What is a cryptocurrency ETF and how does it work?

Exchange-traded funds (ETFs) have become popular as an investment medium since the mid-1990s due to their intraday liquidity and low transaction costs. In general, ETFs track a specific index and are generally traded on an exchange.

In a securities market, ETFs allow investors to trade their shares continuously throughout the trading day, unlike mutual funds, which allow investors to buy or redeem shares only at the close of the trading day.

In the cryptocurrency market, a fund that tracks the price of one or more digital tokens and is made up of various cryptocurrencies is called a cryptocurrency ETF. This article will discuss how a cryptocurrency ETF works and the benefits and risks involved in cryptocurrency ETFs.

What is a cryptocurrency ETF?

A fund is considered publicly traded if it meets one of the following two criteria:

  • Cryptocurrency ETFs invest in companies that transform business applications by creating and implementing blockchain technology.
  • Blockchain-based ETFs invest in cryptocurrency investment products provided by asset managers such as Bitwise or Grayscale or futures and options, the prices of which are tied to the performance of Ether (ETH), Bitcoin (BTC) and other cryptocurrencies.

In general, cryptocurrency ETFs are the extended use case of blockchain technology. For example, Bitcoin ETFs are the first crypto ETFs that seek to track the price of BTC, the most popular cryptocurrency among digital assets.

On October 18, 2021, ProShares Bitcoin Strategy ETF (BITO) began trading Bitcoin ETFs, followed by Valkyrie (BTF) and VanEck (XBTF). While there are no ETFs tied directly to Bitcoin’s spot price (the current market price at which the underlying stock can be bought or sold), the managers of these products control the price of BTC via futures markets. Furthermore, the mainstream public cannot access Grayscale’s Bitcoin Investment Trust, as it is not an ETF.

In addition to offering indirect exposure to BTC, Bitcoin ETFs could pose risks to investors if the fund holds a sizable portion of the futures market. Therefore, investors should be cautious while investing in volatile stocks such as cryptocurrencies.

How does a cryptocurrency ETF work?

Cryptocurrency ETFs own the futures, options or other securities based on cryptocurrencies, unlike traditional ETFs that own the underlying asset directly. The intention is to emulate the price fluctuations of the fundamental cryptocurrency. However, there may be times when the ETF’s movements don’t exactly match those of the underlying cryptocurrency because they don’t hold anything.

Cryptocurrency ETFs are backed by physical cryptocurrencies or synthetic variants such as derivatives. In the first, cryptocurrency investors indirectly own cryptocurrencies without incurring any expense to own them outright, and in the second, instead of reflecting the prices of actual cryptocurrencies, the price of ETF shares mimics the price movements of derivatives.

So why are cryptocurrency ETFs important? The most obvious reason is portfolio diversification, as Bitcoin or Ether ETF investors can gain exposure to more than one crypto asset, in particular, beyond conventional securities markets.

What are the benefits of cryptocurrency ETFs?

While there is regulatory uncertainty about cryptocurrency ETFs, cryptocurrency investors who own exchange-traded funds can benefit from the following:

  • The primary benefit of investing in exchange-traded funds such as Proshares Bitcoin Strategy ETF is the convenience element of investing in a volatile asset class.
  • The learning curve is outsourced to analysts as they invest in cryptocurrency ETFs, making it an ideal investment vehicle for novice investors.
  • Owning crypto ETFs saves investors from costs such as custody fees and network and transaction fees.
  • An ETF provider is responsible for the security of the fund, offering a sense of security to investors, particularly when it comes to phishing attacks, cryptojacking or cryptocurrency robberies.
  • There is currently no fully developed infrastructure for buying and selling cryptocurrencies. For example, although some tokens are offered on specific cryptocurrency exchanges, others are not. However, investors can diversify their portfolios with cryptocurrency ETFs without paying for individual tokens.

Related: What is cryptojacking? A beginner’s guide to cryptocurrency mining malware

Are cryptocurrency ETFs safe?

Let’s answer these questions first: Are cryptocurrency ETFs regulated and are ETFs good for beginners? – before finding out if cryptocurrency-traded funds are safe.

All parties involved in investing in cryptocurrency ETFs are audited and their operations are audited to prevent market abuse or finance illegal activities. That said, one can more confidently invest in cryptocurrency-traded funds because they are issued by regulated companies and traded on well-known and regulated exchanges.

However, the US Securities and Exchange Commission has received numerous requests to legitimize exchange-traded funds for cryptocurrencies, but there is still no spot ETF for Bitcoin. The Bitcoin futures ETF has, however, been accredited by some companies.

Aside from regulation, you need to be aware of the risks of investing in cryptocurrency exchange-traded funds. For example, beginners or advanced traders need to understand that there is a limited choice of funds to start exploring cryptocurrency ETFs. Furthermore, the available funds only track a few digital currencies and are subject to cybercrime risks such as hacking.

Furthermore, given the volatility of the cryptocurrency market, there is no doubt that large price fluctuations can also be seen with investments in exchange-traded funds, especially in the case of physical funds. Therefore, the safety of any cryptocurrency investment is in the hands of the investors and depends on their knowledge of the pros and cons of the various financial instruments.

How to invest in a cryptocurrency ETF?

A cryptocurrency ETF can be the ideal choice over buying digital assets directly if you don’t want to actively manage your cryptocurrency investments but still want to diversify your portfolio. To invest in blockchain-based ETFs, do the following:

  • Open an account with brokers such as Fidelity Investments, Robinhood, etc. by completing their onboarding process.
  • Decide what percentage of your total investment budget you want to invest in ETFs.
  • Fund your brokerage account and search for the ETFs you want to invest in. For example, if you intend to invest in ProShares Bitcoin Strategy ETFs, type BITO (ticker symbol) in the search bar.
  • Place a market order for the cryptocurrency ETFs you wish to buy. Click Buy. Enter the maximum number of shares you can buy with your current budget.
  • If you want to continuously expand your investment portfolio, set up an automatic investment plan with your broker.

Related: A Beginner’s Guide to Cryptocurrency Trading Strategies

Despite the simplicity of the above process, keep in mind the expense ratio or management fee associated with investing in ETFs. For example, investors who hold mutual funds and exchange-traded funds are subject to an annual fee known as an expense ratio. If you want to know how ETFs earn? Then the expense ratio is the answer. The expense ratio and transaction fees of the funds are how ETF providers primarily recoup their costs.

Furthermore, you should also think about their exit plan. For example, even hodlers, or long-term investors, will likely want or need to sell some of their holdings at some point, which involves paying another trading cost when they sell.

Cryptocurrency ETFs vs Mutual Funds

Brokers and asset management firms provide mutual funds, which can be actively or passively managed. Active management means that experienced professionals actively engage in trades to increase returns, while in the case of passive management, fund managers track a specific benchmark or index to match its performance. A cryptocurrency mutual fund specializes in investing in one or more digital currencies.

As mentioned, a cryptocurrency ETF fund tracks the price of one or more digital tokens, making it quite similar to an investment in a mutual fund. Additionally, existing investment accounts can be used to purchase both crypto mutual funds and ETFs, and investors have to bear an expense ratio. However, there are various differences between the two investment vehicles, as listed in the table below:

Regardless of your choice of investment vehicle, keep in mind that when you invest in crypto mutual funds or exchange-traded funds, you technically don’t own any cryptocurrency. Therefore, always measure your risk-reward trade-off before investing your hard-earned cash in the volatile market.

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