Exploring bitcoin: What investors should know
This article covers bitcoin's role as a high-risk investment, how it works, the smart way to add exposure to bitcoin in your investment portfolio, and why it’s important for investors to carefully assess its fit within their portfolio.
Introduction
The Smart Bitcoin ETF (BTC) offers investors a means of gaining exposure to bitcoin through a New Zealand listed fund. The Smart Bitcoin ETF invests in the iShares Bitcoin Trust ETF, which is based and listed in the United States, and seeks to reflect generally the performance of the price of bitcoin. This article provides an introductory overview of bitcoin.
Bitcoin is a highly speculative and volatile investment and may not be appropriate for all investors. The Smart Bitcoin ETF is only intended for investors who understand the significant risks involved in investing in a product with bitcoin exposure. Any allocation to the Smart Bitcoin ETF should represent a small proportion of a balanced portfolio.
About bitcoin
What is bitcoin?
Bitcoin is the world’s most recognised and widely adopted cryptocurrency1 - and the first form of internet-native money to gain widespread global adoption. Bitcoin allows for peer-to-peer transactions outside of central intermediaries like banks. There is no physical form of bitcoin; it is solely a digital currency. Additionally, some people see it as a global monetary alternative.
How does a bitcoin work?
Bitcoin is a decentralised digital asset and an application of blockchain technology. The blockchain is a public, digital database of transactions maintained by a distributed network without a centralised authority. Leveraging the blockchain, bitcoin enables peer-to-peer transactions and ensures the security of each transaction without the need of central intermediaries, like banks or clearinghouses.
Bitcoin transactions are validated, and new bitcoins are created through a process known as “mining,” during which computers or “miners” race to solve complex mathematical computations. The winning miner updates the blockchain with the latest verified transactions and earns a predetermined amount of new bitcoin generated by the network.
The bitcoins are then held or traded based on supply and demand, which determine the value or dollar price of bitcoin similar to other commodities or assets. Bitcoins are stored in crypto wallets, which are also used to send and receive bitcoin. Each wallet contains a private key that allows you to send bitcoin to complete a transaction, and a public key that allows you to receive bitcoin.
Bitcoin “mining” process
The Bitcoin network is commonly understood to be decentralised and does not require governmental authorities or financial intermediaries to create, transmit or determine the value of bitcoin. Instead, bitcoin is created and allocated by the Bitcoin network protocol through a “mining” process.
Bitcoin’s value is determined by the supply of and demand for it on bitcoin platforms or in private end-user-to-end-user transactions. New bitcoins are created and rewarded to the miners of a block in the Bitcoin blockchain for verifying transactions.
The Bitcoin blockchain is a shared database that includes all blocks that have been solved by miners and it is updated to include new blocks as they are solved. Each bitcoin transaction is broadcast to the Bitcoin network and, when included in a block, recorded in the Bitcoin blockchain. As each new block records outstanding bitcoin transactions, and outstanding transactions are settled and validated through such recording, the Bitcoin blockchain represents a complete, transparent and unbroken history of all transactions of the Bitcoin network.
How many bitcoins are there?
According to bitcoin code, there is a maximum supply of 21 million coins and no new bitcoins will be released after that limit is reached.2 As of September 2024, there are around 19.8 million bitcoins in circulation, and 1.2 million left to be rewarded.3 This limited supply is one of bitcoin’s key characteristics, which was designed to increase scarcity - and therefore demand - over time.
Why do people use bitcoin?
Cryptocurrencies like bitcoin have enabled a way for secure transactions to be conducted directly between two parties without the need for an intermediary (e.g., a bank) anywhere in the world.
What themes are driving bitcoin adoption
Driving the demand for a bitcoin is the fact that there are investors who view bitcoin as more than just a form of digital payment. They view bitcoin as an investment which can fit into a diversified portfolio as a "digital store of value."
Similar to gold, bitcoin may be viewed as a diversifying asset that can serve as a potential hedge against increasing geopolitical and economic risks. While bitcoin has a short history compared to gold, it arguably shares similarities, as it exists independently of any one country or government, has limited supply, and is global in nature.4
Investing in bitcoin
Investing in bitcoin through a fund
Bitcoin is a highly volatile asset exhibiting significant price swings in both directions since its inception in 2009 and may not be suitable for certain investors. Investing in bitcoin through a fund can help alleviate some of the challenges of investing directly in bitcoin, such as storage. Traditional forms of investing directly in bitcoin require deciding where to store the purchased bitcoin, which can be in a crypto wallet or on a crypto exchange. This approach gives the investor certain direct responsibilities in preventing security risks such as theft or loss of private keys, which are essentially passcodes to a crypto wallet.
With a bitcoin fund, investors own shares in the fund, removing the need to determine where to store their bitcoin, as this is handled by the fund’s custodian. It is important to note, however, that investing in a bitcoin ETP (Exchange Traded Product) still involves risk, including possible loss to your initial investment.
