How Do Bitcoin ETFs Work and What Are the Pros and Cons?

Last month, the first Bitcoin exchange-traded fund (ETF) debuted. Since then, several others have hit the market, with more expected.

Bitcoin ETFs are different from more traditional stock- or commodity-based exchange-traded funds invested in equity or physically backed funds, though, as they don’t offer actual exposure to Bitcoin. Rather, these Bitcoin ETFs trade on Bitcoin futures. At least for now.

So should you invest in a futures-based crypto ETF?

To help you decide, we’re answering the question, “What is a Bitcoin ETF?” along with offering the pros and cons of Bitcoin ETFs. But first, we need to look at what an ETF is, as well as the role futures currently play in crypto ETFs (assuming non-BTC ETFs hit the market).

What Is an ETF?

In the most basic terms, an exchange-traded fund is a security that tracks a commodity, index, sector, or other asset-such as gold or cryptocurrency. As with traditional stocks, ETFs can be bought or sold on a stock exchange.

For example, an S&P 500 ETF might consist of actual shares of stocks proportional to the makeup of the S&P 500. For an investor seeking broad exposure to the entire market-or who doesn’t feel comfortable picking individual stocks-this can be a great way to get broad market exposure. And because these types of ETFs consist of a portfolio of stocks, they are less vulnerable to individual stock volatility.

Not all ETFs track a basket of assets, though. Others track a single asset. Take a gold ETF, for example. This type of ETF tracks gold price changes. The benefit is that you as an investor are able to generate returns from exposure to gold without physically possessing it yourself, which requires storage space, security, and other logistical concerns.

A Bitcoin ETF is more like the example of a gold ETF in that it tracks a single asset. At least in theory. The reality, however, is a little more complicated, as Bitcoin ETFs do not give you actual exposure to BTC. To understand why this is, we need to explore an additional concept: that of futures.

What Are Futures Contracts?

Futures are contracts to buy or sell an asset at a pre-established price. This means you could end up purchasing an asset below or above the current market price at the end of the contract (called an expiration date).

Traditionally, futures contracts have been used to help insulate producers and suppliers from price volatility by allowing each party to “lock in” a sale or purchase price-the goal being to manage risk rather than maximize profits.

We’ll use corn as an example. By negotiating a sale price for a portion of the upcoming yield in advance, a farmer can worry less about finding enough buyers at the time of harvest, or of the value of corn dropping due to a particularly high-yield year. Similarly, by agreeing on a purchase quantity and price before the crop is even planted, a cereal producer is able to secure a certain bushel price, which could be advantageous should a drought reduce overall yields-in turn driving up prices at harvest.

Futures don’t just apply to commodities like corn, wheat, milk, or oil, though. Investors also trade futures contracts on:

• Bonds
• Currencies
• Precious metals
• Stocks
• Stock indexes
• Treasury notes

And now, futures contracts apply to cryptocurrencies, such as Bitcoin. Still, these crypto futures ETFs are predictably a bit more complex.

How Do Bitcoin Futures ETFs Work?

Over the past few years, the Securities Exchange Commission (SEC) has received numerous applications from companies looking to create ETFs with Bitcoin in them. To date, though, the SEC has rejected spot-based Bitcoin ETF approval (meaning ETFs that hold actual BTC).

As a result, what are often called “Bitcoin ETFs” in the news are more accurately described as Bitcoin futures ETFs. These funds don’t hold actual Bitcoin, and experts say it is unlikely we’ll see ETFs backed by actual Bitcoin for quite some time.

Rather, the current wave of BTC futures ETFs comprise a form of “synthetic” Bitcoin. Backed by a mix of securities and other assets as collateral, this synthetic Bitcoin is designed to deliver returns similar to Bitcoin’s actual returns during the period of the contract. It is somewhat ironic that the collateral held by BTC futures ETFs usually consists of treasury bills and fiat currencies, in addition to futures.

In other words, with a Bitcoin futures ETF, you’re betting on what the price of Bitcoin will be when a given contract expires. This means these funds will not give you long-term Bitcoin exposure. So why invest in a Bitcoin futures ETF vs. actual Bitcoin?

Is a Bitcoin ETF a Good Idea for You?

While there are pros and cons to investing in crypto futures ETFs, the decision ultimately comes down to your investment style and goals, especially over the long term.

