FTX Collapse: Lessons for Investors

In this podcast, Motley Fool senior analyst Jim Gillies discusses:

• Why the Dow Jones Industrial Average is “the dumbest index.”
• Where investors can find ballast for their portfolios.

Motley Fool analyst Dylan Lewis and Motley Fool producer Ricky Mulvey take a closer look at what actually happened with the collapse of FTX.

To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

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This video was recorded on Nov. 30, 2022.

Chris Hill: It’s time to talk about crypto. Motley Fool Money starts now.

[music]

I’m Chris Hill. Joining me today: Motley Fool Senior Analyst Jim Gillies. Thanks for being here.

Jim Gillies: Thanks for inviting me.

Chris Hill: Before we get to the collapse of FTX, today is the last day of November. The Dow Jones Industrial Average is on pace to finish up 3% for the month, which is not a lot. But if we could do that every month, that’d be pretty great. Barring a collapse, the Dow is going to finish well ahead of the S&P 500 for the year and even further ahead of the Nasdaq — which, Jim, is leading some of the people in financial media to pound the table. There’s a little bit of “see, I told you so” going on and pointing to the Nasdaq and saying, “that’s why I’ve always said you got to stay away from these” and pointing to the Dow and saying, “and that’s why you got to get behind companies that we just see in the Dow Jones Industrial Average.”

I understand why someone in that position might take a little bit of a victory lap or even pound the table a little bit. However, I’m curious what you think of all this, because when I think about you and your investing style, you strike me as someone who is certainly open and embracing of the idea of ballast in a portfolio of sure, yeah, have some growth in there, but particularly as you get older, have some ballast. I’m wondering, do the pro-Dow Jones Industrial Average people hold any sway over you?

Jim Gillies: Well, as someone as well who looks at quite often at a lot of the companies in the Nasdaq could say, see I told you so. I’ve done that once or twice or 3,000 times. Yeah, I suppose I’m the natural guy to come along and a couple, pull one of those, but I’m not going to. I have some thoughts on how you can get some growth into your portfolio.

As you mentioned, I am very much someone who likes ballast. But we are Fools, and one of the tenets of Foolish investing is we think long-term. Yes, the Dow is going to win the month. Well, that’s lovely, and I don’t care. You are right again, they are probably … “they.” I feel like we’re attacking a straw man we’ve just constructed, but why not? It’s the construct for the show.

Chris Hill: I’m going to defend myself. I don’t think this is a straw man. I look at financial media every day, and I think that part of what we deal with as investors is yes, we want to be focused on the businesses, but we also live in an environment where there is all this news swirling around us and the news has narratives. I feel confident in this prediction. This is absolutely going to be a narrative in the month of December as people start their year-end, they’ll look back and it’s like, look, boy, this was the year you wanted to, you should have been in the Dow.

Jim Gillies: Yeah, well, so let’s talk about the outperformance of the Dow then in this year, 3% in the month. Whoop-de-doo. Chris, the Dow is in fact leading the charge for the major American indices in 2022. The Nasdaq, as of last night’s close, is down 29.8% for the year; the S&P 500, as of last night’s close, is down 17% for the year. Note I’m not including dividends, I’m just going straight numbers. The Dow leading the charge down only 6.8%. It’s still down. How is this me winning?

But again, we want to talk total return. I shouldn’t really call it total return because I’ve not bothered to grab the dividend numbers, but the absolute numbers over the past decade. Of course, as Fools, we like to talk about we expect to hold a minimum of five years. We encourage you to buy at least 25 stocks. Several multiples of those numbers myself.

As far as the length of time, I’ve got several stock holdings that are older than both of my children. I’ve got one child in university which should tell you how old I am.

But over the past decade, the leader of the pack, and it’s not close with a 265% total return, that is 13.8% annualized is — drum roll — the Nasdaq. The thing that you’re supposed to avoid. If you bought, held, didn’t worry about it, then shut up. You are beating the Dow with it’s 160% total return, which is roughly 10% annualized. The S&P lands in the middle at 180% total return, 10.8% annualized. Buying and holding, dollar-cost averaging.

