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Cryptocurrency ETFs 'are not a winning strategy,' expert says: There are better ways to diversify

"You've been effectively selling low and buying high."

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If you're interested in a particular investment area, such as, say, a sector of the stock market, you likely don't have time to research every single company to determine which you think is best. Plus, even if you know your stuff, there's still the chance that any investment in a single entity could go down dramatically. That's why market pros recommend spreading your bets by buying a large swath of investments, thereby lowering the chances that your portfolio could tank due to a large drawdown in any particular position.

When it comes to traditional investments, such as stocks and bonds, a cheap and easy way to access that kind of diversification is often an exchange-traded fund, which holds a basket of investments, trades on an exchange like a stock, and usually comes with a small management fee.

If you're interested in the world of cryptocurrency, however, an ETF is a less straightforward bet. Last week, the Securities and Exchange Commission rejected an ETF from fund firm VanEck that would have directly tracked the price of bitcoin. When it comes to cryptocurrency prices, "The SEC has fundamental concerns about the potential for fraud and manipulation," says Ben Johnson, director of global ETF research for Morningstar. He added that you're unlikely to see an ETF that directly tracks the price of crypto "until there are specific solutions in place to address those concerns."

In the meantime, you can still buy one of several ETFs with "bitcoin" or "crypto" in the name, but they may not deliver the kind of investment you're looking for — especially if you're looking to diversify your crypto portfolio. In fact, as currently constructed, prominent crypto ETFs often see investors "effectively selling low and buying high," Johnson says. "That's not a winning investment strategy."

Bitcoin futures ETFs: 'The moment bitcoin became its parents'

For now, most of the crypto ETFs you'll see on the market are designed to track the ups and downs in the price of bitcoin. But because of the SEC's concerns, these funds don't actually own bitcoin itself. "These ETFs track bitcoin futures, not bitcoin," says Johnson.

Though that may not sound like a huge difference, it is, he says. These funds hold futures contracts based on a reference price of bitcoin, and those contracts expire after a certain amount of time. "You're not going to perfectly track the price of bitcoin because to maintain that exposure, you have to regularly sell the futures contracts you own and buy new ones," he says. That process of buying and selling can either help or hinder the returns of a fund, but as a general rule, rising prices of the underlying asset sings your results.

"In the majority of cases, next months' futures have been selling at a higher price," Johnson says. That creates an effect that "eats into your return," he adds.

There is a rationale for owning these funds. ETFs provide convenience for investors, and a way to invest in an unfamiliar asset in the same way that they invest in the rest of their portfolio, Johnson points out. For rapid traders, having cryptocurrency in an ETF form could provide easier access to advanced strategies, such as option trading, which is not available on many cryptocurrency exchanges.

Still, for people who are long-term investors in cryptocurrency, there are better options, Johnson says. "Bitcoin maximalists view bitcoin futures ETFs as an abomination. When the first one was listed, it was like the moment bitcoin became its parents," he says. "Ultimately, there are less costly, more efficient ways to get access to bitcoin."

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How to responsibly diversify cryptocurrency investments

So if not with an ETF that holds actual coins, how can a cryptocurrency investor diversify their portfolio? "There are some baskets of coins that are coming out, but they're mostly for accredited investors," says Ben Weiss, CEO of cryptocurrency ATM and trade desk provider CoinFlip, referring to investors who, generally, have a net worth of $1 million or more.

For everyone else bullish on crypto's prospects, he says, you're better off buying cryptocurrency directly from an exchange and building a diversified portfolio on your own. Make sure you're starting small, he says. "There's potential for exponential returns," he says. Because crypto assets are extremely volatile, though, there is also the potential for exponential loss. Allocating only a small chunk of your portfolio "gives you exposure, but not so much that it's going to hurt you when it goes down."

"You have to have a mindset that you're going to hold it," he adds. "You should never have to sell crypto to pay your bills, and you shouldn't be checking prices every day. That makes it more likely that you'll freak out and sell if you have a big loss."

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Weiss recommends holding the bulk of your crypto assets in well-established coins that play on crypto's most prominent themes, such as decentralized payments and tokenization. Smaller, newer coins, he says, come with much greater chances of flaming out.

That doesn't mean you shouldn't take a shot on a more obscure coin that you're excited about. It just means that adding a small amount of an unknown coin to your portfolio should come with a higher level of scrutiny. "You don't have to fully understand the underlying technology to understand what a project is trying to do. But you should get a decent idea of the project so that you can make an informed investment decision," he says. "If you think there's friction in real estate, for instance, and Coin 'X' is allowing people to tokenize properties, maybe you throw a little money behind it."

Tread carefully, he warns. "Smaller coins are less tested and don't have the same network effects," he says. "The smaller the coin, the more of a crapshoot it is to invest."

Disclosure: Cryptocurrency is a relatively new innovation, and this market is subject to rapid price swings, changes, and uncertainty. Cryptocurrency is subject to the risk of fraud, theft, manipulation, or security failures, and operational or other problems that impact cryptocurrency trading venues. Unlike the exchanges for more traditional assets, such as equity securities and futures contracts, cryptocurrency and crypto-trading venues are largely unregulated. Investors should closely consider their investment objectives, risk tolerance, and time horizon prior to investing.

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