WHAT ARE CRYPTO ETFS AND HOW DO THEY WORK?

Crypto ETFs exploded onto the scene in January of this year and have already taken the financial world by storm, as they have already become some of the most purchased ETFs in the entire stock markets of some nations.

But, what exactly are crypto ETFs and how do they differ from a regular ETF?

In this post we’ll answer both of these questions in detail.

Key Takeaways

• Learn what Crypto ETFs do and how they work
• Understand the difference between a crypto ETF and a traditional ETF
• Familiarize yourself with the world’s most traded crypto ETFs

How Does a Cryptocurrency ETF Work?

A Cryptocurrency Exchange Traded Fund (ETF) operates as a bridge between the traditional financial markets and the digital currency space as it offers a way for investors to gain exposure to cryptocurrencies through the stock market, without the complexities and risks associated with buying, holding, and trading cryptocurrencies directly.

Here’s a deeper look into how cryptocurrency ETFs work and an expansion into Bitcoin ETFs specifically:

A cryptocurrency ETF is designed to track the performance of one or more digital currencies and it can do this either by holding the actual cryptocurrencies in custody or by using derivatives and futures contracts to emulate the movements of the crypto market.

Investors purchase shares of the ETF on a stock exchange just as they would with any other stock.

The price of these shares fluctuates based on the underlying performance of the cryptocurrencies or contracts the ETF is tracking, along with market demand for the ETF itself.

By investing in a cryptocurrency ETF, investors can buy and sell shares just like any other stock through traditional brokerage accounts, eliminating the need for a cryptocurrency exchange account or a digital wallet, lowering the entry barrier for traditional investors.

As mentioned, some cryptocurrency ETFs may track the price of a single cryptocurrency, while others may track a basket of cryptocurrencies. This allows investors to diversify their exposure within the crypto market through a single investment.

Bitcoin ETFs, however, specifically track and follow the price of Bitcoin, which is the ETF’s underlying asset.

When investors purchase shares of a Bitcoin ETF they are essentially investing in a financial product which tracks the price of Bitcoin and its growth.

When the trading day ends, the Bitcoin ETFs are given 24 hours to purchase an amount of Bitcoin that is equal to the dollar amount that they received from investors in their Bitcoin ETF for that trading day.

This process ensures that the Bitcoin ETFs are actually holding Bitcoin and are influencing the price of Bitcoin proportionally.

Exchange Traded Funds (ETFs): Why are they important?

For investors who want to minimize risk and properly diversify their asset holdings, ETFs can be a good investment in the stock market.

They are considered the most trusted stocks in the market and are always among the most popular options for long-term investing.

ETFs are important for investors, because they provide diversification, they are cost efficient, have great liquidity, offer a high level of transparency, and are generally tax-efficient.

ETFs also provide access to a wide range of markets and asset classes, including those that might be difficult for individual investors to access directly.

This includes international markets, specific industries, commodities, fixed income markets, and even cryptocurrency. ETFs lower the barrier to entry for investors to diversify their portfolios globally.

And of course, when it comes to crypto ETFs we see the innovation aspect and flexibility that comes with ETFs.

Types of ETFs

Exchange Traded Funds (ETFs) come in various types, catering to different investment strategies, risk profiles, and market sectors.

Below are several of the main types of ETFs, along with two specific examples for each to illustrate the diversity within.

STOCK ETFS

These ETFs invest in stocks and aim to track the performance of a specific index or sector of the stock market.

• S&P 500 ETF (SPY): One of the most well-known ETFs, it aims to track the S&P 500 Index, representing the performance of 500 large companies listed on stock exchanges in the United States.
• Vanguard Total Stock Market ETF (VTI): Seeks to track the performance of the CRSP US Total Market Index, which represents nearly 100% of the U.S. investable equity market.

BOND ETFS

Bond ETFs invest in various types of bonds. They can be used to gain exposure to different segments of the bond market, including government, municipal, and corporate debt.

• iShares Core U.S. Aggregate Bond ETF (AGG): Aims to track an index composed of the total U.S. investment-grade bond market.
• Vanguard Total International Bond ETF (BNDX): Seeks to track the performance of a benchmark index that measures the investment return of non-U.S. investment-grade bonds.

SECTOR AND INDUSTRY ETFS

These ETFs target specific sectors or industries, allowing investors to gain exposure to particular areas of the economy.

• Technology Select Sector SPDR Fund (XLK): Aims to provide investment results that, before expenses, correspond generally to the price and yield performance of the Technology Select Sector Index.
• Financial Select Sector SPDR Fund (XLF): Seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the Financial Select Sector Index.

