Wednesday, March 23, 2011

Buffett, Munger, and the 90% Tax

In the following exchange, Warren Buffett and Charlie Munger critique the investment profession. From the 2006 Berkshire Hathaway (BRKashareholder meeting:

Buffett: Most professions add value beyond what the average person can do for themselves. But in aggregate, the investment profession does not do this – despite $140 billion in total annual compensation. It's hard to think of another business like that. Can you, Charlie?

Munger: I can't think of any.

Later in the exchange Buffett continues saying...

Buffett: In the investment field, you now have large portions of investment managers that charge fees that, in aggregate, cannot work out for investors. Obviously, some [investments in high-fee managers] do [work out well]. But you can't pay 2 and 20 [2% annual management fee and 20% of the profits, standard for private-equity and hedge funds], in which you pay the manager 20% of the profits if they make money and, if they don't, they just close up and reopen later. If you charge this in an economy that's only growing a few percent a year, the math doesn't work. The question for you is how to pick out the exceptions [e.g., the managers who will outperform, even after fees]. Everyone who calls on you says they are the exceptions.*

I will bet you that if you name any 10 partnerships with over $500 million in assets and put them up against the S&P 500, they will trail the S&P, after fees, over time.

If you know enough about the person and how they've done in the past, you can occasionally find someone. But if you’re running a big pension fund, with everyone calling on you, you will likely invest in the best salespeople.

Munger: I think it ought to be a crime [for an investment manager or his agent] to entertain a state pension-fund manager, and it should be a crime for that person to accept it.

The whole concept of the house advantage is an interesting one in modern money management. The terms of the managers of the private partnerships look a lot like the take of the croupier at Monte Carlo, only greater.

Buffett: Is there anyone we've forgotten to offend? [Laughter]

2006 Berkshire Hathaway Meeting Notes

Someone who invested $ 1,000 in Berkshire Hathaway in 1965 would have just under $5,000,000 today.

Fortunately, since Buffett did not happen to charge what is now the industry standard "2 and 20 fees", that investor would have all of the $5,000,000 in his/her account.

So how much would that investor have if they had paid Buffett 2 and 20 during that time**?

Give or take roughly 1/10th that amount.

In other words, over the long haul the 2 and 20 fees amounts to a tax that transfers 90% of the wealth creation to the person managing your money. (this is easy to calculate: Buffett earned 20.2% since 1965, just subtract the 2 and 20 fees from those returns and recalculate. The power of compounding.)

And that's if the investor happens to be fortunate enough to hire someone as good as Warren Buffett.

What if that investor ends up with a mere mortal?

Adam

* Charlie Munger said this best during a speech back in 1998: "...five centuries before Christ Demosthenes noted that: 'What a man wishes, he will believe.' And in self-appraisals of prospects and talents it is the norm, as Demosthenes predicted, for people to be ridiculously over-optimistic. For instance, a careful survey in Sweden showed that 90% of automobile drivers considered themselves above average. And people who are successfully selling something, as investment counselors do, make Swedish drivers sound like depressives."

** Of course, during Buffett's partnership era, the fee structure was lucrative for him on the upside but also gave him exposure personally to losses on the downside. In fact, he could lose more money than he invested into the partnership by covering a quarter of all losses from his partners. From Alice Schroeder's book, The Snowball: "I got half the upside above a four percent threshold, and I took a quarter of the downside myself. So if I broke even, I lost money. And my obligation to pay back losses was not limited to my capital. It was unlimited." (pp. 201-202)
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