Thursday, March 22, 2012

Buffett's Bet Against Hedge Funds, Part II

Yesterday's post about Buffett's bet that hedge funds (or actually funds of hedge funds selected by Protege Partners LLC) would not outperform the S&P 500 over ten years brought the following to mind:

Let's say a hypothetical hedge fund manages $ 5 billion.

That means just the annual 2 percent management fee* (the 2 percent of assets that a typical hedge fund charges investors each year) alone will cost its investors $ 100 million/year. The costs would be more, of course, since a hedge fund will also usually charge investors 20 percent of profits generated (performance fees). There would also be an additional 1.25 percent of assets and 7.5 percent of any gains charged if a fund of hedge funds is involved as noted in yesterday's post.
(As I write this I still find all these fees very hard to believe.)

Now, compare the above to Berkshire Hathaway (BRKa).**

Berkshire Hathaway's market value is $ 200 billion (it's not hard to argue the company is worth more but that's another topic).

So Berkshire is 40x bigger than the above hypothetical hedge fund but Buffett's pay has been and continues to be much more reasonable. For decades, Buffett's compensation has been the $ 100k/year he collects in salary. Buffett does also benefit from personal and home security that Berkshire pays for but otherwise no bonus, stock options, or other forms of compensation.
(Buffett's primary source of wealth has come from the shares he purchased decades ago.)

Quite a contrast and, well, quite a bargain.

What Buffett has been paid during the forty plus years as CEO added together is, in total, less than 5 percent of what the hypothetical hedge fund above would be paid in one year.

Now naturally some of the $ 100 million paid to the hedge fund goes to other operating expenses. So to be completely fair, at least some of the operating costs of Berkshire's headquarters (though much of those costs are presumably related to the operating businesses Berkshire owns outright), including the new investment managers, shouldn't be ignored. That's the only way to make this a true apples-to-apples comparison of frictional costs (though I know of no corporation Berkshire's size with such a small headquarters).

Let's not split hairs. This difference in costs, I think, speaks for itself. Precision not required. Berkshire is built to minimize frictional costs for investors like few other investment vehicles. Add the cost for Berkshire's headquarters (all 19 employees) and the total frictional costs compared to the value of the assets being managed is still lower than any fund in existence by a large margin.
(Consider I'm also ignoring the performance fees that hedge funds charge which are far from inconsequential.)

...frictional costs of all sorts may well amount to 20 percent of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80 percent or so of what they would earn if they just sat still and listened to no one.- From the How to Minimize Investment Returns section of the 2005 Berkshire Hathaway Shareholder Letter

What if Buffett had been charging '2 and 20' fees instead all these years?

Berkshire would be a shadow of itself and its long-term investors, of which it has many, a lot less rich.

We know with Buffett in charge Berkshire has produced ~20 percent returns per year for decades. Due to its sheer size, it will almost certainly not do that well in the future whether Buffett's at the helm or not.

Having said that, the company is made up of a pretty fine set of assets that are likely to compound nicely in value over time.

I'm guessing no matter who is running Berkshire over the coming decades, even if not the compensated at a bargain $ 100k per year rate, that the frictional costs as a percent of value will continue to be lower than just about any fund in existence.

Adam

Long position in BRKb established at less than recent market prices

Related posts:
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* The article mentioned in yesterday's post noted that, in addition to the '2 and 20' fees hedge funds typically charge (investors are charged 2% of the assets each year in management fees plus 20% of profits generated in performance fees), the funds of funds add another layer of fees. According to the Bloomberg article, on average this is an additional 1.25 percent of assets and 7.5 percent of any profits.
** Berkshire's not a hedge fund, of course, but I think it's worthwhile to make the comparison. Much like a hedge fund, Berkshire is an investment vehicle that attempts to generate satisfactory returns and manage risks. The investor is just charged a lot less for the privilege.
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