Structure and taxation of the Smart Bitcoin ETF
The Smart Bitcoin ETF invests into the iShares Bitcoin Trust ETF (ISBT) which is listed in the United States. This fund seeks to reflect generally the price of bitcoin. It holds bitcoin as an underlying asset. The Smart Bitcoin ETF is a listed Portfolio Investment Entity (PIE) and is taxed using the Fair Dividend Rate method at a rate of 28%. The PIE tax rules can simplify tax compliance for investors by allowing PIE-compliant funds to manage tax obligations at the fund level.
Bitcoin is a high-risk investment
This section provides a summary of the risks of investing in Bitcoin. For more information on the risks involved with this investment please see the Product Disclosure Statement and Other Material Information document, both available here.
Key risks of investing in the Smart Bitcoin ETF
Bitcoin is a significantly volatile and high-risk investment that is only suitable for investors that understand the risks involved with investing in bitcoin. The key risks of investing in the Smart Bitcoin ETF include:
Volatility risk
Bitcoin is a high-risk investment, with an annualised standard deviation of returns of 67% over the past 5 years (CME CF Bitcoin Reference Rate – New York Variant, as at 30 September 2024). Standard deviation is used by investors to assess the volatility of an investment's returns. It shows how much returns deviate from the average. A higher standard deviation indicates an investment is higher risk.
A standard deviation of 67% is very high. By comparison, over the same 5-year period, the standard deviation for United States shares was 18%.5 This implies that bitcoin is more than three times more volatile than shares.
This significant volatility could have a material adverse impact on the value of the units in the Smart Bitcoin ETF and could result in those units losing all or substantially all of their value. The Smart Bitcoin ETF is not actively managed and Smartshares (Smart) will not take any actions to take advantage of, or mitigate the impacts of, volatility in the price of bitcoin.
In addition, the market for trading bitcoin is generally open 24 hours a day, 7 days a week. Therefore, the price of bitcoin could be adversely affected outside of NZX trading hours and this could result in material losses for investors in the Smart Bitcoin ETF. In such circumstances, investors would not be able to sell their units until NZX trading resumed.
No income stream
Bitcoin provides no income stream, meaning there is no ongoing cashflow and any return will only come from an increase in the bitcoin price.
Cyber security risk
Bitcoin is a digital asset and is treated like a digital bearer instrument. Each holder of bitcoin has a unique public key (for receiving bitcoin) and private key (for sending bitcoin) to secure ownership. These keys can be exposed to potential loss or theft. If a cyber criminal gains access to a private key, or if the private key is lost, then the holder will lose control of their bitcoin with no way to recover those bitcoin assets.
The Smart Bitcoin ETF invests in an underlying fund that directly holds bitcoin, which means the Smart Bitcoin ETF may be exposed to loss if the underlying fund’s private keys are stolen, lost or damaged. The underlying fund chosen by Smart has taken steps to mitigate this risk (including through offline storage or cold storage of bitcoin), but it is still possible. Cyber-attacks or breaches may also reduce confidence in the general bitcoin market. These risks may affect the value of bitcoin, and therefore the Smart Bitcoin ETF.
Blockchain and network-related risks
Any issues related to the Bitcoin blockchain or associated networks may impact the value of bitcoin. If the digital asset award for mining bitcoin and transaction fees for recording transactions on the Bitcoin network are not sufficiently high to incentivise miners, or if certain jurisdictions continue to limit mining activities, then miners may cease expanding processing power or demand high transaction fees, which could negatively impact the value of bitcoin and the value of the units in the Smart Bitcoin ETF.
Market adoption risk
The value of the units in the Smart Bitcoin ETF is closely tied to the acceptance and recognition of bitcoin as a store of value and/or a digital currency. New digital assets are continually developed, which could become more popular or offer greater functionality than bitcoin. This could cause the demand for bitcoin, and the value of the units in the Smart Bitcoin ETF, to decrease.
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iShares® and BlackRock® are registered trademarks of BlackRock, Inc. and its affiliates (“BlackRock”) and are used under license. BlackRock makes no representations or warranties regarding the advisability of investing in any product or the use of any service offered by Smartshares Limited.
Past performance is not a reliable guide to future performance. The calculations and returns used in this article are illustrative and intended as a guide only, and are not an indicator of future returns. The value of investments can go down as well as up and investors may not get back the full amount invested nor any particular rate of return referred to in this article. Returns are not guaranteed. This information is intended to provide a general guide and is based upon, and derived from sources Smart considers reliable. Neither Smart nor NZX Limited, or their respective directors and employees accept any liability for any errors, omissions, negligent misstatements, or for the results of any actions taken, or not taken in reliance on this information. This information is not a substitute for professional advice. In preparing this information Smart did not take into account the investment objectives, financial situation or particular needs of any particular person. Accordingly, before making any investment decision, Smart recommends professional assistance from a licensed Financial Advice Provider is sought.
This article was published in November 2024
1 Source: CoinGecko, as of October 18, 2024. Bitcoin predominance based on its market capitalisation of US$1.3 trillion, which accounts for greater than 50% of the US 2.4 trillion total market capitalisation of all cryptoassets, excluding stablecoins.
2 There is no guarantee that the current 21 million supply cap for outstanding bitcoin, which is estimated to be reached by approximately the year 2140, will not be changed.
3 Source: statista.com
4 iShares, Investing in Bitcoin
5 Source: Bloomberg data, FT Wilshire 5000 Index.