The U.Sstock market has witnessed a remarkable surge in certain stocks, notably those related to BitcoinHowever, recent events have led to unexpected downturns for leveraged exchange-traded funds (ETFs) that aimed to capitalize on this booming asset classThe market had been thrilled with the performance of MicroStrategy (MSTR), a prominent player known as the "largest Bitcoin proxy" in the realm of U.SstocksWith Bitcoin prices soaring nearly 40%, MicroStrategy's value skyrocketed by 67%, culminating in an astonishing 455% gain since the beginning of the yearThis formidable increase outpaced Bitcoin's own performance by nearly four timesFascinated by this trend, investors flocked to newly launched MicroStrategy leveraged ETFs, including the Defiance Daily Target 2x Long MSTR ETF (MSTX), which began trading in August and was restructured to provide double the leveraged exposure by October

Another ETF, T-Rex 2x Long MSTR Daily Target ETF (MSTU), made its debut in September.

Within a mere six months, these ETFs saw a dramatic rise in their assets under management, reaching around $5 billionHowever, this impressive ascent was soon overshadowed by alarming discrepancies in performanceInstances on November 25 and 27 shocked investors, as the performance of MSTU deviated significantly from the expected returns based on MicroStrategy’s price movementsFor instance, when MicroStrategy’s stock dipped by 1.9%, MSTU plummeted by 6.2%—far exceeding the anticipated dropConversely, on a day when MicroStrategy rose by 9.9%, MSTU managed only a 13.9% increase, falling short of its expected double performanceInvestors took to social media, expressing frustration and discontent, accusing these funds of mathematical inaccuracies and calling it a "scam."

The disillusionment stemmed from an investment experience that left many feeling cheated

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Instead of enjoying the anticipated doubling of returns, these leveraged ETFs experienced losses that exceeded what was rationally expectedThis raises a profound question: where did things go wrong?

Leveraged ETFs commonly employ derivative instruments, such as swap contracts, to attain their ambitious daily performance targetsFor MSTX and MSTU, rapid growth in the short term led brokerage firms to reach the limits of available swap contractsConsequently, they had to utilize options contracts, which are sometimes less precise and come with larger price fluctuations, resulting in an increased tracking error for the ETFs.

At its core, the fundamental issue was the unprecedented surge of these high-leverage ETFs eclipsing the risk appetite of Wall Street institutionsBitcoin itself is a highly volatile asset, and MicroStrategy's stock price carries a high premium corresponding to its investments in Bitcoin

The integration of high leverage atop this already unstable foundation of cryptocurrencies only exacerbated the situationThe demand surge created a situation where swap contracts became insufficient to meet the needs of these funds.

Single-stock ETFs are a relatively novel concept in the U.Sequity market, having only been approved for launch in 2022. In the past two years, demand for such funds targeting volatile technology stocks like Nvidia, Tesla, and Apple has soared, as risk-tolerant investors seek to leverage or short individual stocksTo date, these ETFs have largely fulfilled their promotional aims, consistently achieving targeted daily performance.

Unlike traditional ETFs that hold a basket of stocks, single-stock ETFs do not directly own the underlying equities but instead aim to track a single stock’s performanceThey rely on derivative contracts to achieve leveraged or inverse exposure

Total return swaps are among the most commonly utilized contracts, enabling the ETFs to closely replicate the daily performance of the selected stock.

However, the rapid growth of MicroStrategy's leveraged ETFs hit a snag—demand outstripped the availability of swap contracts needed to support themIn October, as MicroStrategy shares started to soar, Matt Tuttle, CEO of Tuttle Capital Management (the firm managing MSTU), received unfortunate newsThe primary broker with which they worked had reached its limit regarding the swap exposure it could provide for MSTU.

With the volatility surrounding MicroStrategy's stock, only a handful of brokerage firms were willing to collaborate with MSTUTuttle expressed to the media that he struggled to obtain the necessary swap amounts; at one point needing $1.3 billion in exposure, he found that brokers could offer a meager $20 to $50 million of contracts

Consequently, Tuttle resorted to using options to meet performance targetsMeanwhile, MSTX experienced a similar predicament, and Sylvia Jablonski, CEO of Defiance ETFs, noted that MSTX had also started using options shortly after its launch to achieve the desired leverage.

