WSJ: Risks of MicroStrategy Stock's Bitcoin Bet Emerges Amid Bitcoin Fervor

Editor's Note: This article analyzes leveraged funds launched by Tuttle Capital and Defiance ETFs, focusing on MicroStrategy stock to amplify its Bitcoin-related returns. These funds use derivatives and options for leverage but face liquidity issues, resulting in underperformance. Investors disappointed by the funds' deviation from expectations criticize that these funds exacerbate MicroStrategy's stock price volatility and pose a risk that could lead to losses.

The following is the original content (slightly rephrased for better readability):

Investors have flocked to funds seeking to amplify daily returns on MicroStrategy stock, but these ETFs have recently failed to perform as expected.

MicroStrategy's founder Michael Saylor, this software company has turned into a Bitcoin buying machine. Image Source: LIAM KENNEDY/ BLOOMBERG NEWS

Investors have poured into a pair of high-leverage exchange-traded funds (ETFs), seeking to capitalize on Bitcoin's momentum, but these funds carry hidden risks that are not widely understood. These ETFs aim to amplify MicroStrategy's daily returns, as this company has transformed itself into a Bitcoin buying machine. Through the use of complex derivative trades, their goal is to provide twice the stock's daily returns, whether it is up or down.

These funds, launched by asset management companies like Tuttle Capital Management and Defiance ETFs, inherently carried high risks from the start, as MicroStrategy itself is a leverage bet on Bitcoin, holding around $35 billion in Bitcoin. However, optimistic investors have driven its market value to nearly $90 billion, more than twice the value of its held Bitcoin, leading skeptics to believe that this situation is unsustainable.

The Defiance Daily Target 2X Long MSTR ETF and T-Rex 2X Long MSTR Daily Target ETF are designed for investors looking to make more aggressive bets on stocks. Since their respective launches in August and September, the total assets of these two funds have expanded to about $5 billion.

Some analysts suggest that these funds are driving the crazy surge in MicroStrategy's stock price. They warn that if the stock were to drop 51% in a day, these ETFs could potentially collapse entirely, similar to some volatility-related ETFs blowing up after the 2018 market turbulence event known as "Volmageddon."

What's even worse is that recently these two 2X leverage ETFs have not performed as expected. On Wednesday, while MicroStrategy's stock rose by 9.9%, the T-Rex fund only rose by 13.9%, falling short of the 19.8% target. When the stock fell, the T-Rex fund's performance was also disappointing. On Monday, when MicroStrategy dropped by 1.9%, the fund's stock price fell by 6.2%.

This has sparked widespread discussion among investors on social media, with many questioning this discrepancy and feeling deceived.

36-year-old wine merchant and day trader Jesse Schwartz in Washington state has been using these funds to amplify his exposure to stocks, and he was particularly surprised to see the stocks not perform as advertised. Schwartz called his brokerage firm Charles Schwab to inquire about the discrepancy, but he was not satisfied with the company's explanation, ultimately selling off all his shares before the end of the week.

"It's safe to say it's been disappointing," Schwartz said. "I took on more downside risk, but did not see the rewards on the upside."

Since regulatory approval in 2022, dozens of ETFs focused on individual stocks have been launched by small fund managers. So far, most of these funds have operated as expected. Popular funds aiming to double the daily returns of Nvidia and Tesla often closely track their targets, thanks to the use of financial contracts known as total return swaps.

Supporters of these funds argue that they offer ordinary investors a strategy Wall Street has long used. Critics, however, believe they could be risky as they do not provide diversification. Take the MicroStrategy funds, for example; these funds expose investors to highly volatile stocks through leverage and are tied to an unpredictable stock linked to cryptocurrency price movements.

Critics warn that this frenzy is part of a broader investor enthusiasm targeting speculative assets that could ultimately crash.

MicroStrategy holds about $35 billion in Bitcoin. Image Source: KEVIN SIKORSKY

The manager of the MicroStrategy fund said they may struggle to achieve their goal of a 2x return as their prime broker — a firm that provides securities lending and other services to professional investors — has hit the limit of willing to provide swap exposure.

Leveraged ETFs typically achieve their desired effect through the use of swaps, which are widely available for the largest, most liquid stocks. Swap contracts pay based on the performance of the underlying asset, allowing the fund to precisely double the daily performance of a stock or index.

Matt Tuttle, manager of the Tuttle Capital and Rex Shares 2x leveraged MicroStrategy fund, said he couldn't get enough swaps to support his rapidly growing fund. He stated that his main prime broker currently offers him swap exposure of $20-50 million, while at one point last week he could have used $1.3 billion in swaps.

Both Tuttle and Defiance ETFs CEO Sylvia Jablonski said they are turning to the options market to achieve leveraged results for the MicroStrategy fund. Traders can effectively use options to double the daily returns of assets, but analysts say this is a less precise method.

Option prices fluctuate, and large buyers like ETFs can move markets. Tuttle said using options is a primary reason for tracking error exacerbation.

Defiance ETF saw a nearly threefold drop on November 25 compared to the underlying stock. Last Friday, while MicroStrategy fell only 0.35%, the ETF dropped 1.76%.

Analysts believe the launch of leveraged MicroStrategy ETFs has accelerated the stock's volatility. These ETFs must adjust their exposure daily to achieve the leveraged effect. Market makers providing swaps and options usually trade the actual MicroStrategy stock to hedge their risk.

“It’s like driving with a cinder block tied to your foot; you can still control the gas, but the default is to floor it,” said ETF industry veteran Dave Nadig, who has worked at VettaFi and FactSet.

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