Bitcoin ETF’s Are Here, Should You Invest? (EP.135)

0:21Welcome to The Long-Term Investor. Before I get into today's episode, I have an exciting announcement. I, along with four other podcast hosts, have launched the Retirement Podcast Network. I, along with Taylor Schulte, host of Stay Wealthy, Benjamin Brandt of Retirement Starts Today Radio, Chad Smith of Financial Symmetry, and Roger Whitney, the Retirement Answer Man, have all come together with the commitment to help people navigate retirement. You can go to the retirementpodcastnetwork.com to learn more. I'll be having a couple of my co-founders on the show later in the year to discuss it. But for now, I just want to say I am really excited about starting this new platform and all the great things it will bring to you, the listener.

1:14Today's episode is also about some very exciting news that came out last week. The Securities and Exchange Commission approved the first U.S. exchange-traded funds that can directly invest in Bitcoin. Until now, investors that wanted direct exposure to digital currencies had to trade on crypto exchanges, which incurred pretty significant transaction fees. or there were some ETFs that came out in 2021 that used futures contracts to gain exposure to Bitcoin price movements. But owning futures contracts rather than the underlying asset leads to differences in return due to the cost of carry. Cost of carry is probably something beyond the scope of this conversation, but you can go back to episode 19, where I talk all about how the cost of carry impacts those Bitcoin futures-backed ETFs.

2:09And of course, I'll also link to that episode in the show notes at thelongterminvestor.com. Now, the ETFs that the SEC approved last week are known as spot price Bitcoin ETFs. Essentially, the term spot indicates the fund's direct holding of Bitcoin rather than a derivative based on Bitcoin's price. And because the funds actually hold Bitcoin instead of these derivatives, the ETF prices should, in theory, mirror the actual Bitcoin price movements in the cryptocurrency market. So for all the investors that haven't learned to deal with digital wallets, remember complex keys, or register on a cryptocurrency exchange, these ETFs offer an easy way to gain exposure through the same brokerages you would use for trading stocks, bonds, or any other ETFs.

3:02In many ways, this development reminds me a lot of when gold ETFs launched in the early 2000s, which offered an accessible avenue to invest in gold via a common brokerage account rather than purchasing actual gold bars. The only notable difference, in my opinion, is security, because most of the physical gold owned by the gold ETFs is held in a giant vault underground in London. But with Bitcoin, security is a valid concern as there is always a risk of cyber theft. ETF providers won't have an underground vault, but they do employ third-party custodians to securely store Bitcoin in an offline, what is called cold storage locations.

3:45But I do think the security issue is a little ironic given that the SEC's social media accounts were hacked and false notice of approval of these ETFs were sent out from the SEC's social media accounts just one day before the ETF filings were actually approved. So there is no doubt that this space is still rife with cyber risk. All these details probably aren't the most interesting thing to talk about given the news. No, that is, should you invest in spot Bitcoin ETFs? Let's start with what is perhaps an overly obvious statement. Fear of missing out is a poor investment strategy. You really should only be investing in Bitcoin ETFs if you see the value in doing so.

4:33I've been consistently publishing content on cryptocurrency since 2017, And what has changed the most over time, in my opinion, about the space has been the complete demise of the case for Bitcoin as a currency. And I mean, that was really the primary case for owning Bitcoin for most of the past decade. And now nearly all of Bitcoin's proponents would agree that that is extremely unlikely because traditional currencies fulfill three purposes. The first is a medium of exchange, so just an instrument or a system used to facilitate the sale, purchase, or trade of goods between parties. The second is that it is a unit of account, a standard monetary unit of measurement, a value, cost of goods, services, assets, liabilities, etc.

5:24And third, a store of value. The function of an asset that can be saved, retrieved, and exchanged at a later date and be predictably useful. Keyword, predictably useful when retrieved. So a store of value is anything that retains its purchasing power into the future. Let me quickly explain why Bitcoin fails on all three accounts. As a medium of exchange, it fails for a number of reasons. For starters, it's wildly volatile, which makes it pretty impractical to use in most everyday transactions. A thing that always comes up is this guy who bought two pizzas for 10 ,000 Bitcoin in 2010 because it'd now be worth something like a half a billion dollars.

