Wednesday, March 22, 2017

Buffett: Innovators, Imitators, & the Swarming Incompetents

From Warren Buffett's most recent Berkshire Hathaway (BRKa) shareholder letter:

"...the great majority of [investment] managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well. Bill Ruane – a truly wonderful human being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the long haul – said it well: 'In investment management, the progression is from the innovators to the imitators to the swarming incompetents.'

Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that some investment professionals, just as some amateurs, will be lucky over short periods. If 1,000 managers make a market prediction at the beginning of a year, it's very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him."

Buffett later adds:

"When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients."

What's an investor to do? According to Buffett, the vast majority of investors, large or small, would be better off owning index funds with reasonably low expenses.
(A view he's advocated previously including in the 2013 letter.)

Buffett, late last month on CNBC, further elaborated on his thinking on the high expenses investors often end up paying:

"The amount of money people wasted getting investment advice is just ridiculous in this country."

He then goes on to say:

" borders on obscene...I've known 10 or so people with modest amounts of money, I would bet a lot of money that they would do better than average. And I say that there are hundreds, maybe even thousands. But there's thousands, and thousands, and thousands and thousands of hedge fund managers charging two and twenty...And you don't get better because you charge a lot. I mean, that does not make you a better judge of securities or anything like that. And so the good salespeople, overwhelmingly, are the ones that attract the money, rather than the very few who are extraordinary at managing money."

Charlie Munger is, not surprisingly, included in that list of 10. Buffett says the people who he thought likely to do well in the investing business were not "the smartest guys necessarily in the world," but then added "although maybe Charlie is."

I find it very tough to argue with that.

Paying something like 1.5% per annum in incremental frictional costs -- or, incredibly, in some cases even more -- may not intuitively seem like a big deal but, on a compounded basis, the difference in long range outcomes is hardly insignificant.

Let's say a basket of investments increase in value -- before any fees -- at an annual rate of 5.0% for 25 years. Well, subtract those 1.5% in annual fees from the returns* over 25 years and you'll find that the gain takes a material haircut. In fact, after 25 years the investor ends up with only 60 cents on the dollar. So instead, for example, of having $ 100k in gains the investor instead keeps roughly $ 60k.**

It's the investor who puts capital at risk for many years yet a good chunk of the gains end up elsewhere.

What if the actual gains over 25 years end up being more modest?

Something like 1.5% annually before fees?

In that case, the gains to the investor would of course have to be zero since the 1.5% in fees exactly offset the returns. So, amazingly, the investment manager ends up with a positive, albeit reduced compared to the 5.0% scenario, result but the investor ends up breaking even. least for the manager.

Once again, remember who actually put the capital at risk here.

Now, what if returns before fees end up being less than 1.5% over 25 years? Well, it will produce a net loss for the investor. Those fees still have to be covered somehow and if gains aren't sufficient the costs must be subtracted from the funds initially invested. This creates a scenario where, once again, the manager gets a positive, though admittedly more muted, result while the investor necessarily incurs a loss.

So 1.5% per year in fees sounds kind of harmless until considered in dollar terms over a proper long-term investing horizon.

What if during -- or, especially, toward the end of -- the 25 year period there's a big decline in market prices? Well, if the money is not needed by the investor (and emotions don't take over) during such an event this need not be the end of the world. Prices may normalize if whatever precipitated the decline mostly comes to an end. Yet it is the investor who has to ride it out or otherwise take the hit. In other words, the manager keeps all those fees paid out in prior years no matter what happens. Add a couple of zeros or more to the numbers above and it's not difficult to see why, as Buffett said in the letter, usually it's "the managers who reap outsized profits, not the clients."

Some managers, of course, suggest they have the capability to produce even greater returns than the examples I've used above and, well, a small number might even achieve such a result (without taking crazy risks). Yet picking a manager beforehand who will actually end up being worth something like 1.5% per annum in fees is easier said than done. During bull markets, when returns seem like they'll indefinitely be high, the high fees being charged will also seem like not terribly important background noise. Unfortunately, it's likely that with a long enough investment time horizon -- multiple market environments that inevitably include the good, the bad, and the ugly -- the importance of those fees will, ultimately, more or less become foreground noise.

Big declines in capital markets from time to time are unavoidable.

When it will happen and to what degree is neither knowable nor controllable.

Keeping expenses low is.

Seems straightforward enough but far too many investors still find it difficult to keep what are mostly avoidable costs at reasonable levels.

The result? A quiet, meaningful, but largely unnecessary wealth transfer.

Dumb ideas emerge from time to time in investing; keeping a close eye on the frictional costs likely won't prove to be one of them.

If expenses are kept in check the bulk of the gains mostly benefit whoever has actually put capital at risk. If not, much of the value that should compound and accumulate over time will, instead, end up in someone else's pocket.

Naturally, as equity prices rise to premium levels -- compared to per share intrinsic business values -- future returns eventually become anywhere from diminished to entirely insufficient while, at the same time, the possibility of permanent capital loss increases.
(Especially when the investment horizon is too short.)

As always, the price paid is paramount. Otherwise terrific asset(s) can be turned into lousy investment(s) if the price paid is too high.

Inadequate margin of safety.

Reduced potential reward.

Greater risk of loss.

Despite the popular view reward and risk need not always be positively correlated.

It's impossible to ignore where equity valuations are now compared to not all that long ago.


Long position in BRKb established at much lower than recent market prices

Related posts:
Bogle & Buffett on Frictional Costs
Buffett on Active Investing
John Bogle: Arithmetic Quants vs Algorithmic Quants
Hedge Funds: Balancing Risk & Reward?
Index Funds vs Actively Managed Funds
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Howard Marks on Risk
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Risk and Reward Revisited
Newton's Fourth Law
Investor Overconfidence
Buffett on Risk and Reward
Margin of Safety & Mr. Market's Mood
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
When Genius Failed...Again

* Excluding tax considerations.
** If 4 times as much capital were invested but otherwise nothing changes in terms of performance, then the outcome over 25 years would of course be proportional (as far as returns and fees). At first this might seem fair enough. More money to manage...more fees, right? Yet, since we're still talking about the same 5% annualized return, those extra fees were generated simply because more assets were under management. Now, more assets no doubt will have some additional cost associated with them, but is 4 times more in fees really justified? Purchasing 4 times as many shares of a particular stock, for example, hardly increases the cost structure by four-fold. Does it really take 4 times the effort and skill to produce such a materially higher amount of fees? I think the question answers itself.
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