Look, you can buy a Dow ETF, you can buy a Nasdaq and S&P ETF. But these are the types of returns that they have delivered and this includes the fact that the Nasdaq, on an annualized basis, has blown past the Dow by almost four percentage points. That’s after the 30% drop this year.

Where I come at the growthy growth names, it’s generally on a purely on a valuation basis. Paying 70 times sales for something, sorry, it’s dumb, shouldn’t do it, in my opinion. And I think my opinion is holding sway with what’s happened in the last year or so.

But buying at 10 times sales, say, we’ll call that company Shopify in 2016. When those sales are in fact going to the moon. Even when it dropped 75% in 2022, or whatever the number is, you’re still up 10-, 12-bagger territory. Growth absolutely has a place. Just don’t overdose on it.

But there’s a few other criticisms ahead for the Dow. Again, I like to get hate mail, so I’ll say it. The Dow is the dumbest index. I look at the Dow as almost worthless as an investing track. Anyone who is encouraging you, especially once the Nasdaq is down, encouraging you to get out of the Nasdaq Index or out of the growth names. We’re playing index games today, so we’ll stay away from individual stocks as investments. Going to mention a few.

Someone telling you to sell low effectively with the Nasdaq off 30% and buy the Dow for its relative success of only being down 7% year to date. They’re basically encouraging you to buy a flawed, idiotically constructed, and poorly managed index that is far less diverse. There’s by definition 30 names in it. The Dow Jones Industrial Average only has 30 names in it. The Nasdaq index, I believe there’s 100. The S&P 500 obviously has slightly more than 500. It’s poor on a returns basis, it’s poor on a diversification basis, and it’s constructed stupidly. But other than that, it’s fine.

Chris Hill: It does speak to the power of both nostalgia and inertia that the Dow Jones Industrial Average continues to get the attention that it does because it’s been around for so long. As you said, just if you were starting from scratch today, you wouldn’t build the Dow. You wouldn’t build an index of 30 stocks unless it was concentrated in a particular industry.

Jim Gillies: Exactly. It does a bad job of what it is supposed to do. The whole point of an index… By definition, the index is to supposedly attempt to measure the incredibly complex breadth of American business. I’m going with an American index.

But I mean, of course, so many of these companies are international, but then the largest company by market cap in the world is Apple, and the largest — at least in America. I’m not sure were Saudi Aramco sits today. Maybe I should say world unless I’m right and I’m [inaudible].

But Apple, largest company America. Apple sells one or two products outside the borders of your fine nation. I think there’s about 17 of them in this room. These are international companies. Coca-cola sells one or two beverages outside of America.

But the whole point of an index to try to capture and measure the health of publicly traded American business. The S&P 500 — which, again, is 500, it’s slightly more than 500 companies, but we’ll pay no attention to that. It’s the largest 500-ish companies in America, and what it does is it captures about between 70% to 80% of total market capitalization in America. Does a pretty good job.

What it doesn’t capture is a host of tiny little companies that are the thousands of this 2,000 largest companies by market cap. It’s pretty good job. If you go out and rank, go find the 10 largest companies by market size. Those 10 companies in America are, I’m going to run them down really quickly, Apple, Microsoft, [Alphabet‘s] Google, Amazon, Berkshire Hathaway, Tesla, UnitedHealth Group, Johnson & Johnson, ExxonMobil, and Visa. Those are the 10 largest-market-cap companies in America.

The first nine are also the top nine holdings of the S&P 500. Visa, the 10th-largest company, is actually 13th on the S&P 500, but you’re starting to get one and two digits after the decimal point. Of those 10 largest companies, without looking, Chris, how many of the 10 largest companies are actually in the Dow? Not just in the top 10 of the Dow, are actually in the Dow.

Chris Hill: I want to say four.

