The rising popularity of cryptocurrency and the company synonymous with aggressive Bitcoin (BTC-USD) buying, MicroStrategy (MSTR), have triggered rare structural challenges within the $15 trillion global exchange-traded funds (ETF) market, according to an exclusive Financial Times report. While ETFs generally perform as expected, the meteoric growth of two U.S.-listed leveraged MicroStrategy funds has revealed significant tracking errors in recent weeks, raising concerns among investors.
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Tracking error is the difference between an index fund’s returns and its benchmark index.
How Is MSTR Impacting ETFs?
MicroStrategy, the largest corporate holder of Bitcoin, has a cryptocurrency stash of $43 billion fueled by debt. Leveraged ETFs like the T-Rex 2X Long MSTR Daily Target ETF (MSTU) and the Defiance Daily Target 1.75x Long MSTR ETF (MSTX) target twice the daily return of this volatile stock. These two ETFs were launched earlier this year. However, by mid-November, their performance began diverging from expectations.
On November 21, for instance, MSTU fell 25.3%, citing FactSet data, which was 7 percentage points less than it should have been as MicroStrategy dropped 16% that day. Conversely, on November 25, MSTU lost 11.3% when it should have declined only 8.7%. MSTX faced similar discrepancies, including a 13.4% drop on November 25—4.7 percentage points worse than expected.
According to the Financial Times report, this shows that while the two ETFs tracked MSTR’s returns fairly accurately since their launch, tracking errors began appearing in mid-November.
Why Is the Tracking Error Creeping in These Two ETFs?
The underlying issue lies in the sheer size of these ETFs, which have attracted billions in daily assets amid growing fervor for Bitcoin. This demand has outstripped the supply of total return swaps from prime brokers, a critical tool for precise tracking. A total return swap is a contract between two parties where one party pays a fixed rate, and the other party pays based on the total return of an underlying asset.
Consequently, the funds have relied on call options, which are less effective in mirroring the desired exposure. A call option is a contract where the seller grants the buyer the right to purchase the underlying asset at a pre-specified price (strike price) by a specific date (expiration date).
However, the report quoted Elisabeth Kashner, director of global fund analytics at FactSet: “The greater the volatility [in the underlying asset, here MSTR stock], the less perfect the options hedge.”
Dave Mazza, CEO of Roundhill Investments, explained: “This isn’t an ‘ETF’ problem or even a ‘leveraged ETF’ problem—this is a MicroStrategy ETF problem.” Mazza added that these funds had indirect exposure to more than 10% of MicroStrategy’s market cap, which is unprecedented. He further noted that brokers are reluctant to provide additional swaps for such high-risk strategies, signaling broader challenges for leveraged ETFs tied to volatile stocks.
Is MSTR Stock a Good Buy?
Analysts remain bullish about MSTR stock, with a Strong Buy consensus rating based on a unanimous eight Buys. Over the past year, MSTR has skyrocketed by more than 400%, and the average MSTR price target of $529.57 implies an upside potential of 47.8% from current levels.
