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Industry ETFs, Risk and the role of Bitcoin

26 May 2022, by Amy Sarcevic

Exchange traded funds are quickly becoming one of the most talked about investment vehicles in Australia, with the record net inflows seen in last year’s industry roundup a particular discussion theme. In the context of crypto ETFs, however, certain aspects of risk assessment have not received as much focus.

Jeff Yew of Monochrome warns that, in contrast to traditional investments, crypto should not be approached with a blanket approach or a ‘traditional’ lens. Within crypto-assets, risk profiles and appropriate use can vary greatly, depending on the category of each crypto asset; so an overarching proposition is fraught with pitfalls, he says.

While Monochrome follows ASIC guidance – as outlined in Consultation Paper 343 and Report 705 – on what is classified as a ‘crypto-asset’ – at this point in time, only Bitcoin and Ethereum meet the suitability criteria .

“Structure and details of an actual ETF offering are important, such as the issuer’s understanding and experience with the underlying asset, custody provisions, tracking accuracy, etc. Even more so with a crypto-asset like Bitcoin, due to the idiosyncratic risks of the nascent asset,” said Jeff ahead of the Inside ETF Australia Conference.

“Such unique features include a 24/7 global markets, volatility, unique custody risk, tracking error risk, risk related to the appropriate use of the asset, and an evolving global regulatory landscape.

“When it comes to a Bitcoin ETF, investors may want to consider the tracking accuracy to the underlying price of the asset (Bitcoin). This ensures their exposure vehicle more closely mirrors the targeted asset.

“A poorly tracked Bitcoin ETF with lower management fees can incur significantly more performance leakage than a better tracked Bitcoin ETF with higher management fees. This can be a rather unusual concept for regular retail investors, hence more education is required.”

According to Jeff, two areas stand out for product structure consideration. Firstly, service partner selection, including the benchmark provider. Secondly, how many degrees of separation an investor has from the underlying asset.

“On the second consideration, cross-national ‘fund of fund’ products introduce caveats relating to diverging regulatory bases and where final product controls lie,” he said.

“One of the biggest developing examples relates to the classification of crypto-assets by regulators. For example, in the US, Bitcoin is considered by the CFTC as a commodity; in Canada, Bitcoin falls under securities legislation governed by the OSC.

“Meanwhile in Australia, Bitcoin and Ethereum fall under ASIC’s new ‘crypto-asset’ classification in REP 705, which means issuers are required to obtain a new AFS authorisation in order to offer true to label spot Bitcoin ETFs.

“The key is to remember that various jurisdictions are going their own way with regulation.” There is “global regulatory divergence”, i.e. no agreed blanket solution.

Understanding the various risks for investors by doing thorough research on each crypto-asset and assessing their suitability as investable assets is important, Jeff added, with the recent Terra Luna situation offering a timely reminder of why.

Bitcoin mining, Bitcoin and industry baskets

Another issue of lumping ETFs together is that investors often do not realise the differences between crypto-asset ETFs and ETFs offering indirect exposure to the sector.

Previously, in the absence of ‘pure’ exposure to an asset like bitcoin, products have entered the listed market in the form of providing proxy exposure via a basket of listed companies that participates in the crypto industry, Jeff says.

“These products may take an active call of including a list of companies that derive revenue or have some form of close interactions with various crypto sectors, be it from payment providers, crypto exchanges, energy and mining companies- and create a broad basket of diffused exposure.”

While these industry-based products have their place, they are not like-for-like replacements for direct exposure, he added.

“Indirect crypto industry baskets offer a notably different risk and volatility profile to spot holdings for example. The same extends to single-asset crypto ETFs versus mixed-assets baskets.”

Following the release in an in-depth report covering these topics, Monochrome is due to present at the Inside ETF Australia Conference later this month. Jeff Yew will join an insightful panel, sharing his thoughts on the latest ETF developments.

This year’s conference will be held May 30 at the Hilton Sydney.

Learn more and register your place here.

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