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Battle of the Beasties

John Rekenthaler

The Finalists
Yesterday, Morningstar's researchers debated which fund had the most intimidating discussion of risk factors in its prospectus. They realized almost immediately that the winner would be an exchange-traded fund, as, try as they might, conventional mutual funds can't match ETFs for bizarre.

Their two finalists were Winklevoss Bitcoin Trust and ProShares Ultra VIX Short-Term Futures ETF (UVXY).

It's an inspired duo. I'll go one step further. These are the industry's strangest funds, period. Not just for their risk factors, but also for their investment complexity and for the wackiness of their performance.

Investment Complexity
Both funds score stunningly well here.

The Bitcoin Trust holds "a digital commodity based on an open source cryptographic protocol existing on the online, end-user-to-end-user network hosting the public transaction ledger, known as the 'Blockchain,' and the source code comprising the basis for the cryptographic and algorithmic protocols governing the issuance of and transactions in Bitcoins (the 'Bitcoin Network')."

For its part, the ProShares fund seeks to double the daily performance of an index that indirectly measures the collective expectation for the level of stock-market volatility over the next month. Per Wikipedia, VIX "is calculated as the square root of the par variance swap for a 30-day term initiated today. Note that the VIC is the volatility of a variance swap and not that of a volatility swap." Noted.

There you have it. Two funds, each as natural as Donald Trump's hair and about as complicated. One fund rises and falls based upon the value of a currency that is supported neither by a tangible asset nor an entity that can raise revenue, and the other rises twice and falls twice based on the performance of an index that was built by mathematicians. A derivative of a derivative, versus a derivative of a derivative of a derivative.

Verdict: Narrow victory for ProShares. The ProShares fund goes one derivative further, and it's leveraged at that. Although for fancy math, its "kernel-smoothed estimator" can't touch Bitcoin's code creators.

Bitcoins' spot price over the trailing 12 months:

The total return of the ProShares fund:

Verdict: Draw. Bitcoin prices are up well over 1,000% for the period, including a week with a 65% loss. Impressive. The 93% decline suffered by the ProShares fund is just as good, however. For this competition, riches to rags counts the same as rags to riches.

Two tree-killers. Bitcoin ETF's prospectus numbers 95 pages. The ProShares fund's prospectus is even longer, at 138 pages, as it shares the territory with a nonleveraged version of the VIX index fund. (I attempted to print the full prospectuses from each fund, but near the end of the ProShares job, after 40 minutes of laboring, the printer froze in protest.)

Discussion of risk factors for the Bitcoin Trust runs 18 pages. Included is the following:

The loss or destruction of a private key required to access a Bitcoin may be irreversible. The Trust's loss of access to its private keys or its experience of a data loss relating to the Trust's Bitcoins could adversely affect an investment in the Shares.

If a malicious actor or botnet obtains control in excess of the processing power on the Bitcoin Network, such actor or botnet could manipulate the source code of the Bitcoin Network or the Blockchain …

The acceptance of the Bitcoin Network software patches or upgrades by a significant, but not overwhelming, percentage of the users and miners in the Bitcoin Network could result in a fork in the Blockchain, resulting in the operation of two separate networks until such time as the forked Blockchains are merged.

ProShares once again wins the paper battle, checking in with a 22-page risk disclosure. But can it beat the botnets?

Due to the compounding of daily returns, the Geared Fund's returns over periods longer than a single day will likely differ in amount and possibly even direction from the two times (2x) the index return for the period

The use of leveraged positions could result in the total loss of an investor's investment.

Verdict: Decisive victory for Bitcoin. Having an index fund that might go to zero, and that can move in the opposite of its intended direction, is a brilliant accomplishment for ProShares. Full credit for crazy. However, that disclosure is sadly standard, holding true of many other leveraged daily ETFS as well. Whereas the kookiness of Bitcoin's ETF is a special sort of kookiness.

A narrow loss, a draw, and a decisive victory in the three equal-weighted sections make the Bitcoin Trust the overall winner. Before conducting this exercise, I had thought that I might need the Winklevoss connection to break a tie, but not so. Winklevoss Bitcoin Trust wins the award as the fund industry's nuttiest fund even without help from its parents.

Completing the Story
From a fund-industry trade publication about outflows from domestic large-growth stock funds*, even as stock fund sales overall are booming:

* The article says "large-cap" but the author must mean "large-growth," because that's in the headline and because domestic large-blend and large-value funds have positive net sales.

What could help domestic large-cap funds bounce back with higher flows is to sustain good performance, according to [Lipper Analytic's Jeff] Tjornehoj. He points out that year-to-date, domestic large-cap funds have a 24.5% return, which is only a handful of percentage points off the 29.5% that small-caps have gained for the year.

Tjornehoj notes that investors' wariness of domestic large-caps grew after the strategies had been marketed as products that could hedge against wild market swings, but then got hit just as hard as small-cap funds during the financial crisis. He adds that the fund industry also began pushing retail alternatives and bonds, causing investors to move away from domestic products in general.

"Investors can have long memories and [the financial crisis] occurred at a very challenging time," Tjornehoj says. "The retirement for the first wave of baby boomers was coming up and their portfolios got crushed."

True enough, in its way. Also true, however, is that of the category's $19 billion in outflows this year, $12 billion have come from a single fund, American Funds Growth Fund of America (AGTHX). In addition, $5 billion has gone into large-growth ETFs. So, aside from the redemptions that are occurring at Capital Research, and including ETFs, category sales are about flat for the year. Still disappointing given the rebound in stock fund sales, but better than portrayed.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.