Summary:
The emergence of investable cryptocurrencies has changed the investment landscape in a way that few could have predicted a decade ago. While still small, at less than $2 trillion in aggregate market cap versus total financial assets in excess of $400 trillion, the asset class has begun to capture tremendous mindshare; debates rage between bulls and bears, leaving many uncertain how to value cryptocurrencies and how to allocate to the asset class in a responsible fashion. Like the DotCom cycle, many individuals and advisors are left scratching their heads, with a high temptation to give in to FOMO (fear of missing out) or to dismiss the assets as a bubble — with risks on both sides. This debate is complicated by the historical success of cryptocurrencies that has left many early adopters with a sizable fraction of their net worth tied up in very volatile assets and by the high margins of crypto exchanges, leaving plenty of advertising dollars available to drive attention to the asset class. Those later to the party are often tempted to make larger allocations in the hopes of catching up. While many suggest a “small” allocation to crypto, in line with the relative market capitalization (roughly 0.5–1% of total global financial assets), there have been few practical tools to allow RIAs to offer clients a modest allocation or for individuals seeking exposure to cryptocurrencies in a direct manner.
The Simplify U.S. Equity Plus GBTC is a strategy designed to accomplish this objective in a tax-efficient manner. By offering an exposure equal to 100% of U.S. Equities plus a 10% additional allocation to the underlying asset in the Grayscale Bitcoin Trust (GBTC), an advisor can select an allocation that matches the desired risk tolerance of clients while eliminating the need for the RIA to buy and sell the exposures to maintain a stable allocation to GBTC. Simplify manages the portfolio by rebalancing quarterly to maintain a more consistent risk profile in the client account; by doing so within an ETF structure, issues of tax calculation, withholding, and reporting are radically simplified for US investors**. Given the much higher volatility of the Grayscale Bitcoin Trust versus the S&P500, this is not a trivial benefit — under plausible scenarios, I believe improvements can potentially be generated in both absolute and risk-adjusted returns.
What are Cryptocurrencies?
A “cryptocurrency” is a digital asset where the proof of its existence resides in a purely digital form. Unlike a common stock or bond, for which a paper and electronic record exist (a stock certificate, CUSIP, etc), a digital currency exists purely as a sequence of digital information on a distributed server network. The ownership of this digital asset is established via a record of transactions, commonly referred to as a blockchain. At any given time, similar to the title on a car or house, a record of the ownership of the digital asset will exist in the blockchain record for that asset; unlike the title of a traditional asset, the records only exist digitally with security being established via massive decentralization of the database records***.
The largest cryptocurrency, by market capitalization, is Bitcoin. Access to cryptocurrencies is difficult for US-based investors. There is no Bitcoin or cryptocurrency ETF or open-end fund currently listed in the United States; the sole dedicated access to Bitcoin as a security is via the Grayscale Bitcoin Trust (GBTC).
Is an Investment in Cryptocurrencies Warranted?
At this point in time, there is significant uncertainty regarding the long-term value of cryptocurrencies like Bitcoin. I am among many who have highlighted the risks to a Bitcoin investment in both writings and via multiple podcast debates. My views are unchanged, and I continue to believe that investment in Bitcoin is socially undesirable, but that is my opinion and others have the right to disagree. Agree or disagree, my objective is to provide them with a method to allocate to cryptocurrencies in an efficient manner.
Many Bitcoin promoters suggest that the “solution” is to allocate a small fraction, say 1%, to Bitcoin. In my view, this is disingenuous. It is virtually impossible to do so given available instruments and Bitcoin’s high historical volatility. An individual, institution, or RIA allocating to Bitcoin could rapidly find themselves with a portfolio whose volatility is dominated by Bitcoin. For investors uncomfortable with direct investments in Bitcoin, a complicated process for most small investors that involves significant risk of asset loss either due to security breaches or outright fraud, there are even fewer options for investment.
I will concede that the answer to the question about the future of Bitcoin is unknowable. The cryptocurrency universe has attracted a diverse pool of talent, both on the design and utility front; significant advances have been made in the security of custody agreements since the early days of cryptocurrencies and institutional investment has risen sharply. High-profile technology companies, like Tesla and Square, have made cryptocurrencies an asset on their balance sheet while financial services companies ranging from Paypal to J.P. Morgan have announced pilot cryptocurrency projects. There are reasonable arguments on both sides even if the tone of the argument is often not reasonable.