Jim Gillies: You missed it by one. Five. But then you get into, well, what’s the largest company by market cap in America? Apple is, oddly enough, market cap-wise, the largest weighting in the S&P 500. It’s the 19th-largest weighting in the Dow. It’s almost in the bottom third. Microsoft, the second-largest company in America, No. 2 in the S&P 500, is No. 6 in the Dow. The largest weighting is UnitedHealth Group.

The reason for this is that the Dow Jones Industrial Average is what’s known as a price-weighted index. Your price is what matters, not your size, not your actual financial results. That is asinine. Then the No. 1 ranking in the Dow wouldn’t need UnitedHealth Group, again, the seventh-largest company in America. The No. 2 waiting in the Dow is some vampire squid company called Goldman Sachs. It’s the 59th-largest company in America by market cap. JPMorgan, which I believe is in the top 15, I think it’s No. 11. JPMorgan is way down, it’s at the 20th-ranked company in the Dow. It’s weird.

The other thing is, why is Apple so small? Why is Apple, the largest company in America, 19th in the Dow? It’s because Apple had the temerity to split their stock in, I believe August of 2020, they split 4 for 1. Because this is a price-weighted index, Apple basically removed 75% of their weighting in the Dow, which is amazing, because that then prompted the Dow Jones selection committee to make moves. Would you like to hear the silly moves they made?

Chris Hill: As quickly as possible. We got to get with the FTX.

Jim Gillies: As quickly as possible.

The argument to take Apple or that when Apple quartered themselves, essentially, by a stock split, it dropped the technology waiting down by almost 28% to about 20%. The folks in charge of Dow Jones selection said, “Cool, what we’re going to do, we are going to take three companies out.” Those three companies were ExxonMobil, Pfizer, and I believe Raytheon. “We’re going to add three companies in: Salesforce” — That’s your technology weighting back up — “Salesforce, Honeywell and Amgen.”

Well, that turned out to have been a really spectacular move. The average return for those three companies they added in August of 2020 is negative 0.7%. The superstar there would be Salesforce, who was down 44% over this time. That’s really what’s weighted. Honeywell’s up a respectable 31%, Amgen’s up 11%, that’s fine.

The three companies they took out, the average return of what they threw away is 91.6%. It’s almost a double over a very volatile market. Chief among them, ExxonMobil up 176.8%, Pfizer up 38.2%, Raytheon up 59.7%.

This was done because they were reacting to the Apple’s price waiting and they felt they needed more technology. What they would do is eliminate, basically, the largest energy producer at America which seems weird to me. But again, I’m not paid to be on the committee. I’m just paid to sit here and laugh at them.

Chris Hill: I was going to say, I don’t know who’s on the committee, but it sounds like they’ve got a lot of work to do.

We got to get out of here. Jim Gillies, always great talking to you.

Jim Gillies: Thank you.

[music]

Chris Hill: You’ve probably heard a lot lately about the collapse of a cryptocurrency exchange FTX. But what actually happened? Dylan Lewis and Ricky Mulvey give you a rundown on the story and the takeaway for investors.

[music]

Ricky Mulvey: Let’s dive into some of the FTX craziness and see if we can find some lessons for investors. Dylan, I think let’s first start with a recap and then pull out some takeaways.

Dylan Lewis: Love it. Yeah, this has been the inescapable story online over the last couple of weeks. It’s fun to do a show on it.

Ricky Mulvey: Let’s get your whiteboard and yarn ready, because there’s a couple of players in this. FTX was a crypto exchange. At its peak in July of 2021, you had over a million users. There was the third-largest crypto exchange by volume.

When it starts, it receives an important investment from another exchange that’s called Binance. Now, you probably saw FTX with the ads during the Super Bowl with Tom Brady and Larry David. Got an arena named after it. Its founder, Sam Bankman-Fried, also called SBF, becomes an immediate darling and makes large political donations.

Dylan Lewis: Yes. I think as crypto goes, FTX is as mainstream as it possibly could be.

