7 FTX lessons for investors

James Gruber, assistant editor for Firstlinks and Morningstar Australia, on what we can learn from the implosion of the crypto exchange.
By Morningstar |  28-11-22 | 
 

The FTX story has a bit of everything. Fraud, greed, lust, political connections, a relatively new concept in cryptocurrency, wealthy families, large financiers considered ‘masters of the universe’, suckers, the Bahamas and multiple other locations of business subsidiaries. That’s not to mention the employees and average investors who’ve been caught up in the downfall. Also, the lawsuits and court drama which are no doubt to follow. Knowing America, books and movies on the subject will already be in the offing.

For Indian investors, it might not have any relevance. However, there are many lessons to take away from FTX. Some obvious; others not-so-obvious.

1) Ideas don’t make investments.

The idea of a cryptocurrency exchange may appear like a great idea. What’s not to like about taking a fees via a trading platform in the then hottest ideas going around? There are lots of ideas for businesses; many of them are sound ones. Ultimately, though, business is all about execution, and FTX had none of that.

2) Do due diligence.

A big question mark hangs over the funds which invested in this company. One of them, Singapore’s Temasek, has defended its due diligence process saying it did eight months of work on FTX before investing. I’m not sure what work they did but it clearly wasn’t enough.

3) Always look at balance sheets.

It’s alleged that when investors asked to see financial statements beyond profit and loss statements, they weren’t forthcoming. No wonder – they didn’t have any cash left. The lesson is that balance sheets and cashflow statements are just as important as the profit and loss.

4) Don’t follow the crowd.

It seems likely that the funds which invested in FTX thought others had done due diligence on the company and therefore they didn’t need to do any themselves. Big error. Do your own work and be sceptical of others piling into investments.

5) Invest in people with a track record.

This may seem obvious, and it is. But the people who invested in Sam Bankman-Fried invested in a guy who was a junior trader for three years and had no track record in anything.

6) Keep on top of your investments.

When you invest in something, it’s not a case of set and forget’. You need to keep track of the investment. In the FTX case, Caroline Ellison, who headed the related company Alameda Research, bragged about regular methamphetime use on social media in May last year. A red flag, one would have thought.

7) Watch the flows.

There is a less obvious lesson from FTX and the cryptocurrency sector. Investors should be wary when significant money is flowing into a sector. Particularly if there are a host of company IPOs in the same sector at around the same time.

The process often goes like this:

  • There is a hot new idea or technology. Startups raise money, which leads to further money raising. That leads to institutions investing alongside venture capitalists. Which leads to more startups trying to raise money in the space.
  • Investment banks will want a piece of the action, so companies will IPO to raise more money and/or cash in for themselves and their investors. After IPO, these investment banks will put buy ratings on companies, and more investors will pile in.
  • All of which results in significant investment in the industry, and often, over-investment. That can lead to lower returns, increased regulation, investments fleeing the sector, cost cutting and eventually, industry consolidation.

This cycle has played out many times before cryptocurrency came along. There was TMT (acronym for technology, media and telecom sectors) in the late 1990s and subprime lending in the U.S. prior to 2008. Last year's bull run in India saw many high-profiled IPOs attract investors. The crash of high-profile IPOs as the Sensex surges looks at Zomato, Paytm, Star Health and Allied Insurance, PB Fintech, Cartrade, and Nykaa.

We see this when a particular sector or theme is doing well and money flows into it. Infrastructure saw an uptrend from 2004 to 2007, and money poured into infrastructure funds.

Director of fund research Kaustubh Belapurkar says that it is important that you do not buy into a sectoral fund that has done well recently. "The past returns may look attractive, but the worst time to get into a sector is when its best times are behind it. Rather, invest in a sector that’s relatively underperformed in the recent years," he says. "Our recent study on the gap between investor returns and fund returns shows us that sector funds tend to display the highest gaps as investor made poorly timed entry and exit in these funds. As on June 30, 2022, Infotech funds returns 27.49% p.a., but the investor returns (average rupee invested) in those funds only earned 3.18% - a huge investor return gap of 24.31%!!! Tech stocks had a great run up in 2020 and 2021, but bulk of the flows came into the funds after this run up." Read more in So you want to buy a tech fund?

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