TheChek News Flow

Moderates object to bill’s cost and its increased levies on companies and the rich

A new levy on the wealth of US billionaires is emerging as an alternative to increases in income tax rates to fund Joe Biden’s spending agenda, as the White House and senior Democrats dash to rework their tax plans.

The last-ditch effort to reach a compromise on tax is part of a broader push by Biden and congressional leaders to reach a deal on the president’s bills to bolster the US economy before he heads to the G20 in Rome next week.

Lawmakers and administration officials have been painstakingly trying to reduce the size of the $3.5tn climate and social safety net proposals to about $2tn in order to appease moderate holdouts within the party.

Their plans to increase income tax rates on corporations, individual income and capital gains for wealthy Americans to pay for the bill have also been upended by entrenched resistance from Kyrsten Sinema, the senator from Arizona.

This has forced them to consider a series of new measures, including a tax on the wealth of between 600 and 700 billionaires, and a domestic minimum tax on corporations to ensure they did not benefit from too many tax deductions and loopholes.

“I think it’s been clear that the majority of Democrats, the progressives and the leadership — have wanted to do a lot more than they had the votes for, and that’s kind of put them in this bind,” said Donald Schneider, an analyst at Cornerstone Macro and a former Republican congressional aide.

Biden had planned to fund his flagship economic legislation with an increase in the US corporate tax rate from 21 per cent to 28 per cent, partially reversing a central element of Donald Trump’s 2017 tax cuts package.

House Democrats had suggested limiting the increase to 26.5 per cent in September, and that figure seemed destined to decrease further to 25 per cent in a compromise with Senate Democrats. The likelihood that there may now be no increase in the corporate tax rate, or a very minimal one, has left progressive Democrats aghast.

“Every year without a partial rollback of the [Trump tax cuts] makes it harder to chip away. It was a terrible piece of legislation, showering tax benefits on corporate shareholders who had seen a bonanza in recent decades,” said Josh Bivens, director of research at the Economic Policy Institute. “So in this sense it is all very discouraging.”

Business groups had led opposition to Biden’s planned tax corporate tax increase, arguing it would deter corporate investment and reduce US competitiveness.

The US Chamber of Commerce calculated the increase would affect 1.4m businesses with fewer than 500 employees, and provided lists to members of Congress of how many smaller companies in their state would be affected. But corporate America is not yet declaring victory in the fight.

Richard Neal, the Massachusetts Democrat who chairs the tax-writing Ways and Means committee, has not yet thrown in the towel on tax rates, however, so another twist may be in store.

“The chairman continues to stand by the Ways and Means product, maintains that the package will be fully paid for, and believes we can still raise the corporate rate and reach an agreement on the overall package,” one Ways and Means committee aide told the Financial Times.

The replacements may be equally unpalatable for business groups.

Biden and the Democrats are considering a surtax on share buybacks — as well as enacting a 15 per cent minimum tax on the income of large companies as a replacement, which would negate the benefits of many of their tax breaks. They have also proposed limiting Trump-era tax breaks for so-called pass-through businesses — often small companies where income “passes through” to the owners to be counted for individual income tax.

“We calculated that the corporate tax rise would generate $700bn, so that is a big gap to fill,” said Garrett Watson, a senior policy analyst at the Tax Foundation think-tank. “The Democrats could look to fill that gap with more complicated measures such as the minimum tax on book income. But if they do so, they risk undermining other parts of the tax code designed to incentivise research and development or business investment.”

On the individual side, the negotiations are also in flux. Biden planned to raise the top tax rate for wealthy individuals from 37 per cent to 39.6 per cent, and increase tax rates on capital gains and dividends, but those are now in question.

Instead, Ron Wyden, the chair of the Senate finance committee, is pushing a tax on the wealth of billionaires — echoing longstanding proposals by progressives such as Elizabeth Warren, the Massachusetts senator. While some Democrats are pleased with that solution, others are wary, saying it would be hard to get such a big change in tax policy over the finish line in short order.

Democrats are increasingly feeling pressure to end their internal disputes over the legislation and find a compromise to move ahead with the package, given the growing concerns that the extended talks are damaging Biden’s approval ratings.

“It’s hurting Biden. It’s hurting the Democrats. It’s undermining the vision of all the accomplishments we will have as being highly significant,” Jeff Merkley, the Democratic senator from Oregon, told NBC on Thursday. “It has to come to an end. I don’t know if soap opera or a nightmare soap opera is the right wording, but we’re in big trouble right now with this extended, getting nowhere negotiation.”