A name that a lot of people have learned over the last couple of weeks is Alameda Research. This is a hedge fund that was also started by Sam Bankman-Fried prior to founding FTX. He was involved in Alameda for a while and then later gave leadership to someone else but was seemingly involved even though it was apparently a separate entity from FTX.

I think the important thing to know about the relationships between Alameda and FTX: The leaders of both sat next to each other and basically cohabitated. People who thought they were wiring money to FTX were actually wiring it to Alameda. That will become very important later.

Ricky Mulvey: They’re giving loans to each other. When you build these ELA, a trading firm, it’s not supposed to take money from people’s deposits to make risky cryptocurrency trades. Those decisions is where the organizations start to unravel.

One other piece is that FTX and Alameda are using a token that’s called FTT. It’s a crypto that has been created by FTX. It’s encouraging people to buy and sell cryptos on the platform. Because it has this trading volume, they’re able to say it has a tremendous market cap.

This becomes a little bit tricky because Binance, the rival firm, owns a lot of these FTT tokens, and also, FTX and Alameda are using this essentially self-created cryptocurrency as collateral for much larger loans.

Dylan Lewis: Yes, and this is where it starts to get a lot cloudier and probably a lot more confusing for a lot of people. But the easiest way to think about FTT is just they essentially created their own coin. And there’s nothing necessarily insidious about that. But what we see increasingly as the story develops is it was a way for them to grow their assets and also exchange money between FTX and Alameda, as well as other people in the crypto industry, relatively easily.

And all this comes to a head earlier this month when a website called CoinDesk, who’s really one of the leaders in this space if you follow it, leaked a balance sheet from Alameda showing that if you looked at its balance sheet, it had roughly $15 billion in assets, but the vast majority of that money was held in FTT tokens. To go back to what I was just saying, this is a token that they created. The value of this is, to some extent, made out of thin air and really only valuable so long as people continue to feel like it is valuable.

Ricky Mulvey: FTT is making loans to the trading arm, Alameda, and receiving their own token as collateral. So you have this self-dealing that can create a lot of risk in the system.

FTX had a number of balance sheet errors. One of the most unfortunately hilarious ones was that they had $2.2 billion marked for a cryptocurrency called Serum on the balance sheet, and the coin’s market cap was only $88 million.

So there’s the revelation from CoinDesk that says that the balance sheet is built on the self-created token. This starts to create a bank run, where traders are making withdrawals, and Binance, which was that early investor in FTX, announces that it’s going to offload all of the FTT tokens, which is worth hundreds of millions of dollars or more.

And this becomes a problem for FTX because there’s now a huge supply, not enough demand in the system, and it can crash the price. This drives down the price of the FTT token, which is the overwhelming asset, and it just compounds the problem from their creating this huge snowball that you’re seeing play out now.

Dylan Lewis: And really, the easiest way to think about how this all comes to head and really how this all gets exposed is this is a bank run. Because people were starting to be concerned that they would not be able to get money out of FTX because so much of FTX was collateralized by money that they had essentially invented.

And so at a very high level, because I know we threw a lot of stuff at people here: The FTX exchange seemingly took customer funds and then made those funds available to Alameda Research to invest without customer knowledge. It seems Alameda racked up losses as they were doing that but was able to cover those losses and continue to keep a lot of their customers, and really generally the crypto industry, in the dark because they could transfer FTT between FTX and Alameda to cover the deficit. They were also able to rehypothecate FTT and some of the other crypto holdings to continue to boost their overall assets.

And this all was fine so long as the value of FTT coin held. But it didn’t because of actions in the market and recent information that CoinDesk was able to unearth.

The fallout, I think it’s almost impossible to know at this point. But if you’re a customer who had holdings with FTX, you are likely never going to be able to access them. And there seem to be a lot of other crypto firms that had exposure to FTX, which has created follow-on bankruptcies and concern throughout crypto.

Ricky Mulvey: I think it’s a huge lesson in that a year ago, people were saying, “Hey, let’s not have this financial regulation going on in crypto.” Boy oh boy, has that tune changed.

