy ETF (EETH) tracks the price of ether using futures contracts. For investors looking for exposure to several crypto tokens, ProShares has ETFs that track a combination of bitcoin and ether using equal or market-cap weighting.

There is even an inverse ETF, the ProShares Short Bitcoin Strategy ETF. This uses futures to generate the inverse of bitcoin's returns, making it possible for investors to profit on days when the cryptocurrency's prices decline.

Spot Cryptocurrency ETFs

It is also possible for an investment fund to directly trade and hold cryptocurrencies. Called spot crypto ETFs, these funds buy cryptocurrencies and securitize them. Investors buy and sell shares as needed, just like a traditional ETF. In a spot crypto ETF, the fund can issue and redeem shares, offering retail and other investors more liquidity in the crypto market and a chance to gain exposure to these assets.

Several different asset managers have sought approval from the SEC for spot bitcoin ETFs starting in 2014. Between October 2022 and October 2023, the SEC received more than 3,500 crypto-related fund applications. In January 2024, the SEC finally approved the first 11 bitcoin spot ETFs, potentially opening the door to more cryptocurrency spot ETFs later on.

Advantages of Crypto ETFs

Cryptocurrency ETFs are a developing asset class, and given the regulatory uncertainty, the market may look different in the future. Nevertheless, owning shares in cryptocurrency ETFs has some advantages when accessing the crypto markets.

Exposure Without Ownership

The most significant benefit of cryptocurrency ETFs is that they provide exposure to crypto without additional ownership expenses or exposure to risk. For example, there are custody charges for cryptocurrencies, and some secure digital wallets charge an annual fee. These charges can add up quickly. Cryptocurrency ownership also has other hidden costs, such as transaction and network fees, which are all taken care of by the ETF providers, even if you pay indirectly through your fees.

Lowering the Learning Curve

Cryptocurrency jargon, derived mostly from its technological makeup, is still a roadblock to crypto adoption. Average investors often find it difficult to grasp the scope and function of cryptocurrencies. Plus, these investors might be unfamiliar with networking technology, making crypto-speak, such as halving and blockchain, even more disinviting. Investing in a cryptocurrency ETF makes learning enough to get into crypto much more manageable.

More Security for Investors

Cryptocurrency exchanges, storage devices, wallets, and some poorly designed blockchains have been hacked since they were launched, leading to constant worries in the crypto world about security. Cryptocurrency security can be a tall order for individual investors, who may not be familiar with the required methods. A cryptocurrency ETF takes care of this for you.

Lower Costs for Investors

There are more than 8,900 cryptocurrencies available in trading markets. The infrastructure to buy and sell them is becoming more sound, but it's still relatively untamed territory compared with securities exchanges. For example, some tokens are available on certain cryptocurrency exchanges while others are not, and exchanges can operate in some countries but not others. There are also extra costs that come with buying crypto. Cryptocurrency ETFs allow you to diversify your holdings without the fees and hassles of buying and exchanging the tokens yourself.

The Disadvantages of Crypto ETFs

The novelty of cryptocurrency ETFs is one of its drawbacks, not least since it's still unknown how regulations in this area will evolve. Given the likelihood that more crypto ETFs will come online, including, perhaps, spot ETFs in the U.S., it's important to be aware of their potential issues.

The Risk of Tracking Error

Crypto ETFs do not always duplicate the price moves of the underlying digital token. This is especially true for ETFs that depend on futures contracts to track cryptocurrencies, which have to roll over their positions as contracts expire.

Higher ETF Fees

While crypto ETFs help investors avoid some costs of directly owning digital currencies, they have their own fees. Since they are often actively managed, crypto ETFs can have higher expense ratios than other ETFs. For example, the ProShares Bitcoin Strategy ETF's expense ratio is 0.95%, while the VanEck Bitcoin Strategy ETF is 0.76%. For comparison, the expense ratio for the SPDR S&P 500 ETF is just 0.09%.

Volatility

Although cryptocurrency ETFs simplify some of what's involved in trading digital currencies, they are still subject to the dramatic price swings of the crypto markets. This means more risk for you, which can be even more worrying if you are more accustomed to the lower volatility of more typical ETFs.

Lack of Direct Ownership

Investors in crypto ETFs are not the owners of the digital assets. While crypto ETFs do bring convenience, you won't have control or access to the cryptocurrency itself, and the decentralization and anonymity associated with crypto don't apply to ETF shareholders.

Alternatives to Cryptocurrency ETFs

In addition to allocating funds to futures ETFs or awaiting the possible approval of spot ETFs, investors can put their money into several other ETF-like products for crypto exposure. Let's dig into these options.

Crypto Trusts

While the SEC has only reluctantly approved a handful of crypto ETFs, a similar product has already been available for years: bitcoin investment trusts. These are closed-end funds that resemble the spot crypto ETFs being proposed. They own bitcoins on behalf of investors, and their shares trade in over-the-counter markets.

But they are not ETFs. They are open only to investment firms, accredited investors, or high-net-worth individuals and are not accessible to the retail public. They tend to have a high minimum investment amount, and each purchase of shares is accompanied by a lock-up period for investors.

Companies That Hold Crypto

Investing in companies that hold cryptocurrencies on their balance sheet is another way to invest in crypto without owning the digital tokens. Some publicly listed companies hold a large number of bitcoins. For example, MicroStrategy Inc. owned 189,150 bitcoins as of Dec. 27, 2023. Galaxy Digital Holdings Ltd. and Square Inc. are also publicly listed companies with bitcoin on their balance sheets.

Crypto-Related ETFs

Plenty of ETFs offer diversified exposure to companies that engage with blockchain technology or crypto companies. For example, the Amplify Transformational Data Sharing ETF (BLOK) holds a portfolio of companies that develop and use blockchain technologies.

The Bottom Line

ETFs are a retail investor-friendly way to gain exposure to assets that might otherwise be too costly. Brokers want to offer exchange-traded funds that hold cryptocurrency so that average investors can participate in cryptocurrency investing. However, these funds tend to come with additional risks and expenses, so it is important to research thoroughly before making an investment decision.

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