Index Investing Can Avert a (Crypto) Series of Unfortunate Events

The crypto crowd is running amuck these days - or for the exits - due in large part to news of FTX and its sister companies FTX.US and Alameda Research filing for bankruptcy. This series of unfortunate events will shake the faith of many crypto investors and tarnish the crypto industry. However, there is a clear path to avoiding this fate in your own investing scenario. Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

Crypto Catastrophe

FTX's fall from public grace took place in a matter of days. This shows how fast a market can crash when investors start panicking.

Regarded as one of the largest crypto exchanges - with a valuation of $32 billion - FTX was a big player before its recent downfall. Its young CEO was spending millions on Super Bowl ads, celebrity endorsements, political lobbying and donations and cryptocurrency company bailouts.

According to Investopedia, on Nov. 2, CoinDesk reported that a large portion of FTX sister company Alameda Research's assets were in FTT, which are tokens that FTX created. This raised all sorts of questions regarding whether Alameda had used the crypto as collateral and how much exposure FTX's balance sheet had to Alameda. The news prompted concern across the cryptocurrency industry about the two companies' undisclosed leverage and solvency.

On Nov. 6, Binance, the world's biggest crypto exchange, sold off FTX tokens worth about $529 million. This intensified concerns about FTX's stability, which led to a drop in price of the FTX token and a $6 billion run on the bank by customers who kept funds in the exchange. FTX reached out to Binance for a bailout, which Binance considered but refused.

Nov. 11 was D-Day for FTX and approximately 130 other affiliated companies that are part of its Chapter 11 bankruptcy filing. Evidence revealed that FTX had used a number of its assets and customer deposits to prop up Alameda after numerous deals went awry, which led to the liquidity issues. The securities regulator of the Bahamas has frozen FTX's assets and the company is strongly advising against customer deposits. Other regulatory investigations also are ongoing and civil lawsuits are being filed.

In short...it's a mess.

Pearls of Wisdom

I do not share this news to disparage crypto investing in general. But I do advise proceeding with caution into any investment scheme or strategy that seems too good to be true.

These words of wisdom come to mind when I ponder the recent FTX calamity:

"I try to avoid things that are stupid and evil and make me look bad…and bitcoin does all three." --- Charlie Munger

and

“I can say almost with certainty that [the crypto clique] will come to a bad ending." --- Warren Buffett

Premature conclusions? Time will tell.

Simplicity at its Best

The late, great Vanguard founder and patient investor, John Bogle, touted what I believe is a secret to long-term investing success. It's not flashy, "new," or virtual, but it can - and does - collectively save investors billions of dollars.

It's index fund investing.

Reduced to its basic principles, Bogle’s index fund hypothesis was to focus on a highly diversified fund that could be bought and held at a very low annual cost in perpetuity.

Before Bogle's index fund became available to the general public, mutual funds were “actively managed.” Wazoos chose which stocks and funds to buy and sell at a not insignificant cost. Bogle’s index fund was “passively managed” by investing money in a fund that simply tracked the stock of companies comprising a given index, like the S&P 500. This concept greatly reduced the time…and cost…spent assembling shares of those companies.

As Bogle’s index fund converts became increasingly aware that very few individuals outperformed the market rate of return, they abandoned the myth that investors could consistently outsmart the market. This led to countless more “buy and hold” investors…Bogleheads®…as opposed to traditional market timers and traders.

Don't Pay to Play

Initially, Wazoos resisted the very concept of index funds, focusing initially on its threat to their livelihood. However, as study after study revealed that passively managed funds frequently performed better than managed funds after accounting for the higher fees charged by active managers, index funds became a popular “movement” in the investment world. Yes, wealthy investors could use active managers to influence stock values, but at the same time, less informed or new investors could avail themselves of market opportunities at much lower costs utilizing these innovative unmanaged index funds.

“Costs matters,” Bogle often preached. “In investing, you get what you don’t pay for.”

Simply stated, the real return for an investor is what the market yields minus costs. If the investor pays nothing, he or she keeps everything. Of course, very few things in life are cost-free, but the more an investor pays the Wazoos for “help,” the less he or she keeps. And that was the driving force behind Bogle’s index fund investing – keeping the Wazoos at bay to the extent possible.

Cost Layers

The best way to select a good quality mutual fund is to focus on a highly diversified, low-cost fund with minimal asset turnover (i.e., one that holds its assets long-term). By doing this, an investor avoids or minimizes the various layers of fund costs, which include its annual expense ratio, sales loads, internal expenses incurred through frequent trading, and associated taxes on capital gains.

• An expense ratio is a clearly disclosed percentage of assets charged annually to the fundholder. The ratio may seem small, and in the case of unmanaged index funds, is small when compared with actively managed funds. As an example, if an index fund charges .1% annually and an actively managed fund charges 1.25% annually, the difference amounts to an annual 12.5 times greater cost of holding the actively managed fund. Small though a 1.5% annual percentage charge may seem, over time it makes an enormous difference in the value of a retirement asset, taking into account the amazing power of compounding.

• A sales load, commonly 5%+ of the amount invested, is paid up front when acquiring a mutual fund. This direct, front-end deduction (and all that it would have earned over time) is gone. Think about the cost of that 5%+ up-front deduction on the value of your asset 20 or 30 years down the road. Avoid front-end sales loads with a passion. By the way, most index funds have no sales loads - another reason to invest in them.

• The fund turnover “hidden” cost. It’s been estimated by the smart money crowd that an investor loses 1% or so per year in asset performance for every 100% turnover in fund assets due to transaction costs. And it’s not uncommon for many actively managed funds to turn over their entire portfolio annually (the average is 60%). In case you’re interested, index funds suffer little if any turnover, which eliminates this expense entirely. Yep, another reason to buy index funds.

• A final expense is taxes, which average 1.8% annually (as a percentage of the fund value) in federal taxes alone for actively managed funds. Again, the smart money crowd estimates that index funds incur taxes in the range of .6% annually, even while often earning greater returns. The impact of taxes on a final yield can be quite a drag over time. As you might imagine, because of infrequent trading, index funds will incur less cost due to tax avoidance…another plus associated with the principle of buying and holding equities long-term.

In his informative tome, “The Little Book of Common Sense Investing,” Bogle mentioned that adding the aforementioned fees together, the average “actively managed” fund grows to only 1/3 the size of an index fund over 25 years.

In Sum

If you don’t carefully address (minimize) the impact of these various layers of costs, 67% of your original investment will be eaten up by fees and taxes during 25 years of investing. Quit working so much for the Wazoos and Uncle Grabby and more for yourself. After all, it is your money.

And, don't give in to memes, dreams and get-rich-schemes. They never, ever pan out - and they could very well spur your very own series of unfortunate events.