The current restrictions on investment in cryptocurrencies in publicly traded funds managed under the Investment Company Act of 1940 (mutual funds and ETFs) are significant. There is no approved mechanism for a fund to invest directly into any cryptocurrency security beyond the Grayscale Bitcoin Trust. The SEC is understandably concerned about the potential for market manipulation in an area where regulation lags significantly behind market interest. As these regulations develop, it is likely that allocations to cryptocurrencies will require flexibility to evaluate additional investment opportunities.
Managing a Portfolio with High Volatility Assets
The unique challenge of managing a portfolio with highly volatile, uncorrelated assets is in the need to rebalance frequently. In the case of Bitcoin, an asset that has realized daily volatility of 94% over the last decade, this is nearly impossible. My calculations suggest that a portfolio that attempted to maintain a ratio of 90% S&P 500 and 10% Bitcoin with an error band of 5% (5–15% Bitcoin) would have required more than 130 separate rebalancing events over the last decade. Each of these events would have required an analysis of the tax implications of the transaction in addition to the challenges of monitoring the respective asset values. For an advisor with multiple client accounts, the management of an allocation to Bitcoin could quickly overwhelm other activities. The problem is magnified for a portfolio of modest size and the desired weight for cryptocurrencies in line with their existing market value-weighted representation of <1%.
While the introduction of Bitcoin futures and the Grayscale Bitcoin Trust closed-end fund has made it easier for advisors to offer clients access to cryptocurrencies, there has not been a tax-efficient method for advisors to rebalance client portfolios. As a result, a client in the highest tax bracket would be facing significant capital gains tax obligations — admittedly a positive outcome, but a challenge nonetheless — and one that can have a significant impact on performance.
But without systematic rebalancing, that return comes with an extraordinary increase in volatility. The benefit of that rebalancing is clear in higher Return/Risk ratios for a rebalanced portfolio using historical Bitcoin data. These results are further enhanced by deploying a rebalancing strategy in a tax-efficient vehicle like an ETF.
The Simplify U.S. Equity Plus GBTC ETF
The Simplify U.S Equity Plus GBTC ETF begins trading on Tuesday, June 25th. The strategy uses a combination of low-cost ETFs that primarily invest in equity securities of US companies and exchange-traded futures contracts to achieve 100% allocation to the U.S. Equities. In addition, 10% of the cash at initiation will be allocated to purchasing exposure to Bitcoin exposure via the Grayscale Bitcoin Trust. As Grayscale is a closed-end fund, if it is trading at a premium or a discount to NAV, Simplify will purchase a target exposure to the underlying cryptocurrency asset that matches the target allocation of the portfolio. This means that if Grayscale is trading at a discount to NAV, as it currently is, clients will purchase additional Bitcoin; if trading at a premium, exposure will be lower. As new vehicles for access to cryptocurrencies become available, Simplify will take an active approach to evaluating the mix of cryptocurrencies.
Portfolios will be rebalanced quarterly with a limitation on cryptocurrency exposure not exceeding 15% of the total portfolio by market value. The ETF wrapper provides compelling efficiencies including transparency, liquidity, tax efficiency, and no K-1’s*.
Product Details
Ticker: SPBC
Inception Date: 5/24/2021
Gross Expense Ratio: 0.50%
Notes:
* Unless you wish to ignore me and allocate a reasonable amount to cryptocurrencies
** In general, ETFs can be tax efficient. ETFs are subject to capital gains tax and taxation of dividend income. However, ETFs are structured in such a manner that taxes are minimized for the holder of the ETF and because the capital gains tax is incurred by the investor after the ETF is sold and is usually not exposed to capital gains on any individual security in the underlying portfolio. However, it is important to note that because the Subsidiary is a controlled foreign corporation, any income received by the Fund from its investments in the Subsidiary will be passed through to the Fund as ordinary income, which may be taxed at less favorable rates than capital gains. The Fund’s investment in Grayscale Bitcoin Trust or similar investment vehicle is a grantor trust for U.S. federal income tax purposes, and therefore an investment by the Fund in such an investment will generally be treated as a direct investment in a cryptocurrency for such purposes.