COMMODITY ETFS

Commodity ETFs invest in physical commodities, such as precious metals, or in commodity futures. They offer a way to invest in commodities without having to physically hold them.

• SPDR Gold Shares (GLD): Aims to reflect the performance of the price of gold bullion.
• United States Oil Fund (USO): Seeks to track the daily price movements of West Texas Intermediate light, sweet crude oil.

INTERNATIONAL AND GLOBAL ETFS

These ETFs provide exposure to foreign markets, allowing investors to invest in countries or regions outside of their home country.

• Vanguard FTSE Emerging Markets ETF (VWO): Aims to track the performance of the FTSE Emerging Markets All Cap China A Inclusion Index.
• iShares MSCI EAFE ETF (EFA): Seeks to track the investment results of an index composed of large- and mid-capitalization developed market equities, excluding the U.S. and Canada.

THEMATIC ETFS

Thematic ETFs focus on specific investment themes or trends, such as technological advancements, social changes, or environmental sustainability.

• ARK Innovation ETF (ARKK): Aims to invest in companies that ARK believes are leading and benefiting from disruptive innovation.
• Global X Robotics & Artificial Intelligence ETF (BOTZ): Seeks to invest in companies that potentially stand to benefit from increased adoption and utilization of robotics and artificial intelligence.

BITCOIN AND CRYPTOCURRENCY ETFS

Bitcoin and cryptocurrency ETFs provide exposure to the cryptocurrency market without the need to directly buy or hold cryptocurrencies.

• iShares Bitcoin Trust ETF (IBIT): The largest spot Bitcoin ETF in the world, managed by the world’s largest investment management firm – Blackrock.
• Bitwise Bitcoin ETF (BITB): BITB provides low-cost access to bitcoin through a traditional, professionally managed ETF, managed by a crypto-native investment firm.

As you can see, each type of ETF offers a unique set of characteristics, risk factors, and potential rewards, catering to the diverse needs and investment strategies of investors.

Advantages and Disadvantages of ETFs

While Exchange Traded Funds (ETFs) have continued to surge in popularity due to their unique advantages, they do also happen to come with certain disadvantages, just like any other investment.

Below we included some advantages and disadvantages to give you a total overview and help you make the most informed investment decisions:

ADVANTAGES OF ETFS

Diversification: ETFs typically hold a wide array of securities, spreading out risk more effectively than individual stocks.

This makes them an excellent tool for achieving portfolio diversification.

Cost Efficiency: Generally, ETFs have lower expense ratios compared to mutual funds, primarily because many are passively managed.

Additionally, the ability to trade ETFs like stocks means investors can avoid the sales loads and minimum investment requirements often associated with mutual funds.

Flexibility and Liquidity: ETFs are traded on stock exchanges, so they can be bought and sold throughout the trading day at market prices.

This provides liquidity and flexibility similar to that of individual stocks.

Transparency: Most ETFs regularly disclose their holdings, allowing investors to see exactly where their money is invested.

This transparency helps investors align their investments with their financial goals and risk tolerance.

Tax Efficiency: The unique structure of ETFs often results in fewer capital gains tax liabilities than mutual funds.

This is because the creation and redemption process of ETF shares typically doesn’t require the fund to sell securities, which can trigger capital gains.

Access to Various Markets: ETFs offer exposure to a wide range of asset classes and niches, from traditional stocks and bonds to commodities and cryptocurrencies, as well as specific industries, sectors, and geographic regions.

DISADVANTAGES OF ETFS

Brokerage Fees: Buying and selling ETFs typically incurs brokerage fees, which can add up, especially for investors who trade frequently or invest small amounts regularly.

Tracking Error: Some ETFs may not perfectly replicate the performance of their benchmark index due to fees, the ETF’s replication method, or other factors.

This discrepancy is known as tracking error and can be drastic if not corrected.

Over-Diversification: While diversification is generally positive, overly broad exposure, especially through multiple overlapping ETFs, can dilute returns and lead to underperformance in rising markets.

Passive Management: Many ETFs are passively managed and aim to track an index.

While this can be an advantage in terms of costs, it also means the ETF won’t outperform the market it tracks, and it may fully participate in market downturns without attempts to mitigate losses.

The Bottom Line

ETFs have long been one of the safest and most effective ways to invest in the stock market, and now with the introduction of crypto ETFs, access to cryptocurrency has never been easier.

The beauty of ETFs are their simplicity, allowing you to diversify and invest in a wide number of companies or asset classes without having to worry about a single corporation ruining your profits.

Now that cryptocurrency ETFs have become mainstream and the increasing trust in Bitcoin as a viable asset, the cryptocurrency industry is seeing remarkable growth.