Exploring the Pros and Cons of Crypto ETFs

Whenever the prices of bitcoin and ether spike, investors not yet trading crypto want in on the action. However, many would like to avoid the complex or time-intensive world of digital wallets and crypto exchanges. To fill this demand, fund managers offer cryptocurrency exchange-traded funds (ETFs), a more accessible way to invest in crypto's digital assets.

Crypto ETFs allow you to gain exposure to these currencies through your regular brokerage account, eliminating the need to directly purchase and store the tokens yourself. These funds typically track the performance of one or more cryptocurrencies, providing investors with a convenient way to diversify their portfolios and benefit from the potential growth of this market. The first crypto futures funds launched in 2021; spot bitcoin ETFs joined them in early 2024.

However, investing in crypto ETFs is not without risk. The market is volatile, with prices fluctuating significantly in short periods. In addition, the regulatory landscape for crypto is evolving, and changes in regulations will undoubtedly impact the performance and availability of these ETFs.

As the cryptocurrency market matures and gains mainstream acceptance, crypto ETFs have a central role as investors want exposure to digital currencies. Below, we discuss the pros and cons of crypto ETFs, the different strategies each type of crypto aligns with, and their potential rewards and pitfalls.

Introduction to Crypto ETFs

Crypto ETFs—a type of exchange-traded product—enable you to add crypto exposure to your investment portfolio. Like typical ETFs, they are traded on exchanges and held in traditional brokerage accounts.

An ETF can provide exposure to cryptocurrencies in two ways. Spot ETFs trade crypto tokens directly on behalf of investors, buying bitcoins or other digital assets and storing them. Bitcoin ETFs were approved in early 2024, but thus far, applications for spot ether ETFs are not likely to succeed.

Crypto futures ETFs, the second kind, have gained traction as an alternative to directly investing in these digital assets. These funds track the expected price of one or more cryptocurrencies by trading futures, which are standardized agreements between two parties to exchange a specific quantity of assets on a particular day for a preset price. For instance, a bitcoin futures ETF uses futures contracts to mimic the fluctuations in the price of that currency.

The futures contracts are combined in the ETF's portfolio, and the fund then offers shares to investors on stock exchanges. This allows investors to gain exposure to the cryptocurrency market without buying and managing the digital assets themselves.

However, the U.S. Securities and Exchange Commission (SEC) has long hesitated to approve crypto ETFs, citing concerns that fund managers would be unable to protect investors from manipulation and fraud within the crypto markets. The cryptocurrency market is still largely unregulated, and the SEC has emphasized the need for robust safeguards to ensure fair and transparent trading practices.

The regulator is also concerned that crypto-related investments could introduce speculative bubbles into the heart of the financial world while leading retail investors to believe that SEC approval means these currencies are safer than they are. Hence, the SEC was largely compelled to approve spot bitcoin ETFs in early 2024 after a federal appeals court ruling against them the previous year.

Acceding on one front does not mean the SEC is standing down on others. After the bankruptcies of FTX, Voyager Digital, and other crypto platforms, the SEC moved to double the size of its crypto enforcement division. In the last several years, the SEC has taken over 140 actions against crypto-related firms, with several frauds worth billions.

The SEC's critics have long depicted the agency as overreaching in an area where innovation and the choice of individuals should trump other considerations. But SEC officials have suggested they never wanted to play such a role but were reluctantly drawn in. "We have worked thoughtfully and incrementally in this space," SEC enforcement division director Gurbir Grewal said in June 2023. After initial investigations and civil actions, officials thought "you'd also see compliance" as in other industries facing a crackdown, "but we're not seeing that in this space, so we had to change strategies."

This brings us to where crypto stands in mid-2020s mainstream markets. The table below summarizes the main types of crypto ETFs available: futures-based ETFs, spot ETFs, inverse (short-selling) ETFs, leveraged ETFs, and blockchain ETFs. Each fund type is for specific kinds of strategies and has its own risk and reward profile.

Advantages of Crypto ETFs

Crypto ETFs offer advantages to those interested in gaining exposure to cryptocurrency in their portfolio:

• Diversification: Crypto is a unique asset class, so adding crypto to a portfolio offers diversification. Crypto ETFs also make gaining exposure to several cryptocurrencies easier than a single type of crypto, enabling you to diversify within the crypto world.
• Simplicity: For most investors, buying shares in an ETF is far simpler than buying and holding crypto directly. To invest in crypto directly, you need to create a wallet, find an exchange to use, connect it with your bank account, and use the crypto exchange to buy and sell cryptocurrency. You can skip much of this and trade shares in crypto ETFs from your brokerage account—many times in seconds.
• Security: If you buy your cryptocurrency through an exchange, you can store your security keys on that exchange if it offers that service. However, wallets and exchanges can be hacked, and keys can be stolen. An ETF doesn’t require you to own any cryptocurrency, store keys safely, or move anything back and forth between different types of storage—you own shares of the fund, available on any device with an internet connection.

