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Good morning. Lots of great responses to yesterday’s margins piece; I address a few of the points raised below. But first, a brief screed about the wrong kind of financial innovation. Email me: robert.armstrong
Bitcoin ETFs: a bad idea whose time has come
You can now buy a bitcoin exchange traded fund. Or rather, a Bitcoin derivatives ETF: ProShares Bitcoin Strategy, which tries to capture returns from the cryptocurrency using futures contracts, started trading yesterday.
I’m sure this is good news for someone, but on the face of it, it is hard to imagine a less appealing financial product.
The original idea of an ETF was that it provided a cheap way to receive the beta available in a given market, beta that would be hard to efficiently capture otherwise. Reproducing the return of the Russell 3000 would be a pain in the ass for me to do at home, but Vanguard’s ETF does an almost perfect job of it for me, for all of 10 basis points.
Bitcoin Strategy provides an expensive way to capture some of the beta in a market, which it would be easy to capture, more efficiently, another way. The annual fee is 1 per cent. It draws its exposure to changes in bitcoin’s price from short-term bitcoin futures contracts, meaning that it has to regularly sell expiring contracts and buy new ones. Because the longer-term contracts are usually more expensive than the shorter ones, rolling the contracts over creates a drag on performance that, it has been estimated, could run to 5-10 per cent annually. The chances that the ETF will perform nearly as well as bitcoin are very low.
This is not very attractive, given than I can jump on to a crypto exchange and buy bitcoins directly, get all of the digital asset’s performance, and pay a lower fee.
Other bitcoin funds might be even worse. The great big Grayscale Bitcoin Trust owns bitcoin directly, but it charges 2 per cent. It is a closed-end fund, meaning new shares are not created when assets flow into it. The trust units therefore trade according to supply and demand, rather than maintaining a link to the value of the underlying assets, as would be the case with an ETF. This year the value of the units have fallen to a 25 per cent discount to the underlying bitcoins (perhaps because investors saw an ETF coming), meaning its relative performance has been awful. But at least a discount to net asset value does not recur year after year, like the costs of rolling futures contracts.
Grayscale wants to convert the trust to an ETF, one that owns bitcoins rather than futures, to lose the discount. Which raises a question: why has the Securities and Exchange Commission approved a bitcoin futures ETF, and not yet a plain bitcoin ETF? Bitcoin is tricky enough. Adding futures compounds the trickiness.
I’m not sure what the answer to this is, but it seems to be that bitcoin scares the SEC, because God knows where it originates (in a server farm somewhere in China?), who holds most of it (cyberbaddies?), what it is used for (illegal activity?), or what risks it may entail (hacking? Fraud?). Bitcoin futures, by contrast, are created and traded within the confines of the CME, under the watchful eye of the Commodity Futures Trading Commission, in the upstanding American city of Chicago.
Now, it seems to me that any derivatives market should have all the risks of the underlying cash market and more. But then I’m not a financial regulator.
So why would anyone want to buy the ProShares fund? Or any bitcoin ETF? I asked an executive in the bitcoin fund industry, and here is what they said:
“The analogy I refer to when asked this question is gold. Investors owned it for years in bars or coins, but then in 2004 a gold ETF was created, and tens of billions [of dollars] have been invested in it . . .
“It’s about convenience and access. If you think about where your investors’ pools of capital lie — in a 401k, brokerage accounts — the fact is that ways to access bitcoin generally lie outside that system . . .
“In the case of a bitcoin ETF, it takes the custody aspect of owning these coins out of individual investors’ hands, and that can be a good thing. Purists will say if you don’t hold your own private key, and so on, you don’t have real control. But lots of investors want access and don’t want to do research into the myriad custodial options. They just want to buy a simple product from someone they trust.”
This is the heart of the matter. People want access to crypto returns, but they want the process to work like a standard financial product, and they want bitcoin to sit right alongside the other products in their portfolio. This is the reason products such as ProShares’s exist.
But it is a bad reason. Bitcoin is not at all like standard financial products. It is supported by highly complex technology, the source of its value is fundamentally open for debate, and by far its most common current use is as a vehicle for the purest speculation. If you can’t be bothered to learn the unique subtleties involved in owning this stuff, you can’t possibly understand the risks, and so you should not own it at all. Bitcoin ETFs should not exist.
A few more points on margins
Several readers suggested that the reason margins are high and (I believe) sustainable is that the US economy is dominated by industrial oligopolies, particularly in technology. This might be true. Certainly, rising margins always indicate something about competition. It is only because competition is limited that all corporate gains in productivity and efficiency are not handed over immediately to the consumer. Software is not a great business just because its marginal cost of production is almost zero. It is a great business because its tiny marginal costs are paired with a legal system that protects intellectual property.
I no longer think we need to worry much about this. Ultimately, an uncompetitive economy will stop innovating and growing, and returns to investors must fall. But I’m not sure what we see in public markets is a degradation of competition as such. Rather, I’m beginning to think we are seeing the mix of public companies, and the mix of businesses within public companies, shift towards products that are brand, research and intellectual property intensive, and these products have higher margins. Here is a chart sent to me by Michel Lerner of Credit Suisse that I think captures this point. It shows the changing proportion of public companies in various markets that spend significantly on research and development. The US is at the left:
I would also note that while tech companies are a big driver of rising margins, they are not the only ones. We have seen notable margin increases in, for example, industrials and consumer discretionary companies as well. Whatever sort of phenomena is unfolding, it is not restricted to tech.
Other readers pointed to another, more pressing threat to margins: inflation. Paul O’Brien noted that while inflation does not cause margin degradation, “some inflationary forces — rising wages, supply constraints — are bad for margins. And higher inflation also can lead to tighter monetary policy and recession, also not good for margins.” He sent along this scatter chart, which plots profits as a share of gross domestic income against inflation (using data from the Federal Reserve). It shows a nasty trend when inflation gets much above 4 per cent:
Here is another way of looking at the same idea, again from Credit Suisse. It shows how inflation spikes were followed by falling operating margins in the US in the 1970s and 1980s. The sequence is certainly suggestive:
If inflation gets bad, it makes sense that margins would fall.
One good read
Sotheby’s is auctioning off the collection of the late master magician Ricky Jay. He was super cool. Here is the catalogue, and here is a great write-up from The New York Times. Maybe I can afford a poster.