This week, Saks Fifth Avenue’s online arm appeared to be headed for a $6 billion IPO while an activist investor pushed Macy’s to follow suit and spinoff its own e-commerce unit. But splitting up online and offline businesses, while tempting in the short-term, may be detrimental to long-term value creation.

The retail industry may be skeptical of Saks’ e-commerce spinoff, but Saks is laughing all the way to the bank.

After the retailer separated its e-commerce operations from its brick-and-mortar segment earlier this year, creating two different companies under the ownership of parent Hudson’s Bay Company, business has boomed. Both verticals are seeing sales soar past pre-pandemic levels, according to internal documents published in the news.

Now, the digital side of Saks is set to go public at a valuation of $6 billion, triple its projected worth just seven months ago, the Wall Street Journal reported earlier this week. With this capital, Saks will have the resources to acquire top talent, invest in marketing and technology and take a larger slice of the luxury e-commerce market.

Investors in Macy’s, like activist investor Jana Partners, which took a stake in the department store competitor earlier this month, implored Macy’s management to take a cue from Saks. Cowen analyst Oliver Chen estimated in a report published Thursday that if Macy’s did so, even a modest valuation would increase its combined market capitalisation from $8.1 billion to $10.9 billion and push its share price from $26 to $40.

But industry insiders are mostly critical of the strategy. At a time when shoppers are increasingly likely to shop across e-commerce and physical retail, often even for a single purchase, does it make sense for major retailers to separate their online and offline operations?

“It’s crazy and nonsensical,” said Steve Dennis, retail consultant and former senior vice president at Neiman Marcus, where he oversaw multichannel marketing and strategy. “There’s just no way not to put the two companies in competition with one another and that’s going to cause inefficiencies [and] ... undermine the overall brand experience.”

There’s no denying that the Saks.com spinoff gives the company tremendous access to new capital. Just two years ago, a $6 billion valuation was unimaginable for the entire Saks business. Saks Fifth Avenue never struggled for survival like many other American department stores, but before going private, parent Hudson’s Bay Company wasn’t exactly in the black. In the 13 weeks ending Nov. 2, 2019 — its last reported quarterly earnings — Hudson’s Bay posted a net loss of $175 million. Total retail sales generated by Saks Fifth Avenue were 799 million Canadian dollars (about $649 million), down from 832 million Canadian dollars in the same period the year prior.

Though the company is in better shape today, a $6 billion valuation is still far higher than what Saks Fifth Avenue could have commanded before the spinoff. Ditto Macy’s and its potential post-spinoff valuation of $10 billion. Cowen’s Chen cautiously highlighted a Macy’s spinoff as an opportunity to “unlock significant value.”

And the window of opportunity may be narrow: investors today are “frothy,” as one analyst put it. Direct-to-consumer unicorn Warby Parker went public earlier this month at a market value of $6 billion — double its previous valuation of $3 billion last year and more than 15 times its 2020 revenue. It remains to be seen how long this level of enthusiasm for e-commerce will last. While Saks has the chance, why not go for it?

So far, this seems to be working. Since the spinoff, Saks has seen business dramatically improve in both online and offline channels. E-commerce sales have been more than 80 percent higher than 2019 levels, while sales in established stores rose 29 percent over the same period, according to a letter penned by Saks chief executive Marc Metrick to the retailer’s vendors and reviewed by Women’s Wear Daily.

Before the split, Saks came up with thousands of potential conflict scenarios between its online and offline arms, according to a source familiar with the arrangement. As a result, hundreds of operating agreements were put in place. For instance, there’s one regarding luxury distribution that allows some stores to sell returned online merchandise without breaking any agreements with vendors. And to avoid discrepancies in product or brand perception, the marketing and merchandising teams for both branches sit under the Saks.com umbrella.

A vital part of the deal was the guarantee that the retail side of the business would grow alongside its digital counterpart. To ensure this symmetry, the e-commerce side would pay the stores side a percentage of revenue, similar to a licensing contract, according to the source.

Still, it’s unclear whether Saks can sustain its recent success — and whether other players can replicate its trajectory so far.

“We believe a [Macy’s] spinoff could be possible, and management and the board have and are analysing this possibility along with other value generating initiatives,” wrote Chen. “However, we acknowledge that there have not been many successful long-term proof points, and there are significant risks to destabilising the business and slowing momentum.”