6:08Using any medium of exchange shouldn't cause potential for regret. My family gets pizza delivered once a week using US dollars and never once have I needed to worry about whether using my currency would be a mistake. Even worse, exchanging Bitcoin for goods and services triggers taxes because the IRS treats Bitcoin as property subject to short and long-term capital gains. So if you want to go buy a pizza with Bitcoin that has appreciated in value, you are going to owe capital gains tax, which will be anywhere between 15 % and 20%, depending on your income. And for married couples with income above$250 ,000, they're also going to owe a net investment income tax of 3.8%.

6:54So really just not a medium of exchange. When it comes to unit of account, Bitcoin also isn't viable on that front because it's not effectively used to quote prices or contracted amounts. And its status of store of value is shaky at best. When I think of national currencies such as the US dollar or the euro, they derive their prices from the underlying economic activity of the countries that issue them. Bitcoin prices are not based on any sort of economic fundamentals, but rather they depend on speculation about the adoption and use of cryptocurrencies. Such speculation fuels a great deal of uncertainty and that, in turn, translates into the type of high volatility that completely undermines the idea of Bitcoin being a store of value.

7:45It's also worth pointing out, by the way, that a store of value, by definition, has an expected real rate of return equal to zero. So I don't think that's anything to get all worried and fear of missing out for an investment thesis that says it's a store of value. Another popular narrative over the past decade plus has been investing in Bitcoin as a bet on blockchain. It's compelling in some sense, the idea of blockchain is compelling, but Bitcoin is just far too inefficient. Its capacity to process payments is less than 10 per second, which means that it falls short of realistically meeting aspirations to become the next Visa or PayPal that can do hundreds of thousands per second.

8:27The idea of buying cryptocurrency to quote, buy blockchain doesn't really make sense either. Owning Bitcoin doesn't actually give someone any ownership in the underlying blockchain. And even if it did, the blockchain technology that underlines Bitcoin does not power the same blockchains used by a wide range of governments, corporations, and financial institutions already utilizing blockchain technology. I do think that some people are grasping onto the idea of Bitcoin as a commodity. This is a little bit of a newer case, perhaps helped by the fact that the Commodities Futures Trading Commission has been trying to declare cryptocurrencies fall under their jurisdiction.

9:09And on one hand, that's understandable because both Bitcoin and commodity values are determined by demand, acceptance, and usage. However, Bitcoin is not a physical raw material that carries any useful value, whereas traditional commodities like gold and oil do. But this idea that Bitcoin is a form of digital gold seems to be gaining a little bit of traction. But this couldn't actually be further from reality. And honestly, even if Bitcoin was the new gold, I don't really understand how that's much of an argument because I'm not really a fan of people investing in gold either. To me, if anything, Bitcoin is most closely aligned with collectibles like art, baseball cards, or I'll say this but I don't mean to be mean, beanie babies.

9:58Things that derive their pricing from scarcity in supply and level of demand. After listening to me question the reasons people say they're bullish on Bitcoin, it would be easy to categorize me as anti-Bitcoin or anti-cryptocurrency, but that really isn't true. And again, I'm going to link to articles, podcasts that I've done dating back to 2017 in the show notes at thelongterminvestor.com. But let me talk to you a little bit about building portfolios. Building a diversified portfolio requires you to combine exposures with various risk and return characteristics that behave differently over time.

10:36And so by combining exposures that zig with others that zag, the volatility of a portfolio's overall returns is reduced. And that, in turn, allows the portfolio's returns to compound at higher rates. And just the math behind this, if you were to compare two portfolios with the same average return and different levels of volatility, the lower volatility portfolio will have higher compounded returns and a greater ending value than the portfolio with higher volatility. Of course, every new exposure added in the name of diversification comes with a diminishing marginal benefit. So you must carefully weigh the expected net benefits versus the degree of uncertainty.

