Investors have poured billions into two highly leveraged ETFs linked to MicroStrategy Inc. MSTR, a company synonymous with aggressive Bitcoin BTC/USD investments.
What Happened: The T-Rex 2X Long MSTR Daily Target ETF and the Defiance Daily Target 2X Long MSTR ETF collectively now manage around $5 billion in assets, reflecting the fervor surrounding Bitcoin's recent rally, according to a report by The Wall Street Journal.
However, these funds, designed to amplify MicroStrategy's daily stock returns by 2x, have exposed investors to significant risks and underperformance.
MicroStrategy, which holds approximately $35 billion in Bitcoin, has seen its market capitalization surge to nearly $90 billion—more than double the value of its cryptocurrency holdings.
Analysts attribute this to bullish sentiment among investors and speculate that the leveraged ETFs are contributing to the stock's meteoric rise.
But skeptics warn that this level of exuberance is unsustainable.
Both ETFs are inherently risky due to their complex derivatives strategies and MicroStrategy's Bitcoin exposure.
The funds aim to double the daily return of MicroStrategy stock, but their performance has fallen short recently.
For instance, on a day when MicroStrategy rose 9.9%, the T-Rex ETF gained only 13.9%, far below the expected 19.8%.
Similar discrepancies occurred during downswings, frustrating investors like Jesse Schwartz, a winemaker and day trader.
"I'm getting more than the full risk to the downside and then not getting rewarded on the upside," he said after selling his holdings.
Single-stock ETFs, a relatively new investment tool approved in 2022, are designed to allow everyday investors access to leveraged strategies previously limited to Wall Street professionals.
While ETFs targeting Tesla and Nvidia NVDA have successfully mirrored their intended 2x returns, the MicroStrategy funds have struggled.
Managers attribute the underperformance to challenges in securing swap contracts, the primary financial tool leveraged ETFs use to track their targets.
Matt Tuttle of Tuttle Capital Management, which operates the T-Rex ETF, revealed that his prime brokers have restricted access to swaps, offering only $20 million to $50 million in exposure—far less than the $1.3 billion needed to keep up with fund demand.
As a result, fund managers are turning to options markets as an alternative, but these come with higher volatility and imprecise outcomes. "The use of options is the primary reason tracking has worsened," Tuttle said.
Sylvia Jablonski, CEO of Defiance ETFs, echoed similar concerns, citing the challenges of achieving 2x outcomes with options.
Analysts note that the funds' reliance on options has introduced additional volatility, as options pricing can fluctuate significantly and large purchases by ETFs can distort market dynamics.
Why It Matters: The introduction of these leveraged ETFs has amplified volatility in MicroStrategy shares.
To maintain their leveraged positions, ETFs must adjust their exposure daily, leading market makers to buy or sell MicroStrategy shares as part of their hedging strategies.
This creates a feedback loop that can intensify stock movements.
"It's like putting a lead weight on your foot when you're driving a car," said ETF industry expert Dave Nadig. "The default mode is going to be floored."
Despite their allure, critics warn that these ETFs lack diversification and heighten exposure to MicroStrategy's inherent volatility, driven by its reliance on Bitcoin.
In extreme cases, such as a 51% drop in MicroStrategy's stock price in a single day, the ETFs could face a complete wipeout, reminiscent of the 2018 "Volmageddon" event in volatility-linked ETFs.
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