But with consumers increasingly shopping across channels and demanding joined-up experiences, many industry insiders are unconvinced by the Saks strategy, citing longstanding struggles at large brick-and-mortar retailers to integrate physical and digital channels across marketing, merchandising, inventory management and more.

“The idea that you’re operating two separate companies and addressing those issues in service agreements and executive buying for both chains — that just seems so hard to work out,” said Dennis, who added that Neiman Marcus and Sears, where he worked in the early 2000s, saw challenges with this exact issue.

Despite Saks online being the dominant decision maker when it comes to consumer-facing tenets of the business such as products and marketing, operating two separate companies can lead to divergence down the line, according to Neil Saunders, managing director of GlobalData Retail. “There are all these tensions that will potentially creep in,” he said. “When divergence happens, it could be enormously confusing for the consumer.”

With e-commerce leading the charge and attracting the talent, the stores segment could weaken over time, Saunders added. This could prove a problem, because stores are still the most important touchpoint in shopping journeys that may end online. The physical shopping and service experience can leave a lasting impression in the minds of consumers — positive or negative.

“The underlying economics stack up better for omnichannel than single channel,” Saunders said.

A $6 billion IPO will certainly give Saks capital to invest in talent and tech, but competition in the luxury e-commerce space is tougher than ever and cash alone doesn’t drive market share. The bottom line: Saks’ new model has yet to stand the test of time, with consumers and investors.

“Valuations against companies like Warby Parker or Vuori make sense because, theoretically there’s a lot of runway,” Dennis said. “But the high-end e-commerce sector is already pretty mature.”

Retail sales volumes fell in September, and consumer confidence is waning, according to two reports published Friday.

LONDON — Who will visit Britain this Christmas — Santa or Scrooge?

Brands, shops and industry organizations are hoping it’s the former, and that retail sales and consumer confidence bounce back in the run-up to the holidays.

But concerns — including higher income taxes and interest rates, rising energy costs and ongoing supply chain woes — persist, and could ruin Britain’s first Christmas post-lockdown.

On Friday, the U.K. Office for National Statistics said sales volumes fell by 0.2 percent in September 2021, following a 0.6 percent fall in August. The figures spooked retailers.

Non-food stores reported a fall of 1.4 percent in September sales volumes, and the ONS said that despite relaxation of COVID-19 restrictions over the summer, “in-store retail sales remain subdued.”

The ONS noted that retail sales volumes have fallen each month since April 2021, when nonessential retailing reopened and retail sales reached levels substantially above those before the pandemic.

Taking into account the September decline, this has been the longest period of consecutive monthly falls since the index began in February 1996, the ONS said.

Consumers, understandably, aren’t necessarily in the mood to shop. GfK’s long-running Consumer Confidence Barometer, decreased four points to minus 17 in October, reflecting consumers’ worries about the macroeconomic environment and their own wallets.

Joe Staton, client strategy director at GfK, a consultancy for the consumer products industry, said that after six months of “robust recovery” in the first half of 2021, “U.K. consumer confidence has taken a turn for the worse with all vital signs weakening.”

He said the sharpest concern is how consumers see the future economy.

“Against a backdrop of cheerless domestic news — fuel and food shortages, surging inflation squeezing household budgets, the likelihood of interest rate rises impacting the cost of borrowing and climbing COVID-19 rates — it is not surprising that consumers are feeling down-in-the mouth about the chilly winter months ahead.”

He noted that British retailers are right to be worried in the run-up to Christmas, as GfK is seeing a further decline in consumers’ intention to make major purchases. “The financial mood of the nation has changed and consumers could do with some strong tonic to lift their spirits.”

Jace Tyrrell, chief executive officer at New West End Company, which represents 600 businesses around Oxford Street and Regent Street said that after a challenging year, “we are disheartened to see that retail sales are down from last month, indicating that a gradual return to normality is still far from reach for retailers across the country. We hope a busy upcoming Christmas period will offer some confidence to West End businesses as they gradually recover sales.”

He called on the government for more support in enticing overseas visitors back to the British capital with a simplified visa process and a review of “restrictive” Sunday trading hours.

“Now is the time to give retailers and visitors alike more freedom, as this announcement is clear evidence that we are still far behind where we need to be,” Tyrrell said.