Dylan Lewis: It’s really interesting, because part of the “poster child of crypto” reputation that SBF was able to create for himself was one of “I’m willing to talk to regulators. I’m willing to do the work to legitimize crypto,” and that seemed to be something that made him trustworthy, along with the fact that both of his parents have compliance backgrounds, are very highly regarded in the academia world.

He also tapped into effective altruism with his way of pitching both himself and his general crypto ambitions. We are starting to realize that a lot of that may have just been window dressing or marketing.

Ricky Mulvey: So, Dylan, what are some of your big takeaways from this story? If you’re terminally online like I am, this just flood of nonstop information about the FTX fallout.

Dylan Lewis: This is going to sound wonky, but I think one of the biggest things that public investors can really take from this — because this is a crypto story, and it may not be something that a lot of people feel like they have access to or exposure to — is related-party transactions are rightly scrutinized, and they are a very large part of the way that we look at companies when they come public. There’s a whole section dedicated to them in the prospectus, and if you see people waving the red flag when they look at them, they are worth paying attention to.

Because when you invest in a business, you want to make sure that the leadership of that business is acting in your best interests. And as we see here, when management controls multiple entities that are tied up together, it can become much harder for you to understand whether they are acting in your best interests or their own.

Ricky Mulvey: Did you see the chief regulatory officer of FTX had previously worked essentially at a poker website where people were given “god mode” so they could see other players’ cards?

Dylan Lewis: I think you need to trust leadership broadly, and this is why we think it’s so important, and really, with related parties and the ability to deal within entities. As we see here, it makes it so much easier to commit fraud, and some of that is because of lack of internal controls or maybe mischievous behavior on behalf of folks calling things.

But also, if you control both the books and the piggy bank for multiple entities, it becomes a lot easier to do “fun with numbers” questionable accounting, and, as it seems in this case, commit fraud without tipping off other people because you control everything.

Ricky Mulvey: That’s where I think the narrative about this being a series of unfortunate mistakes becomes a little bit flimsier to me is that the chief technology officer of FTX built a back door so they could take customer funds and put it in Alameda Research without tipping off any regulatory red flags. So is this deliberate track covering that means that they were not looking out for the best interests of investors.

And you can understand, though, why a lot of people wanted to use FTX in these crypto investments, because there were these very high promises of return even for seemingly safe investments.

Dylan Lewis: This industry is so inaccessible to a lot of people. At core, there’s nothing bad about being a crypto exchange. FTX made crypto ownership much more democratic and much easier for a lot of people. It’s just they decided to do so many other things that were seemingly nefarious, and that’s really where it got into trouble.

Well, I think one other thing that people should probably be paying attention to is this: As FTX was raising money and as Alameda was raising money, there were some other red flags that I think people probably should have seen. One of them is there was an Alameda pitch deck from 2018 surfaced by the Block, which basically showed an investment opportunity that included a 15% annualized fixed-rate loan with the statement, “These loans have no downside. We guarantee full payment, the principal and interest enforceable under U.S. law and established by all parties legal counsel.”

I think the thing that you have to remember when you see high-promise, low-risk returns is the only way that someone is able to offer you a high rate of return, like 15% — which is well above what we typically see for the stock market annualized — is because they are going to do something with that money that is inherently riskier than how they are borrowing it from you.

Ricky Mulvey: Than buying U.S. Treasuries?

Dylan Lewis: Yes, exactly. And there is nothing truly risk free. Even buying a Treasury technically has some risk to it.

And so if you are providing funding to someone and they are paying you a relatively high rate for that, the only way, economically, they’re able to pull that off, it’s because they are able to do something that earns more money with those dollars or with that crypto, whatever it might be. And you have to question, at a certain point, the sustainability of that model and whether they can really continue to do it for years and years.

Very few people have been able to, and I think that that’s something that probably should have concerned people a little bit earlier than it did.

Ricky Mulvey: They weren’t the only exchange that were offering those late exchange. It was staking returns and hey, give us some Ethereum and we’ll give you a guaranteed six- to double-digit return.