Comparatively, while options provide a path towards achieving ETF investment goals, they do not offer the level of precision that swap contracts typically deliverOption spreads tend to be wider, leading to greater price volatilityAs large ETF buyers, when they engage in the market, they can inadvertently cause increased tracking error for these ETFs.

So, what's the crux of the accountability in these discrepancies? The high-risk profile of MicroStrategy, the underlying asset for these ETFs, stands out prominentlyTuttle noted, “If the ETF's underlying asset were a stable company like Procter & Gamble, I could secure as much swap contract exposure as desired, but MicroStrategy is entirely different.”

Initially, MicroStrategy was an obscure enterprise software manufacturer

Following the onset of the pandemic in August 2020, the company made the bold decision to invest heavily in Bitcoin as a hedge against inflation, and it quickly garnered the title of the most recognized corporate Bitcoin investor worldwideOver the past four years, MicroStrategy has announced over 40 separate Bitcoin purchases, amassing an impressive total of 402,100 Bitcoins, representing roughly 2% of the entire circulating supply, making it the largest Bitcoin holder among publicly traded U.Scompanies.

MicroStrategy began its journey into Bitcoin investment using cash flowEventually, it leveraged its investments through convertible notes and other financial instruments, continually seeking new funding avenues to acquire additional BitcoinMost recently, during its third-quarter earnings announcement, MicroStrategy unveiled a “21/21 Plan,” which aims to raise a staggering $420 billion over the next three years through a combination of equity and debt financing to further add to its Bitcoin reserves.

This relentless ambition underscores MicroStrategy's conviction in Bitcoin's value, with its CFO, Phong Le, characterizing the cryptocurrency as possessing “unique and special characteristics.” According to Le, the number 21 holds significance in Bitcoin realms, correlating to its maximum supply of 21 million coins.

As Bitcoin surged amid favorable regulatory expectations, MicroStrategy found itself at the epicenter of U.S

market dynamics, with rapidly swelling stock values and market capitalizationYet, concerns regarding the inherent risks were increasingly surfacingWith Bitcoin currently trading above $100,000, MicroStrategy's Bitcoin holdings are valued at approximately $40 billion, while investors have driven its market cap to over $80 billion—more than double the worth of its Bitcoin holdingsThis significant premium rests firmly on an asset class notorious for its historic volatility, alongside the risks inherent in the complex derivatives strategies of leveraged ETFs.

Warnings have emerged that in extreme market conditions, should MicroStrategy's stock plummet by 51% within a single day, these leveraged ETFs might face catastrophic outcomes, reminiscent of the "Volmageddon" incident in 2018. Prior to that event, the volatility index (VIX) had remained at historically low levels, with the market exuding an overly optimistic sentiment

Yet, in early February 2018, U.Sstock indexes suffered a sharp downturn, resulting in the VIX experiencing a sudden spike from 17 to over 37—increasing over 100% in a single day before even surpassing 50 a few days later.

In these extreme market conditions, numerous ETFs and funds reliant on low-volatility strategies bore tremendous lossesAmong the hardest hit were two inverse VIX ETFs—VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and ProShares Short VIX Short-Term Futures ETF (SVXY)—which witnessed their asset value plummet dramatically from $3 billion to a mere $150 millionThe XIV ETF nearly collapsed in value, with a staggering one-day loss of 96%, leading to its subsequent delisting after Credit Suisse announced its liquidationInvestors holding the product faced near-total losses on their investments, and while SVXY avoided liquidation, it too struggled to recover from the fallout.

The "Volmageddon" event serves as a quintessential example of how sudden shifts in market sentiment can wreak havoc on leveraged ETF products like MSTX and MSTU, presenting a stark warning to investors about the risks inherent in the pursuit of leveraged gains amidst dizzying volatility.