Springboard, which measures footfall on behalf of retailers across Britain, sounded further alarm bells in its pre-Christmas forecast.

Earlier this month, it forecast that footfall across U.K. retail destinations this Christmas will be, on average, 17 percent lower than in 2019. Footfall is set to be lower on high streets and in shopping centers, but retail parks will show “ongoing resilience” this Christmas, strengthening by 5.5 percent.

Springboard also believes that footfall in large city centers will strengthen over the six-week Christmas period, overtaking smaller high streets, “as consumers seek out the Christmas shopping experience they missed last year.”

The lion’s share of shopping will be done before Christmas, with the Boxing Day sales losing their appeal. Springboard said that in the week post Christmas, footfall in high streets and shopping centers will drop by around 20 percent “as Boxing Day sales continue to be less appealing for consumers.”

China’s stock market is bouncing back after getting trounced for much of the year. Don’t be fooled into thinking it’s time to buy.

At first glance, it looks like it could be a prime buying opportunity. The iShares MSCI China exchange-traded fund (ticker: MCHI) has dropped more than 10% in 2021 amid concerns about the country’s tech crackdown, the implosion of real estate giant China Evergrande Group (3333.Hong Kong), and the slowing of its economy amid attempts to wipe out Covid-19. With the S&P 500 up more than 20% this year, a lot of bad news does seem priced in.

That idea has almost certainly crossed the minds of many investors. The MSCI China ETF has gained 7.3% in October, nearly three percentage points more than the S&P 500. China’s beaten-down tech stocks have rallied even more, with Alibaba Group Holding (BABA) surging 22% amid reports that it would build its own chips and that founder Jack Ma had emerged from hibernation to travel to Europe, and Baidu (BIDU) is up 18%.

Those moves are too large to chase. While the declines in Chinese stocks reflect a lot of pessimism, analysts remain far too optimistic, according to Cirrus Research’s Georgiana Fung. Despite the market tumble and China’s slowing economy, earnings revisions have been strong, while the certainty of those estimates—measured by the relative lack of dispersion among them—all point to a level of overconfidence heading into earnings season. “Currently, the rise in earnings expectations appear to be too buoyant,” Fung writes. “These cautionary readings signal lower expected returns to come.”

The bigger issue, however, may be policy makers’ lack of action to boost the economy, something that may be necessary for China’s stock market to sustain a rally. According to Gavekal Dragonomics’ Thomas Gatley, it rallies when private credit growth is accelerating but underperforms when credit growth is slowing.

It’s not difficult to see why. When credit growth is accelerating, it means that demand is increasing, something which should lead to higher profits for Chinese companies. And just as with the Federal Reserve, when the People’s Bank of China eases, the cash often makes its way into stocks. For now, private credit growth, based on the three-month moving average of the year-over-year change in private credit, is still slowing, though that could change in the next few months. “A true turning point in that indicator has not yet arrived, but is probably only a few months off,” Gatley writes.

For now, there is no sign of it. In fact, the market appears to have given up hope that the PBOC will act to boost the economy, according to BofA Securities rates strategist Janice Xue. There was no mention of a rate cut during a press conference the bank held to discuss third-quarter economic data, suggesting that one wasn’t on the radar. But just because the PBOC didn’t mention monetary easing at the meeting doesn’t mean it won’t happen, writes Xue, who expects the central bank to do so by the end of the year.

Maybe so. But until the PBOC decides to ease, it’s probably best to stay far away from China’s stock market.

U.S. Treasuries, anyone?

The conventional approach to emerging market investing often focuses on sectors typically associated with the asset class—such as industrials, materials, and energy.

But that top-down approach can ignore or downplay the industries now thriving in the region, like technology. Analyzing these newer entrants requires a different skill set, says Dara White, co-manager of the $2.4 billion Columbia Emerging Markets fund (ticker: EEMAX).

When White, 46, created the fund’s strategy in 2008, he assembled a team of sector specialists who build portfolios by picking stocks from the bottom up, rather than country specialists. The team, of course, doesn’t ignore the bigger picture for an emerging market country, but rather considers how regulation, demographics, and other macro factors affect the earnings and valuations of the companies they own.

This tactic has helped the fund outperform, earning it a four-star, bronze-medal rating from Morningstar. The fund has beaten the MSCI Emerging Markets index and 90% of its peers in the diversified emerging markets category on a three-, five-, and 10-year basis. Its 1.470% expense ratio is average for the category.