The complexity of buying and holding crypto directly means that many investors either can’t be bothered or won’t have the technical knowledge required.

Disadvantages of Crypto ETFs

Though crypto ETFs offer benefits, there are significant potential drawbacks:

• Fees: Investing in a crypto ETF is likely to be more expensive than buying cryptocurrency directly. When buying crypto, you only need to make a one-time payment to the exchange, which can be as low as a few hundredths of the value traded. When buying shares of an ETF, you pay your brokerage’s trade fees and the fund’s expense ratio. Crypto ETFs have expense ratios from 0.39% to 1.5%, much higher than the transaction fees charged by crypto exchanges.
• You don't own the tokens: You won't own the crypto directly; even the fund doesn't if it’s a crypto futures ETF.
• Deferring to the ETF management’s strategy: A drawback all ETFs share is that you give up some control. You rely on the fund manager’s strategies, so more complex or precise strategies are unavailable.
• Volatility and unregulated nature of crypto: Many crypto investors speak about the decentralized aspects of the blockchain and these currencies, but the other side is the volatile speculation and unregulated trading within the crypto markets. While the funds are regulated, the crypto market still essentially isn't.
• No 24/7 trading: Finally, you are more limited when you can trade crypto ETFs. Typically, you can only buy and sell ETFs during regular market hours. Crypto exchanges often run 24 hours a day all year.

Crypto ETFs vs. Direct Investment in Cryptocurrency

Investing in crypto ETFs and directly buying crypto provide exposure to cryptocurrency. However, there are many differences between the two.

For many investors, the simplicity of using crypto ETFs will offset its drawbacks, such as higher fees and less control. It’s a significant advantage to buy and sell crypto ETFs like any other fund and hold them in the same brokerage account as your other investments.

However, crypto enthusiasts likely prefer to buy crypto directly. Many coins can be divided into tenths, hundredths, thousandths, or even more granularly, allowing direct investors to buy or sell precisely the amount of each coin they select. Direct investment also has lower costs and the ability to trade at all hours of the day.

Regulatory Considerations

A critical concern for anyone interested in cryptocurrency is regulation. The regulatory environment for crypto has been changing rapidly, and these changes can affect the value of crypto or how funds pegged to their value are run.

The SEC’s review of spot bitcoin ETFs is front and center. These funds directly put money into crypto rather than rely on derivatives to simulate bitcoin's price moves.

Another issue is that the legality of cryptocurrency in some jurisdictions is still not settled. Digital currencies are commonly used in criminal activity, such as smuggling or money laundering, and certain jurisdictions have taken steps to curtail or ban them outright. Major moves to ban crypto could cause a steep drop in value, even if it remains legal in your jurisdiction.

Ethereum ETFs

When the SEC first approved spot bitcoin ETFs, it gave hope to backers of other cryptocurrencies for the same. For example, regulators are reviewing proposals from fund managers like VanEck, Greyscale, and Fidelity for spot ether ETFs, the digital currency native to the Ethereum platform.

Ether is the second-largest crypto by market capitalization, with over $400 billion worth of ETH circulating. This means it's of significant interest to both crypto enthusiasts and institutional investors.

The approval of spot bitcoin ETFs hasn't cleared the way for such funds to be used for ether. As we have reported, regulators have focused on the differences between Ethereum and Bitcoin. In particular, they are concerned that staking—locking up ether as collateral to support a blockchain network in exchange for the rewards of additional crypto—means it's more like a security than bitcoin. The SEC has investigated and fined Kraken and Coinbase for their staking businesses, which it has argued makes these platforms illegal securities operations.

It's worth reviewing quickly what the SEC charged in the Kraken case from November 2023 since this could apply to much of how ETH is traded. In essence, the SEC argued that Kraken engaged in activities typically performed by regulated exchanges, brokers, dealers, and clearing agencies but without being registered or exempted from doing so by the agency:

• Operates as an exchange by providing a platform that matches buyers and sellers of securities using established rules and methods.
• Acts as a broker by executing securities transactions on behalf of its customers.
• Functions as a dealer by buying and selling securities for its account without being exempt from registration.
• It serves as a clearing agency by acting as an intermediary in settling securities transactions for its customers and holding securities on their behalf.

Since investors in a spot ether ETF wouldn't hold the crypto directly, determining who benefits from ether's staking model could mean the SEC thinks there's still much legal ambiguity related to ether trading to allow a spot ETH ETF onto the U.S.'s regulated exchanges.

The Bottom Line

Crypto ETFs allow institutional and everyday investors to speculate on the price of digital currencies. Nevertheless, it’s essential to understand the differences between crypto ETFs and direct investment in crypto, such as higher fees and the lower amount of control you’ll have over the digital assets.

Before investing in crypto ETFs, it’s important to note that crypto is a volatile asset class. Before plunging into these investment waters, getting professional advice is always prudent.

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