The hype and excitement have been building for the potential launch of America’s first Bitcoin ETF. Bitcoin and other cryptocurrencies have been a quagmire for investors, financial advisors and regulators. Is this a digital currency like Euros and Yens? Is it like Gold? Regulators like the SEC have yet to make any definitive answers on these questions, but they might very soon.

Cryptocurrencies have been a difficult issue for many from day one. For the government, it’s a difficult issue to regulate. The SEC says they don’t even consider a “security” like a stock, bond, currency, or commodity – but that’s mainly because laws haven’t caught up to today. For investors, it’s a difficult issue because it’s so hard to invest in. Bitcoin, Ether, digital wallets, tokens, blockchain, NFTs… Huh? That is why so many investors (large and small) have been waiting for the SEC to make things easier by approving an ETF or mutual fund that gives them exposure to cryptocurrencies without actually owning them.

Currently, there are over ten investment firms looking to launch a bitcoin ETF or mutual fund. But the SEC is moving very cautiously. It was only a few weeks ago that regulators approved America’s first bitcoin mutual fund; and it is expected that they will approve a bitcoin ETF any day now. Unfortunately, that comes with a host of caveats. For one, these mutual funds and ETFs will not be allowed to own bitcoin directly. They can only buy derivatives of bitcoin like regulated “futures” that are traded on large exchanges like the Chicago Board of Exchange (CBOE). While it might be a huge step in the right direction, is it the right direction for you?

Investing in eclectic areas like bitcoin, currencies, and commodities isn’t exactly the easiest thing. For example, if you think oil prices are going to go up and want to invest $25k in oil, how would you do it? To invest $25k in oil, you’ll need to buy about 375 barrels of oil or about 16,000 gallons. Sixteen thousand gallons? Unless you have a pool in your backyard that you aren’t using, that might be a problem. That is why most investors don’t actually hold barrels of oil or gold bars at home. Instead, they own currencies and commodities through regulated securities called “futures”.

Simply put, futures are derivatives that represent the underlying asset like oil or gold. They’re great, super liquid, easy to buy and sell. Many trade in Chicago at the Chicago Board of Exchange. The biggest problem with derivatives is that they don’t actually represent owning things like gold, oil, or cryptocurrencies. They represent the promise to deliver the underlying asset at a future date. So, you can buy oil futures for September delivery or October delivery. They were designed so farmers could lock in crop prices before harvest. These derivatives are complex and come with embedded costs (the technical term is “roll costs”) that eat away at your returns. Inventors that buy futures based ETFs rarely get the returns they wanted (reply to this email and I’ll be happy to discuss issues like contango and backwardation in the futures curve).

Oil prices have been a huge area of speculation for investors recently. During the plunge back in 2016, investors sought out oil ETFs to take advantage low oil prices. Back then, the most popular ETF was an oil futures-based ETF from ProShares trading under the ticker “USO”. Unfortunately, if you bought that ETF when oil prices bottomed in 2016, you never got the returns you were expecting when oil soared. From the bottom in 2016 to now, oil prices rose around 120% (blue line), but the USO ETF is down 32% (red line). This is because the embedded costs of oil futures were so high that they ate away much of the expected return.

Issues with embedded costs will likely be the same with a cryptocurrency ETF. Eric Balchunas from Bloomberg estimates that the embedded costs of a futures-based ETF will be around 5-10% in a good year. That is 5-10% on top of any management fees! That’s crazy. Index ETFs from Schwab and Vanguard charge 1/100 of that. And these huge fees eat away at YOUR returns. Even crazier is that these roll costs are even higher when markets are super volatile like 2020 (and crypto is always volatile). Bloomberg estimates these roll costs could have been as high as 45% during the past twelve months! So Crypto ETF investors would have only gotten HALF of the returns of the cryptocurrency! And it’s not an anomaly. The same thing happened to investors that invested in the USO ETF!

The approval of cryptocurrency ETFs could be a vanguard moment for crypto fans. But the costs of a potential futures-based crypto ETF seem prohibitive. I’m not here to say if cryptocurrencies are right for you (consult Harmon, Rhonda, Landon, Chris or Josh). But as the SEC approves more and more futures-based crypto ETFs and mutual funds, we warn you about some of the issues that might arise. For Apriem, these issues are too large. We expect that the SEC will approve more futures-based cryptocurrency ETFs any day now. They will get better as the market matures and as regulators catch up to modern times. But as of now, we still haven’t found what we’re looking for.

/ben