White, however, has one exception for the fund’s bottom-up strategy: emerging market powerhouse China.

“China is such an important market, such a difficult market, and such a diverse market that we find it to be really powerful to have two sets of eyes on the market—one from a global EM sector perspective and one from a country perspective,” White says. Co-manager Derek Lin serves as both a sector and country specialist. Three additional managers round out the team: Perry Vickery, Robert Cameron, and Darren Powell.

Chinese President Xi Jinping’s discussion of “common prosperity” has some investors worried about the future of the private sector in the world’s second-largest economy. China’s government has cracked down on tech firms and the for-profit education industry to rein in what it considers excesses.

White and Lin believe those worries are overblown: They say these recent measures are China’s way to broaden the middle class, not an effort to return to a planned economy. “Today, it’s a 400-million-person middle class. And maybe five years from now it’s a 600-million-person, true middle class. And with that, there are a lot of opportunities,” White says.

China is the top country represented in Columbia Emerging Markets’ portfolio, at 26%, versus about 34% for its benchmark. The team invests in industries that the government is encouraging, such as innovative healthcare and electric vehicles.

One example is No. 5 holding WuXi Biologics (2269.Hong Kong), a global open-access technology platform for biologics drug development, part of the portfolio since 2017. Biologics are drugs made from living organisms and include vaccines and gene therapy. WuXi has a 5% total global market share, and the team says the potential growth of biologics could parallel the semiconductor industry.

The fund also bought Chinese electric-vehicle maker XPeng (XPEV) during the company’s 2020 initial public offering. Lin sees not just an EV investment, but the potential future of autonomous driving. EV manufacturers enjoy a high barrier to entry, and autonomous driving may become a subscription-based model.

“Suddenly you’re more of a software company, with really high margins and a recurring-revenue model,” he says.

The team takes a long-term approach, focusing on high-quality firms and has held some names for a decade, which explains its 29% turnover rate. They seek companies with trustworthy management who have a strong record of being good stewards of capital. Return on invested capital is their most important metric, so they look for strong balance sheets with good cash flow.

The fund’s patient approach helps temper some volatility in a sector known for higher risk. The managers group companies into three categories: global champions, domestic champions, and future global or domestic champions. Many holdings compete against state-owned enterprises or operate in industries still dominated by mom-and-pop shops.

“If it’s truly an innovative company, truly an innovative management team, there’s often an element of exponential growth through new business lines, or new markets getting opened up that people don’t appreciate,” White says.

Technology is the fund’s top sector holding, with the managers favoring e-commerce, and fintech in particular. The managers says these companies should continue to grow rapidly in the next three to five years as e-commerce penetration expands.

The team considers Russian e-commerce platform Ozon (OZON) a future domestic champion and bought its November 2020 initial public offering. The Russian retail market is $450 billion annually, and 81% of the population uses the internet. But Russian e-commerce penetration is far below both developed markets and many emerging markets, at 10% of shopping—leaving plenty of room for growth.

The fund is also betting on low-cost Brazilian airline Azul (AZUL) as a reopening trade, White says. The carrier’s routes are 95% domestic, and Azul is the only option on 80% of its routes. During the pandemic, management focused on its cargo business, which coincided with Brazil’s e-commerce growth. Azul has a 35% cargo market share, up from 20% prepandemic.

White believes it has never been a better time to buy emerging market stocks. The quality of the companies and their management teams are stronger than they were even five years ago, and are much less sensitive to changes in the economy.

“This is a universe now that you can buy and hold,” White says. “Personally, I’ve never owned more of our own fund than I do today.”

Stock investors may be feeling a tad jealous of their crypto cousins. Bitcoin, the largest cryptocurrency, blew past its record high this past week, reaching new heights around $67,000, up 50% since Sept. 30. Bulls now see a path to $100,000.

Just a few weeks ago, Bitcoin was in the doghouse—hit by regulatory fears in the U.S., a crackdown in China, and mounting criticism over the carbon footprint of “miners” that process transactions and add new coins to the supply. But the fear, uncertainty, and doubt—that’s FUD in cryptospeak—has been swept away, or at least under the rug, as excitement builds over a new milestone: Bitcoin is cracking one of Wall Street’s favorite products, exchange-traded funds, opening a channel into a market worth $9 trillion. What’s good for Wall Street, however, isn’t always good for investors.