Bitcoin ETFs can feel familiar to those who prefer to invest through traditional brokerage accounts. Despite offering typically straightforward pricing, they can come with hefty fees and other trading costs-meaning there are likely less costly ways to invest in Bitcoin and other cryptos.

Because ETFs are heavily regulated, some would argue they are at lower risk of fraud than some of the unregulated crypto exchanges out there. Additionally, since Bitcoin ETFs are not able to offer exposure to the actual assets, there’s no risk of losing the keys to a digital wallet. For this reason, investors might see Bitcoin ETFs as a simpler and “less risky” way to invest.

Investors should, however, note that while ETFs generally track the performance of the market, investing in futures often involves a great deal of speculation. Crypto is also a highly volatile asset class. Futures ETFs, in particular, can behave in unexpected ways, especially in volatile markets-meaning Bitcoin ETFs could pose a risk even to sophisticated investors.

A Bitcoin ETF likely will not beat the market. Nor will a Bitcoin ETF allow you to realize the potentially large gains that may come with holding Bitcoin and other cryptocurrencies over the long term.

To recap the pros and cons of Bitcoin ETFs:

Bitcoin ETF Pros

• Easy to invest in via the stock market
• Typically offer straightforward pricing
• Familiar to those who prefer investing through traditional brokerages

Bitcoin ETF Cons

• Significantly more expensive than buying Bitcoin directly
• Don’t offer exposure to actual Bitcoin
• You can’t sell at any time
• Futures markets are highly speculative
• Unlikely to outperform the Bitcoin market
• Contract lengths negate much of the long-term potential of HODLing

For many of these reasons, Bitcoin ETFs are more likely to be popular with short-term traders looking to profit from market volatility than those wanting to invest in the long-term potential of crypto.

A Better Way to Invest in Crypto?

If you want exposure to crypto without the hassle of wallets or the tax reporting requirements associated with cryptocurrency investing, a self-directed IRA could be your best option.

By investing in Bitcoin and other cryptocurrencies from an IRA account, you’re able to benefit from all the tax advantages associated with an IRA. And because most Americans have a majority of their investable assets tied up in retirement accounts, an IRA could be the only way to begin investing in this fast-growing asset class.

Alto offers two ways to get exposure to Bitcoin and other digital assets:

1. Alto CryptoIRA®

Alto CryptoIRA lets you trade crypto in real time, 24/7, with all the tax advantages of a traditional, SEP, or Roth IRA. Unlike many crypto IRAs, which offer just a few cryptocurrencies, Alto CryptoIRA gives you access to more than 135 coins and tokens via the Coinbase Exchange. These include:

• Bitcoin
• Ethereum
• Solana
• Cardano
• Dogecoin
• Polygon
• Litecoin
• Axie Infinity
• Shiba Inu
• Stellar

And because it’s a tax-advantaged IRA account, you can buy and sell crypto as much and as often as you like without needing to report individual transactions on your taxes. (If you’ve sold crypto in a prior tax year, you know how much of a hassle this is.)

2. Alto IRA

With an Alto IRA, you can invest in a number of trusted crypto asset funds, which hold actual Bitcoin and select other cryptocurrencies (such as Ethereum) based on careful analysis of market trends and long-term potential.

Alto investment partners that provide exposure to crypto include:

• Arca
• BKCoin Capital
• Eaglebrook Advisors
• Grayscale
• NYDIG
• Osprey
• SkyBridge Capital
• Valkyrie
• Vision Hill Group

It’s Never Been Easier to Get Crypto In Your IRA

Whether you’d rather entrust an asset manager with investing in crypto for you or control your own crypto trades, Alto makes it easy to do so within a tax-advantaged IRA.

Depending on the IRA type you choose, you can invest in crypto tax-deferred (via a traditional or SEP IRA) or completely tax-free (via a Roth IRA)-assuming you wait until you’re at least 59-^1/2 years old (and, in the case of a Roth, have had your account open for at least five years).

However you choose to do so, there are major benefits to investing in crypto with an IRA versus on exchanges or via a crypto ETF.

Create an Alto account today and discover a better way to add crypto to your portfolio.

Alto is an administrator of IRAs, is not a fiduciary, and does not provide investment advice. Nothing herein shall be construed as financial, legal, or tax advice. All information in this article is solely for information purposes.