WGMI ETF: Managing Long Term Expectations (NASDAQ:WGMI)

Bitcoin (BTC-USD) is back above $60k. Roughly seven weeks after spot ETF approvals in the United States, the coin has printed six consecutive monthly gains and a whopping 157% low to high return dating back to September 2023. Naturally, when Bitcoin rallies like this, stock market investors often look for equity-based ideas that will benefit from such moves.

Late last year I called MicroStrategy (MSTR) a “strong buy” and submitted it as my entry into Seeking Alpha’s top long idea for 2024. Since that post, MSTR is up 76% and has had no issue whatsoever besting Bitcoin’s also very impressive 40% return. Many of you who have followed my work on this site over the last couple years no doubt know I’ve been bullish a few of the Bitcoin mining equities as well. Since the MSTR article, CleanSpark (CLSK) is the only company out of the top 3 miners by market cap that is still beating BTC – though it has given that edge back quite a bit since February 27th.

While absolutely still long CLSK personally, I did recently downgrade the stock from “buy” to “hold.” In this article, I will outline why I think the Valkyrie Bitcoin Miners ETF (NASDAQ:WGMI) is also a hold despite the renewed exuberance in Bitcoin and by extension many of the miners.

Fund Objective & Details

Unlike the recently approved spot Bitcoin ETFs or the futures ETFs that have been on the market for years, the Valkyrie Bitcoin Miners ETF has no direct exposure to BTC or BTC derivatives like futures contracts. Rather, the fund is entirely focused on total return from exposure to the miners and hardware providers that power the computer network that gives Bitcoin its value. From the WGMI summary prospectus:

The Fund is an actively-managed exchange-traded fund (“ETF”) that will invest at least 80% of its net assets (plus borrowings for investment purposes) in securities of companies that derive at least 50% of their revenue or profits from bitcoin mining operations and/or from providing specialized chips, hardware and software or other services to companies engaged in bitcoin mining.

The bold in the quotation above is my own emphasis and we’ll explore that idea a bit more in a moment. But as a thematic fund, WGMI seems to be the closest thing to a pure play Bitcoin mining ETF as I’ve come across. For the sake of comparison, I’m going to use the Fidelity Crypto Industry & Digital Payments ETF (FDIG) as a primary peer based on both AUM and the fact that 8 of that fund’s top 10 holdings are Bitcoin miners.

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Source: Seeking Alpha

We can see in the table above that WGMI has a higher turnover ratio and roughly half the positions that we find for FDIG. The fund pays a slightly higher yield which is essentially nullified by the higher expense ratio. If we use the beginning of 2023 as our starting point, we can get a feel for which fund has performed better since the miners broadly bottomed near the end of 2022:

The returns in WGMI have been explosive to say the least. With a total return since the end of 2022 that has occasionally eclipsed 300%, there is no question WGMI has outperformed FDIG and even Bitcoin at times to a significant degree. As the saying goes though, past performance is not indicative of future returns. Before we get too much further, I think it’s important to get into the core issue with Bitcoin mining as a fundamental business model.

The Mining Business

To those who have followed my work for awhile, I beg your pardon as this entire section will be essentially a review for many of you. That being said, Bitcoin retaking $60k has brought a renewed enthusiasm from investors and speculators who may not be as familiar with the supply/demand mechanics of Bitcoin halving cycles. And for the benefit of being thorough for those entering the game today, I think it’s important to lay out how the Bitcoin network incentives transaction validation.

In part, Bitcoin’s value comes from the idea that it is he native unit of a decentralized and distributed digital ledger. The ledger is secured by a network of computers, or “miners,” which are validating the transactions from user to user on this decentralized ledger. While it’s likely well understood that the BTC currency has a fixed supply at 21 million coins, the circulating supply of that cap is about 19.6 million coins. The remaining 1.4 million BTC that has yet to come into circulation will be awarded to miners through coin issuance when new blocks on the chain are created.

