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A Bitcoin exchange-traded fund (ETF) is a security that mimics the performance of the actual Bitcoin digital currency. The underlying asset in the case of a Bitcoin ETF is the digital Bitcoin currency. There are Bitcoin exchanges, which are just networks of computers, where Bitcoin and Bitcoin ETFs are traded. However, the Securities and Exchange Commission (SEC) has not approved a Bitcoin ETF for trading on U.S. exchanges. Consider working with a financial advisor before you decide to invest in cryptocurrencies.

How ETFs Work

An ETF is a basket of securities in which you can invest and diversify your portfolio. Lets say you would like exposure to the entire stock market. There are several market indexes that reflect the stock market. Perhaps the most well-known is the Standard and Poors 500 (S&P 500) market index. Very few investors would have the funds available to buy stock in all 500 companies. Instead, they can invest in an ETF that holds equity securities traded on the S&P 500. It tracks the price of the S&P 500. The ETF gives the investors exposure to the securities in the S&P 500 since that market index is the underlying asset.

ETFs are set up like mutual funds, although ETFs are usually cheaper. They have passive management and the management fees are lower. They are traded on the exchanges just like stock. More importantly, they give investors access to types of financial assets to which investors would usually not have access as well as some diversification.

How Bitcoin ETFs Work

Man touches a digital crytocurrency price board

Bitcoin ETFs work exactly the same as other ETFs, but Bitcoin is the underlying asset instead of stocks or bonds. Investing in a Bitcoin ETF gives you exposure to the Bitcoin market. By purchasing a Bitcoin ETF, you are indirectly investing in Bitcoin, but you hold a position in an investment portfolio without having to deal with the security and storage issues of holding the Bitcoin currency. If you invest in a Bitcoin ETF, your risk is lower but still very significant.

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Keep in mind that Bitcoin is subject to extreme price volatility. As a result, Bitcoin ETFs have more risk than many other ETFs because of the price volatility of the underlying asset.

The beauty of investing in a Bitcoin ETF instead of in the digital currency itself is that ETFs are investment vehicles that are subject to regulation, which makes them safer for private investors. Even though there is no Bitcoin ETF approved for trading on U.S. exchanges, speculators or investors can use the Canadian exchanges.

Recently, several Bitcoin EFTs have been approved in Canada. Bitcoin financial assets can also be traded on several exchanges in Europe. Some of those are exchange-traded notes. There is an over-the-counter Bitcoin Trust available for investors to invest in. Heres what you need to know about this type of security.

Pros and Cons of Bitcoin ETFs

There are several potential benefits of Bitcoin ETFs over Bitcoin digital currency:

Bitcoin ETFs are safer and easier for cryptocurrency investors to invest in. By contrast, buying Bitcoin currency raises the issues of security and storage.

Bitcoin is a new investment asset. Since it is not related to stocks or bonds or other traditional investment assets in any way, it does provide a degree of diversification to your portfolio although it also increases the risk. Bitcoin ETFs provide a little less risk.

If you invest in Bitcoin ETFs instead of the underlying digital currency, then you can trade through traditional exchanges. You wont have to deal with a cryptocurrency exchange.

If investors think the price of Bitcoin is going to go down, they can short-sell Bitcoin ETFs, but not Bitcoin currency outside an ETF.

While there are potential advantages to Bitcoin ETFs, there are several reasons to be cautious:

Bitcoin ETFs have management fees. The more shares you own of the ETF, the higher your management fees.

You cannot trade Bitcoin housed in an ETF for other cryptocurrencies.

ETFs may be inaccurate. Due primarily to price volatility, a Bitcoin ETF may not accurately track its market index.

Special Considerations for Investors

Woman checking her Bitcoin ETF

There are special considerations investors should make before investing in Bitcoin ETFs. The industry is rife with fraud. Unscrupulous individuals may try to sell you false Bitcoin. Keep in mind that your Bitcoin key is the same thing as your PIN for your debit or credit cards and that key is subject to theft. There are also computer glitches that might allow in hackers, malware or computer viruses. The cryptocurrency market has almost no uniform rules and regulations.

As Bitcoin ETFs are developed in various countries, governmental regulations that are imposed could devalue any cryptocurrency, including Bitcoin. The lack of regulation could cause a lack of liquidity in the market as well as a question about the legitimacy of Bitcoin and all cryptocurrencies.

The Bottom Line

Bitcoin ETFs are more convenient ways to invest in the currency than the underlying Bitcoin digital version. The SEC is being cautious before it approves Bitcoin ETFs for the U.S. due to the inherent riskiness of this new type of currency. Due to the lack of regulation in the cryptocurrency market and its Wild West reputation, the SEC fears manipulation and is concerned that one rogue investor could move the market.

Tips on Investing

Bitcoin and all cryptocurrencies are risky and not meant for beginning investors. If you think you might want to invest in Bitcoin EFTs, it would be best to talk with a financial advisor. Finding one doesnt have to be hard. If you use SmartAssets financial advisor matching tool, you can find a financial advisor to your liking. If youre ready, get started now.

It may be inevitable that Bitcoin ETFs come to U.S. exchanges. If you are interested in buying shares in an ETF, even if it is not a U.S. EFT, use SmartAssets asset allocation calculator to get an idea of how it would fit in your portfolio.

Photo credit: iStock.com/Nature, iStock.com/Funtap, iStock.com/DisobeyArt

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