MicroStrategy ETFs Encounter Tracking Error Due to Market Volatility

Investors in exchange-traded funds (ETFs) associated with MicroStrategy Inc. (NASDAQ:MSTR) have observed sharp deviations in performance. This phenomenon appears primarily due to the volatility linked to the company’s underlying swaps and options.

What Happened: New leveraged ETFs have recently been launched to track MicroStrategy’s performance. The T-Rex 2X Long MSTR Daily Target ETF (MSTU), which debuted on September 18, 2024, and the Defiance Daily Target 2x Long MSTR ETF (MSTX), which launched on August 14, 2024, both strive to deliver double the daily returns of MicroStrategy.

Despite their intentions, these ETFs have experienced notable tracking errors relative to MicroStrategy. This raises concerns about the potential risks investors might face.

• MSTU: On November 21, the MSTU ETF fell by 25.3%, which was 7% less than expected given MicroStrategy’s actual drop of 16%. In contrast, on November 25, MSTU declined by 11.3%, significantly exceeding the expected drop of 8.7% based on a mere 4.4% fall in MicroStrategy’s stock.
• MSTX: This ETF has also demonstrated tracking discrepancies; for instance, on November 25, it decreased by 13.4%, which was 4.7% more than anticipated.

These discrepancies highlight the risks associated with leveraged ETFs like MSTU and MSTX, which may deviate substantially from their goal of delivering double the daily performance of their underlying assets.

Why It Matters: MicroStrategy is notable for being a publicly traded company with the largest reserves of Bitcoin (BTC/USD), holding approximately 2.1% of the total 21 million Bitcoin supply at a cost of $27.1 billion. The company has also raised $20 billion in debt in 2024 aimed at acquiring more Bitcoin.

According to Dave Mazza, the CEO of Roundhill Investments, the issue of ETF tracking error stems not from the ETFs themselves but from the challenges linked to MicroStrategy. Mazza points out that these ETFs own over 10% of MicroStrategy's market capitalization due to their indirect exposure through swaps and options, which is an extraordinary level for leveraged ETFs and even many traditional ETFs.

He elaborated, "Simply put, MicroStrategy is too small of a company to support the assets under management (AUM) and trading volume in these ETFs. They are nearing a breaking point.”

Elisabeth Kashner, a director of global fund analytics at FactSet, suggested that one way to manage the tracking error would be to halt new unit creation, allowing these ETFs to operate similarly to closed-end funds once their swap lines are used up. However, this strategy is not favored by the Securities and Exchange Commission (SEC).

Kashner stated that the firms managing T-Rex and Defiance ETFs must make a difficult decision. “They can either limit their growth or accept the limited accuracy of their investment vehicle; so far, they have opted for growth over accuracy,” she added.

Price Action: In premarket trading on Tuesday, shares of MicroStrategy experienced a decline of over 1%. Nevertheless, the stock has achieved an impressive year-to-date gain of 385%, in contrast to the Nasdaq Composite's return of 33.85% during the same period, as reported by Benzinga Pro data.

Currently, 12 analysts tracking MicroStrategy have given the stock a consensus ‘buy’ rating, setting a price target of $449.5 per share. The latest assessments from analysts at Bernstein, TD Cowen, and Barclays suggest a potential upside of 62% for MSTR.

In Conclusion: The tracking errors experienced by these ETFs signify heightened risks that could impact investors. For those interested in MicroStrategy’s performance, careful consideration of these factors is critical.

ETFs, MicroStrategy, Volatility