Every four years, the amount of BTC that is awarded to miners through those blocks is cut in half. This has come to be known as the “halving cycle” or “halvening.” As of article submission, we are less than two months away from the latest halving. What this means is, all things being equal, miner revenue denominated in Bitcoin will be cut in half by the end of April. In the past, this shortfall in BTC-denominated rewards has generally been alleviated by the market repricing BTC much higher through the supply crunch that comes with less BTC available to be mined. However, when the mania for BTC wears off, prices fall back down and dollar-denominated miner revenue falls with it.

Something else to consider is the possibility that transaction fees can theoretically become a more meaningful portion of miner revenue long term. Bitcoin somewhat notoriously has very low transaction per second throughput and during times of high network usage, transaction fees can spike to as high as $20-30 per transaction and we witnessed this for approximately three full months last year. While this may diminish Bitcoin’s ability to serve small dollar transactions on the base layer of the network, high fees are actually a very good thing for the miners because it gives a supplemental income stream in addition to the new coin issuance.

The final consideration is global hash rate. When the price of BTC is higher in fiat-terms, there is generally more compute power competing for the BTC block reward. Despite surging compute, coin issuance remains the same through each four year halving cycle. Thus, without either higher transactions going forward or higher coin prices essentially in perpetuity, mining Bitcoin is a risky and cyclical business that historically suffers from diminishing BTC returns over time.

WGMI Holdings

There are roughly two dozen public Bitcoin miners in the equity markets and in my view many of them are flat out not going to make it when the block reward is chopped in half. Given the low amount of public mining companies, it’s not surprising seeing the really high 84% concentration to top 10 holdings that we observe with Valkyrie’s mining fund. What is somewhat surprising is exposure to NVIDIA (NVDA):

I don’t think I need to spend too much time on NVIDIA as it’s now one of the most well known stocks on the face of the earth and demand for the company’s GPUs has been unrelenting over the last year as the scramble to build datacenters and AI models has gone full throttle. At one point, GPUs were widely used in cryptocurrency mining. But with both the emergence of ASIC machines for Bitcoin and Proof-of-Stake migration for Ethereum (ETH-USD), NVDA’s inclusion in the fund is a bit of a head scratcher. Especially considering the higher turnover and somewhat large expense ratio. That said, in referring again to the summary prospectus, Valkyrie only has to allocate 80% to Bitcoin mining-specific businesses.

The remaining stocks in the top ten make sense to me. I particularly like both CleanSpark and Marathon Digital (MARA) at the top of the list as I think those stocks will outperform most of the sector if mining is profitable post-halving. But there are several stocks here that I think will underperform the market as well.

Risks

Personally, I think the ETF is probably an effective way to swing trade Bitcoin’s cyclicality. However, I’m not sure WGMI makes sense for most cryptocurrency and crypto-adjacent investors. I’m of the view that this industry isn’t as simple as it might seem on the surface. For instance, there is a wildly different approach to treasury management between a company like Iris Energy (IREN) and CleanSpark (CLSK). IREN sells all production each month regardless of price. CLSK tries to be more opportunistic with BTC management. One of these strategies is going to work a lot better than the other by the end of the year. I won’t claim to know which one definitively but I suspect these companies will have very different full year returns.

Summary

The approvals of the spot ETFs have dramatically altered the way we’ve previously understood Bitcoin cycles. In the past, the coin has rallied to new highs well after the halving event. What we’re seeing now appears to be a relentless push from investors to front run the halving with Bitcoin now a few thousand dollars away from a new all time high before the halving in April. Miners have been big beneficiaries of this rally as many of them have surged by over 20% in the last month. However year to date, there have only been a few real winners and returns between the companies in WGMI’s top ten have been all over the place:

If mining had more than 5-10 relevant equities in the public markets, I could see longing an ETF like WGMI. But in this case, I believe stock pickers will do better in the individual names rather than in the ETF. Throughout the last year or so I’ve liked the idea of longing certain miners over Bitcoin more directly for the leveraged returns. Miners are great for trading. But over time, longing BTC directly is the better investment.