What is a cryptocurrency ETF and how does it work?

Exchange-traded funds (ETFs) have grown in popularity as a means of investing 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 exchanges.

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

In the cryptocurrency market, a fund that tracks the price of one or the multiple digital tokens and consists 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 treated as an exchange-traded one if it meets either of the two following criteria:

Cryptocurrency ETFs invest in businesses transforming business applications by creating and deploying blockchain technology.
Blockchain-based ETFs invest in cryptocurrency investment products provided by asset managers like Bitwise or Grayscale or futures and options, whose prices are linked to the performance of Ether (ETH), Bitcoin (BTC) and other cryptocurrencies.

In general, cryptocurrency ETFs are the extended use case of blockchain technology. For instance, Bitcoin ETFs are the first crypto ETF that try to track the price of BTC, the most valued cryptocurrency among digital assets.

On October 18, 2021, ProShares Bitcoin Strategy ETF (BITO) started trading Bitcoin ETFs, followed by Valkyrie (BTF) and VanEck (XBTF). Although there are no ETFs tied directly to the spot price of Bitcoin (the current market price at which underlying security can be bought or sold), managers of these products watch the price of BTC via the futures markets. Also, Grayscale’s Bitcoin Investment Trust can’t be accessed by mainstream audiences, as it is not an ETF.

Along with 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 securities like cryptocurrencies.

How does a cryptocurrency ETF work?

Crypto ETFs either own the cryptocurrency futures, options or other crypto-based securities, in contrast to traditional ETFs that directly own the underlying asset. The intention is to emulate the fundamental cryptocurrency’s price fluctuations. However, there may be periods when the ETF movements don’t precisely match those of the underlying cryptocurrency because they don’t hold any of it themselves.

Cryptocurrency ETFs are either backed by physical crypto assets or synthetic variants such as derivatives. In the former, crypto investors indirectly own cryptocurrencies without bearing any expenses of owning them outright, and in the latter, instead of reflecting the prices of actual cryptocurrencies, the ETF share price imitates the price movements of derivatives.

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

What are the benefits of cryptocurrency ETFs?

Although there is regulatory uncertainty around cryptocurrency ETFs, crypto investors who own exchange-traded funds may benefit from the following:

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

Are cryptocurrency ETFs safe?

Let’s first answer these questions — are cryptocurrency ETFs regulated and are ETFs good for beginners? — before finding if crypto exchange-traded funds are safe.

All parties involved in cryptocurrency ETF investments are subject to verification, and their trades are being watched to prevent market abuse or funding illegal activities. That said, one can invest more confidently in crypto exchange-traded funds because they are issued by regulated companies and traded on well-known, regulated exchanges.

Nevertheless, the U.S. Securities and Exchange Commission has received numerous requests to legitimize crypto spot exchange-traded funds, but no Bitcoin spot ETF has existed yet. The Bitcoin futures ETF has, however, been accredited by a few businesses.

Apart from the regulation, one should be aware of the risks of cryptocurrency exchange-traded fund investments. For instance, beginners or advanced traders need to understand that there is a limited choice of funds to start exploring cryptocurrency ETFs. Also, the available funds track only a few digital currencies and are subject to cybercrime risks like hacking.

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

How to invest in a cryptocurrency ETF?

A cryptocurrency ETF may be an ideal choice than buying digital assets directly if you don’t want to manage your cryptocurrency investments actively but still want to diversify your portfolio. To invest in blockchain-based ETFs, follow the steps below:

Open an account with brokers like 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 look for ETFs you want to invest in. For instance, if you’re going to invest in ProShares Bitcoin Strategy ETF, type BITO (ticker symbol) into the search bar.
Place a market order for cryptocurrency ETFs you want to buy. Click Buy. Enter the maximum number of shares you may purchase with your current budget.
If you wish to continuously extend your investment portfolio, set up an automatic investment plan with your broker.

Despite the simplicity of the above process, be aware of the expense ratio or management fee associated with ETF investments. 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 do ETFs make money? Then the expense ratio is the answer. The funds’ expense ratio and transaction fees are how ETF providers primarily recoup their costs.

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

Cryptocurrency ETFs vs. mutual funds

Brokers and asset management companies provide mutual funds, which can be either actively or passively managed. Active management means seasoned professionals actively make trades to increase returns, while in the case of passive management, fund managers replicate 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 multiple digital tokens, making it quite similar to a mutual fund investment. Moreover, existing investment accounts can be used to buy both crypto mutual funds and ETFs, and investors incur an expense ratio. However, there are various differences between the two investment vehicles, as listed in the table below:

Regardless of your investment vehicle choice, please note that when you invest in crypto mutual funds or exchange-traded funds, you don’t technically own any cryptocurrency. Therefore, always measure your risk-return tradeoff before investing your hard-earned money into the volatile market.

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This article was originally published by Cointelegraph.com. Read the original article here.