Market Commentary
Market Commentary: Contango
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October 18, 2021

That was quick. From opening October at $43,436, bitcoin reached an intraday high $62,875 on Friday, October 15, just 0.84% from the all-time-high daily close of $63,410, and 3% off the all-time intraday high of $64,870 (using Bloomberg data). Price ended the week at $59,400, up 7.2% from the week prior, the third straight week of gains. Bitcoin has gained 36.8% MTD and 104.9% YTD.

While the trending bullish catalyst has been the milestone approval of a bitcoin futures-based ETF, investors highlight bitcoin’s resilience throughout the many uncertainties since May:

  • Elon & Tesla’s Flip Flop
  • China Banning Mining (see our on-chain note at the end of this piece)
  • China Banning Crypto/Yuan Transactions
  • Uncertainty related to Tether, Tapering, and US Regulations

Despite these concerns, accelerating adoption has been a significant driver of bitcoin’s advance. In the big picture, 2021’s financial integration is the real milestone of the year, with awareness, education, and ease of access driving new investors at an incredibly rapid pace.

$50,000 remains a key level of support, despite being 13% lower than Sunday’s close. Near-term, $60,000 will be of focus, with traders and investors eager to learn how bitcoin will trade on the launch of Proshares Bitcoin ETF (BITO) on Tuesday, October 19.

This week, we discuss the downsides of futures-based ETFs, as well as global mining, in which the U.S. is now the clear leader.

Buyer Beware: Futures-Based ETFs: USO as an Example

With the approval of a bitcoin futures-based ETF, we remind investors that the negative effects of contango and roll yield can significantly detract from long-term performance.

Let's use United States Oil Fund (a futures-based ETF on crude oil) to compare performance of Spot WTI Crude, 1st-month Crude Futures, and a futures-based ETF. In short, five-year total-returns:

Spot Crude Index +61.5%
1st-month Crude Futures, manually rolled each month: +31.4%
USO, Futures-based ETF: -37.9%

Let us explain.

The United States Oil Fund LP is a Delaware limited partnership incorporated in the USA. The Fund's objective is to have changes in percentage terms of its unit's net asset value reflect the changes of the price of WTI Crude Oil.

USO holds a variety of futures contracts across the curve:

Before contract expiration, futures-based ETFs must sell 1st month futures and purchase 2nd- and further out futures to not receive physical or cash delivery.

So when the curve is in contango, futures-based ETFs sell cheaper futures and purchase more expensive futures each month. This “roll yield” is negative when the futures curve is positively sloped.

But how much does this affect underlying performance of the ETF? Let’s look at five-year total returns:

Spot Crude Index +61.5%
1st-month Crude Futures, manually rolled each month: +31.4%
USO, Futures-based ETF: -37.9%

Even though spot crude is up +61.5%, a futures-based ETF is down -37.9%.

Note that the crude futures curve has only been in contango ~half of the time in this period:

Even so, the damage was done from the most recent contango on ~1/13/20 to ~1/19/21. Here are the returns:

Spot Crude Index -8.8%
1st-month Crude Futures, manually rolled each month: -18.3%
USO, Futures-based ETF: -63.4%

So in just over one year, a futures-based ETF underperformed spot by 54.6%. Even with "backwardation" (the opposite of contango) this year and returns that are similar (spot +69.6% and USO ETF +73.1%), the long-term damage has already been done. Spot returns are positive in the last five-years (+61.5%), and futures-based ETF returns are negative (-37.9%).

The same phenomena occurs with futures-based ETFs on gold as well, which has more persistent contango but less of a magnitude than crude oil.

Invesco DB Gold Fund (DGL, futures-based ETF,+31.9%) significantly underperformed SPDR Gold Shares (GLD, Spot ETF, +40.8%):

Now, with bitcoin, the futures curve remains in contango:

As of Friday, 2nd month futures were 84bps higher than 1st month futures.

While the effects of bitcoin's contango may not be as significant as those seen in USO, we nonetheless illustrate that contango detracts from annual returns, and large, one-off stress events can completely change total performance over long-term holding periods.

These futures-based ETFs are for trading, not long-term investing. The risk of contango decay on top of zero direct ownership is not much of a benefit for long-term bitcoin investors.

One can invest in bitcoin with direct ownership, minimal tracking error, daily liquidity, cold storage, and full integration into portfolio management workflows with Eaglebrook SMAs.

On-Chain: Hash Rate Migrates to the US, The New Clear Leader

As one may remember, China banned miners in the mainland back in May, pushing price lower on initial concerns. As we wrote, this led to the “Great Migration” of hash rate westward to Europe but particularly, the United States.

According to the Cambridge Bitcoin Electricity Consumption Index (CBECI), bitcoin miners in the U.S. now account for 35.4% of the total global BTC mining hash rate distribution. The United States is now the leading geographical miner across the globe:

Decentralization works.

As always, please reach out with any questions or comments.

Stay Tuned,

Joseph Orsini, CFA
Director of Research

Investment advisory and management services are provided by Eaglebrook Advisors, Inc., a registered investment advisor. Information presented is for educational purposes only. Past performance is no indication of future results. Please see our Form ADV Disclosures and Privacy Policy in our website.
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