After years of false starts, a Bitcoin-futures-based exchange-traded fund, the ProShares Bitcoin Strategy ETF (ticker: BITO), debuted Tuesday on the New York Stock Exchange. It racked up a record $1.1 billion in assets in two days, but it already has company. Another futures ETF, the Valkyrie Bitcoin Strategy (BTF), launched on the Nasdaq on Friday. Other futures ETFs that could win approval soon include funds from VanEck, AdvisorShares, and ARK 21Shares.

The flurry of futures ETFs may be a turning point for Bitcoin and the broader crypto investment space. Bitcoin came to life as a piece of libertarian digital agitprop—a decentralized money-transfer system aimed at swiping power from central bank fiat money and the broader financial establishment. That ethos still prevails in crypto, which remains both threatening and alluring to Wall Street. JPMorgan Chase CEO Jamie Dimon recently described Bitcoin as “worthless,” even as the firm’s investment bank and wealth management divisions aim to profit off it.

Love/hate feelings aside, Bitcoin and Wall Street are converging for mutual gain. “With a $2 trillion market value and 200 million users, the digital asset universe is too large to ignore,” observed Alkesh Shah, head of crypto strategy at Bank of America, in a recent coverage launch of crypto. Venture capital poured $17 billion into digital assets through the first half of the year, up from $5.5 billion in all of 2020, he notes.

ETFs could be the next stage of crypto’s colonization. Wall Street is eager to sell, trade, and create derivatives around the product, opening up new revenue streams. “What you see Wall Street doing with these ETFs is sucking Bitcoin in with its tractor beam,” says Ben Johnson, head of ETF research at Morningstar.

A true marriage of Bitcoin and ETFs would be funds that own the crypto directly, rather than futures—a market used to price commodities such as oil and wheat. ETFs with “physical” ownership of Bitcoin already trade in Canada, racking up $2 billion in assets. And they’re far more efficient than futures funds, which come with unique drawbacks. While front-month futures tend to track spot prices closely, funds may fall far behind due to cost frictions, taxes, and limits on position sizes.

A physical Bitcoin ETF isn’t expected to be approved soon by U.S. regulators, for both political and practical reasons. But the crypto markets are rising on hopes that even futures-based ETFs are a big win for the industry, pushing crypto deeper into the financial heartland. Other cryptos are rallying, including the second-largest, Ethereum. Coinbase Global (COIN), the largest publicly traded crypto brokerage, is up 32% this month despite the prospect of traders shifting to commission-free Bitcoin ETFs rather than paying up to 4% for a trade through Coinbase.

Filings for more crypto-futures ETFs are almost certain to follow, now that the Securities and Exchange Commission has signed off on the first Bitcoin products. Global ETF assets hit $9 trillion globally in August, including $7 trillion in U.S.-based funds. If crypto ETFs captured 1% of the global market, they would be worth $90 billion, a little less than 10% of Bitcoin’s recent market cap of $1.1 trillion.

“In theory, that’s your addressable market,” says Johnson. “Just the existence of a Bitcoin futures ETF could drive demand among people who view this as a validation of the underlying asset.”

Investors already have plenty of ways to get crypto, of course. They can buy it directly through trading apps; buy a closed-end trust that trades over the counter, such as the Grayscale Bitcoin Trust (GBTC) or Bitwise Crypto 10 Index fund (BITW); or even less directly, by owning shares in companies that own Bitcoin, like MicroStrategy (MSTR). Futures-based ETFs are another derivative, and now another artery into the market.

But the ETF packaging is coveted since it opens up a channel for advisors, human or digital, to add crypto in managed accounts. Bitcoin ETFs can slide seamlessly into a portfolio, working within existing tax-reporting and rebalancing software. Robo-advisors like Betterment could add it to automated accounts. The company is looking at how to offer crypto “responsibly,” a spokesperson tells Barron’s. Crucially, advisors can charge management fees on Bitcoin ETFs far more easily than if Bitcoin were held outside a managed portfolio.

More than 20% of advisory clients own Bitcoin, but only 3.5% keep it with an advisor, according to a survey conducted this year for the crypto investment firm NYDIG. Moreover, 73% of clients would move their crypto to an advisor if possible, the survey found. “It’s a step in the right direction—allowing advisors to access Bitcoin through traditional financial-services plumbing,” says Nate Geraci, president of The ETF Store, an advisory firm in Kansas.