11:19Bitcoin certainly behaves differently than a traditional asset class such as stocks and bonds, but it doesn't offer any expected premium for bearing the risk of Bitcoin's price movements. That, to me, increases the already high uncertainty around the net benefit from including such an exposure to a portfolio. Bitcoin prices depend mostly on speculation about its adoption and use, and while the increase in institutional adoption has helped drive prices higher, it still lacks an enduring economic rationale that would allow anyone to expect Bitcoin to generate positive, real returns over time. Perhaps that will change over time, or perhaps you don't even care.

12:01Because I'm generally more concerned with implementing a bad idea than missing out on a good one, I'm just not really that big of a believer in Bitcoin as a strategic diversifier. But if you've listened to me throughout this whole episode and you still want to do it, you still want to invest in Bitcoin, I do think there are maybe two reasonable ways to at least think about it. The first is treating the investment like an individual stock. And that actually seems to be the most logical approach when I'm having conversations with people, because while the risks of owning individual stocks are a bit different, there are some decent parallels between the betting nature of owning an individual coin, like Bitcoin or Ethereum or whatever your coin of choice may be, and carving out some part of your portfolio to actively trade can actually be a good thing if it helps you stay the course with your long-term allocation.

12:57And if you hit it big with your active portfolio, great. And if you don't, at least you've limited the exposure to speculative assets. The second way to incorporate Bitcoin into your portfolio is as a strategic part of your long-term asset allocation. And with these products coming to market, I suspect more and more people will be interested in this route. And if that's the case, here's how I think about allocating to a new exposure. I start by considering the relative market weight of that exposure compared to the relative market weights of your other portfolio assets. For example, the global stock and bond markets have a market capitalization of roughly$200 trillion.

13:41I actually think it's closer to$210 trillion, but I'd like to keep the math easy here. So let's say global stock and bond markets have a market capitalization of$200 trillion. Bitcoin's market value is just over$900 million. But again, I'd like some easy math, so I'm going to round up to a trillion. So a prudent asset allocator starting point could consider taking the market cap of Bitcoin, which we're going to call$1 trillion, divided by the market cap of global stock and bond markets, which we're going to call roughly$200 trillion. And that means the starting point for considering an allocation would be half a percent of a portfolio.

14:18If you go either of these routes with Bitcoin or other cryptocurrency exposure, because I would expect other ETFs backed by other cryptocurrency are going to come to market eventually, I strongly suggest you follow a set strategy and try to remove emotional decision-making as much as possible. One of the practices I incorporate into making investment decisions is writing down the reasoning behind my investment decisions. Not only does this force me to clearly define my beliefs about a particular exposure, but it also provides me with honest feedback about my abilities as a prognosticator. And with something as narrative-driven as Bitcoin, I think there are just some simple questions you can ask yourself, such as, what is your time horizon?

15:07What is your return expectation over that time horizon? What is your expected range of outcomes and what probability would you assign to each scenario? How does the position fit into your financial plan? What is your thesis for making an investment and how will you determine if you are right or wrong? Can you tolerate severe losses in the process? Because remember, Bitcoin has already fallen at least 85 % on several occasions. How will this investment change your life in a bullish scenario? And how would it change if it went to zero? I think answering these questions will help you define the why behind your investment and set some reasonable expectations.

15:52Just as important, putting your initial assumptions and strategy in writing guards against overconfidence in your ability to predict the future if your bets pay off for the reasons unrelated to the original thesis. That's all I have for you today. Remember, you can go to the long-term investor.com. You can sign up for my email newsletter. And once you're on that newsletter, all you have to do is hit reply. I send out something every other Wednesday. And when you hit reply, those email responses go directly to me. I answer every single one of them. Nothing makes me happier than hearing from listeners truly.

16:25So please go check that out. thelongterminvestor.com. And as always, thanks for listening.

16:56BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.