I also want to talk about, even if you don’t own crypto, there are some public-market ramifications that will affect stock owners, investors everywhere.

Dylan Lewis: This is something that dramatically affects the number of people that trust crypto and the number of people that are willing to invest in crypto. I don’t personally own crypto, but I think it’s an incredibly interesting space to follow, and if you have any exposure to a company like Robinhood or any exposure to a company like Coinbase, you’re going to take a hit here regardless of whether you own crypto or not.

What we’re also seeing is, there was a lot of big money and a lot of smart money tied into this. Tiger Global was involved, Sequoia Capital was involved as investors. But also, we’re seeing that the Ontario Teacher’s Pension Fund was involved, and this is one of Canada’s largest pension funds, and they had almost $100 million invested in FTX. They are writing down the entirety of that. And so this is something that is affecting people that maybe didn’t even necessarily know that they had crypto exposure.

Ricky Mulvey: I want to know how many people are invested in Coinbase that don’t own crypto. That’s got be a thing that I agree on, Dylan.

Dylan Lewis: I’m curious. I think this contagion, it’s easy to see a story just being played out and moving on after one cycle, but back in June…

So the price of Bitcoin right now is around like $16,000, and you’re seeing a lot of lack of faith. People aren’t entering the space that much. And back in June, MicroStrategy has said that they would face a margin call if Bitcoin essentially fell to $21,000. Right now, it’s at $16,000, and I haven’t heard much about that story. So I feel you might see some other developments continue to play out.

My takeaway from this is just being careful about investing in things you don’t understand. I would say I got stung but not burned by investing in crypto. I was excited about it. I thought it was a really cool, unique beginning of something. Even after this, I don’t own Bitcoin, but I’m not totally unsold on it. Because there’s still a part of my brain that’s saying, “Hey, if you bought Bitcoin every time it got cut in half, that wouldn’t be a bad way to make money.”

Ricky Mulvey: I think this is not the death of crypto, and I think the people saying that are probably going to be wrong. There’s a critical base of people that are interested in this, and it seems there are interesting projects and interesting applications for it.

I think it is a massive setback for the industry, and one that is probably going to just lead to increased oversight, increased regulation, and also just a longer adoption cycle for people that were on the fence about jumping in. It’s not the death of crypto, but it is the end of this segment.

Dylan Lewis, always good to chat with you.

Dylan Lewis: Thanks for having me, Ricky.

Chris Hill: As always, people on the program may have interest in the stocks they talk about and the Motley Fool may have formal recommendations for or against, so don’t buy or sell stocks based solely on what you hear. I’m Chris Hill. Thanks for listening. We’ll see you tomorrow.

JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Chris Hill has positions in Alphabet, Amazon.com, Apple, Exxon Mobil, JPMorgan Chase &, Johnson & Johnson, Microsoft, Shopify, UnitedHealth Group, and Visa. Dylan Lewis has positions in Alphabet, Amazon.com, Apple, Salesforce, and Shopify. Jim Gillies has positions in Amazon.com, Apple, Berkshire Hathaway, and Visa. Ricky Mulvey has positions in Ethereum. The Motley Fool has positions in and recommends Alphabet, Amazon.com, Apple, Berkshire Hathaway, Bitcoin, Coinbase Global, Ethereum, Goldman Sachs Group, JPMorgan Chase &, Microsoft, Salesforce, Shopify, Tesla, and Visa. The Motley Fool recommends Amgen, Johnson & Johnson, Pfizer, and UnitedHealth Group and recommends the following options: long January 2023 $1,140 calls on Shopify, long January 2023 $200 calls on Berkshire Hathaway, long January 2024 $47.50 calls on Coca-Cola, long March 2023 $120 calls on Apple, short January 2023 $1,160 calls on Shopify, short January 2023 $200 puts on Berkshire Hathaway, short January 2023 $265 calls on Berkshire Hathaway, and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.