Fund companies view a futures product as a bridge to the ultimate prize: an ETF that owns Bitcoin directly, much as gold ETFs own the physical metal. Grayscale Investments and Bitwise Asset Management, two of the largest crypto fund sponsors, both filed in the past few weeks for ETFs; Grayscale aims to convert its trust and Bitwise is pushing for a new ETF.

Both filings are packed with research arguing that the futures and spot markets (where actual assets are traded) have matured enough to meet SEC standards for direct ownership. Backers also argue that the futures and spot markets are now largely in sync, cutting down the potential for market manipulation or arbitrage from one to the other. If Bitcoin futures are good enough to be in an ETF, they argue, so should the coins themselves.

“The futures and spot markets reference the exact same prices,” says Matt Hougan, chief investment officer at Bitwise. “From a 30,000-foot view, any market manipulation that would affect futures would be similar to spot. We’ll eventually get physical Bitcoin and Ether ETFs and crypto will be a fully normalized asset.”

That view isn’t universally held in Washington. The SEC has been clear that the path for crypto ETFs is through futures—a highly regulated U.S. market. Spot markets and exchanges, the basis for direct ownership, pose more challenges. Spot markets for stocks, such as the NYSE or Nasdaq, are long-established and well regulated by authorities around the world. Much of Bitcoin’s trading volume takes place on newer exchanges, many of them abroad and outside the reach of U.S. watchdogs. It’s also thriving on automated platforms such as PancakeSwap and Uniswap, which aren’t even registered as money-transfer exchanges like Coinbase is.

For regulators tasked with surveillance, Bitcoin remains something of a cipher. Yes, they have had some success tracking illegal activity, notably in recovering payments for ransomware attacks. And yes, transactions are all visible on the blockchain. But the movement of cash to crypto and back to cash, especially overseas, runs through a digital labyrinth. Crypto can also hop from country to country in wallets that resemble suitcases of cash condensed into thumbnail drives.

Crypto trading, lending, and payments are also expanding on gaming platforms and other decentralized venues beyond regulators’ reach. “It will be difficult for regulators to keep playing catch-up,” says Chris Matta, president of 3iQ, an ETF sponsor in Canada.

The crypto industry would love Washington to clear up the patchwork of rules, enforcement actions, and regulatory agencies keeping tabs on the industry—establishing a crypto “czar” to oversee it all. But there’s no bipartisan consensus in Congress on how to regulate crypto, and the SEC, under Democratic Chairman Gary Gensler, has been talking tough—arguing that the SEC should exert sweeping authority over many tokens, exchanges, and DEXes, or decentralized exchanges, like Uniswap. The SEC recently blocked Coinbase from expanding into lending products. If Gensler approves a true Bitcoin ETF, it would be a U-turn from an agenda he has staked out for months.

How did the futures ETFs push through? Partly by meeting standards in the Investment Company Act of 1940, the overarching framework for fund-company registrations. For direct ownership of physical assets, ETFs have to go through the Securities Act of 1933, says Hougan. That means additional requirements for funds to be approved, notably a surveillance mechanism of underlying markets for regulators to protect against manipulation. That could still prove challenging since the spot markets are far more decentralized and freewheeling than regulated futures; Bitcoin, by its nature, subverts national boundaries.

“Every company that has tried to launch a direct ETF has run aground on the ’33 Act reef,” says Hougan. Gensler could still use it to keep a direct ETF off the market on his watch.

While regulators may be comfortable with futures, the ETFs themselves can be murky. The ProShares ETF owns a mix of futures and money-market funds. It holds 25% of its assets in a Cayman Islands subsidiary, a common structure for futures funds to avoid U.S. federal taxes. But because of margin and position limits on futures, it’s unclear how much Bitcoin a fund can actually own without violating regulatory requirements. Also unclear is the impact of offshore tax rules on the portfolio.

Perhaps more problematically, futures ETFs may not closely match the spot returns of the crypto over long periods. Futures are rolling contracts that a fund must continuously buy as old ones expire—a costly process that becomes more so when contracts for future delivery are priced higher than the front month, a situation known as contango. Futures in contango impose “negative roll yields” that erode long-term returns.