*** Cryptocurrencies are extremely new and nontraditional assets and a potential shareholder’s ability to evaluate the performance of cryptocurrencies may be limited. Digital assets, represented on a decentralized public transaction ledger that is maintained by an open source protocol, are substantively different from traditional assets and investments. Blockchain systems could be vulnerable to fraud, particularly if a significant minority of participants colluded to defraud the rest. There is little regulation of cryptocurrency and blockchain technology other than the intrinsic public nature of the blockchain system
Investors should carefully consider the investment objectives, risks, charges and expenses of Exchange Traded Funds (ETFs) before investing. To obtain an ETF’s prospectus containing this and other important information, please call (855) 772–8488, or visit SimplifyETFs.com. Please read the prospectus carefully before you invest.
An investment in the fund involves risk, including possible loss of principal. Past performance does not guarantee future results.
The Simplify U.S. Equity PLUS GBTC ETF seeks long-term capital appreciation. The fund is new and has a limited operating history.
Fund Risks:
The Fund invests in companies without restriction as to capitalization. The earnings and prospects of small and medium-sized companies are more volatile than larger companies. Small and medium-sized companies normally have a lower-trading volumes which may tend to make their market price fall more in response to selling pressures and may have limited markets, product lines, or financial resources and lack management experience.
The Fund invests directly in equity securities of U.S. companies and also in exchange-traded futures contracts, Grayscale® Bitcoin Trust, a wholly-owned subsidiary and other exchange-traded funds and is therefore subject to the same risks as the underlying securities. The cost of investing in the Fund will be higher because you indirectly bear the expenses of the Subsidiary as well as entails higher expenses than if invested into the underlying ETF directly. The Subsidiary is a private fund not registered under the Investment Company Act of 1940 and is not subject to all of the investor protections of the 1940 Act, such as limits on leverage when viewed in isolation from the Fund. Futures contracts involve the risks of an imperfect correlation between the change in market value of the instruments held by the Fund and the price of the forward or futures contract; possible lack of a liquid secondary market; leverage, which means a small percentage of assets in futures can have a disproportionately large impact on the Fund and losses are potentially unlimited.
Risks Specific to Bitcoin and Cryptocurrency:
Bitcoins, Cryptocurrencies and pricing on Bitcoin Exchanges and other venues can be highly volatile.
The Fund will not invest “directly” in bitcoin, bitcoin futures, or other cryptocurrencies. The Fund is not expected to track the price movements of cryptocurrencies however the value of the Fund’s investment in the Grayscale® Bitcoin Trust is subject to fluctuations in the value of bitcoins. The value of bitcoins is determined by the supply of and demand for bitcoins in the global market for the trading of bitcoins, which consists of transactions on electronic bitcoin exchanges. The shares of the Grayscale Bitcoin Trust may trade at a premium or discount, may not directly correspond to the price of Bitcoin, and are highly volatile.
Currently, there is relatively small use of bitcoins in the retail and commercial marketplace in comparison to the relatively large use of bitcoins by speculators, thus contributing to price volatility that could adversely affect the Fund’s investment in the Grayscale® Bitcoin Trust. Bitcoin transactions are irrevocable so that stolen or incorrectly transferred bitcoins may be irretrievable. As a result, any incorrectly executed bitcoin transactions could adversely affect the value of the Fund’s investment in the Grayscale® Bitcoin Trust.
Cryptocurrencies operate without central authority or banks and are not backed by any government. Cryptocurrencies may experience very high volatility, and related investment vehicles that invest in cryptocurrencies may be affected by such volatility. Cryptocurrency is not legal tender. Federal, state or foreign governments may restrict the use and exchange of cryptocurrency, and regulation in the U.S. is still developing. Cryptocurrency exchanges have been known to stop operating and have permanently shut down due to fraud, technical glitches, hackers or malware. Cryptocurrencies exchanges are new, largely unregulated, and may be more exposed to fraud.
Simplify ETFs are distributed by Foreside Financial Services, LLC.