Criticism of the “roll effect” is overblown, ProShares CEO Michael Sapir tells Barron’s: “Right now, you’re talking about 20 basis points [0.2%] to roll from the current contract to the next.” That’s hardly an overwhelming drag in the context of Bitcoin’s long-term gains. Futures are also a deep, liquid market whose nominal volume is 40% greater than the largest U.S. spot exchange. And some research indicates that the futures market is a leading indicator of spot.

Still, commodities ETFs can go awry for several reasons. A recent standout was the United States Oil fund (USO), which plunged 44% over a few days in April 2020 as crude oil prices briefly went negative. That selloff was triggered by collapsing oil demand due to Covid-19 and producers facing an unprecedented storage crunch. But Bitcoin isn’t exactly known for orderly trading, and it’s unknown how the futures or ETFs would trade in a massive flight out of crypto—probably not well.

Bitcoin futures have other quirks. Starting with the November front-month contract, the CME will limit the amount of Bitcoin futures that a buyer can purchase to 4,000, dropping to 2,000 three days before expiration. Moreover, it’s unclear if a fund can own more than 5,000 contracts of any length in total. Each contract represents five Bitcoins, capping total ownership at 20,000 Bitcoins. At recent prices that represent $1.2 billion worth of Bitcoin, only slightly more than the ProShares fund’s assets. ProShares has applied for a waiver from those position limits with CME, which did not have a comment on when it will decide.

If the CME holds the line, the ETF may have to find other mechanisms for exposure. Sapir says the fund could shift assets into later-dated contracts, swaps, or structured notes. The prospectus indicates another possibility: The ETF could invest in unspecified crypto equities. Asked if that might include miners like Riot Blockchain (RIOT), or holders like MicroStrategy, Sapir says, “We’d be looking for equity securities that we think have a high level of correlation to the performance of Bitcoin. And if it did, we would consider it.”

For all these reasons, advisors and other professional investors are giving futures ETFs mixed reviews. “I suspect this ProShares ETF will have significant dispersion from the actual Bitcoin price,” says Matthew Allain, CEO of advisory firm Leo Capital and an early crypto adopter. He says he has no plans to buy the ETF for clients, preferring direct exposure. “It’s not a product that’s appropriate for what we’re trying to achieve in cryptos,” he says.

Others are waiting to see how they perform. A vote of confidence would come if the ETFs do a better job of tracking Bitcoin than the Grayscale Trust, which has been a laggard, says Matt Kilgroe, president of Cyndeo Wealth Partners in Florida: “We need time to watch how they unfold.”

Brokerages could win and lose from Bitcoin ETFs. Coinbase has rallied as Bitcoin’s price exploded, driving higher volumes and trading fees. Piper Sandler analyst Richard Repetto says the ETF brings “more credibility and attention to the crypto space.” Another major brokerage, Interactive Brokers (IBKR), is getting into crypto trading, launching a platform this week.

Interactive Chairman Thomas Peterffy doesn’t seem concerned about competition from ETFs, arguing that investors will want to hold actual Bitcoin as a kind of “doomsday protection,” similar to the role that gold has long played. The ETF is “completely useless for that purpose,” he says.

Still, if investors can trade Bitcoin ETFs for free on apps like Robinhood or Webull, they may be less inclined to pay commissions for direct exposure. Coinbase charges a hefty fee for a Bitcoin trade, while Robinhood captures fees in payment for order flow. Other brokerages take a spread, or cut, on the price difference between buys and sells. Interactive charges 0.12% to 0.18%.

The hype around Bitcoin belies the fact that it still faces tall hurdles to financial legitimacy. Real-world uses are expanding—notably in emerging markets as an alternative currency—but it’s still a digital token without tangible value, living on borrowed regulatory time. China and other countries view Bitcoin as an imminent threat to their monetary sovereignty; China recently banned all commercial crypto transactions as it expands a digital version of its own currency.

Bitcoin miners are still consuming vast megawatts of electricity, giving it a carbon footprint bigger than some countries. While the U.S. is home to more miners using renewable energy, the industry could still be subject to new carbon taxes or other fees. ESG investors may balk at Bitcoin’s carbon toll, which grows with its market value.

One other consideration: Bitcoin tends to plunge after a jump pegged to a positive development. After shooting up in anticipation of futures in 2017, it tanked shortly after they launched; Bitcoin also fell more than 20% in the days after Coinbase’s stock hit the market in April. Three days after the first Bitcoin futures ETF launched, the price of the coin was down 8% from its high, succumbing to profit-taking as the euphoria over ETFs lost steam.