Friday, June 30, 2017

Compound Returns, Compound Costs...

"Hedge funds (so-called; actually concentrated investment accounts which offer a wide variety of strategies) manage about $2.8 trillion of assets, at a cost equal to at least 3% of assets per year (300 basis points, an informed guess), generating some $84 billion in annual fees." - John Bogle in a speech last year

Bogle's "informed guess" is, of course, primarily driven by the 2 and 20 compensation structure common to hedge funds.

In a prior post, I wrote what "if Buffett charged investors something like the 3% in annual fees to manage Berkshire Hathaway's (BRKa) current portfolio...?"

Well, 3 percent of Berkshire's now roughly $ 300 billion of cash and investments would increase Berkshire Hathaway (BRKa) expenses by ~ $ 9 billion which would naturally hurt shareholders by reducing intrinsic value -- materially so if this were to become an ongoing annual expense.* For many reasons such a fee structure would never exist at Berkshire, of course, but it's worth considering carefully how much less valuable Berkshire would be today if 1) Buffett had been draining those kind of fees out of the company all these years and 2) how much it would hurt investors going forward. If those kind of fees were charged in the past, Berkshire would in fact be a rather much smaller company and it's capacity to invest (not just in common stocks but also things like the capital intensive businesses Berkshire owns outright) would be a fraction of its current capability. Going forrward, if for some reason Berkshire started paying the $ 9 billion in fees -- fees likely to increase over time as the portfolio grows -- the impact would be substantial. Consider that Berkshire's invested roughly $ 13 billion in property, plant and equipment last year. Much of it to build and maintain things like the railroad, utilities, and energy infrastructure. Useful stuff. Well, that $ 9 billion in hypothetical fees would sure chew up a substantial chunk of Berkshire's $ 13 billion capital expenditure budget.

It's compounding returns pitted against what Bogle calls "the tyranny of compounding costs".

These annual Berkshire capital expenditures -- assuming they're intelligently implemented -- aren't just a likely future benefit Berkshire's continuing shareholders, they're potentially of substantial benefit more generally. In 2015, Buffett wrote that 86 percent of their property, plant and equipment budget was "deployed in the United States."

If this kind of high fee structure is detrimental to Berkshire shareholders -- never mind the possible adverse societal impact caused by high fees draining capital that could have been used to upgrade infrastructure --  why wouldn't this similarly apply to anyone managing lots of capital and charging high fees?

That question, at least for me, answers itself. The justification is usually that the money manager is so exceptional that the fees are fully justified. So that means, apparently, there's a large army of money managers so talented that they deserve compensation orders of magnitude greater than Mr. Buffett.

The money doesn't completely disappear, of course. The high fees being charged naturally get invested and spent somewhere but effective investment needs for good ideas to get backed by sufficient financial scale and real patience. Yet, at least relative to the Berkshire model, what could have been concentrated long-term investment seems, instead, destined to become rather diffuse and impatient while producing fewer things of lasting value.

"We have two [investment] managers at Berkshire. They each manage $9 billion for us. They both ran hedge funds before. If they had a 2/20 arrangement with Berkshire, which is not uncommon in the hedge fund world, they would be getting $180 million annually each merely for breathing." - Warren Buffett at last year's Berkshire Annual Meeting

Buffett, in any case, based on long-term track record is easily among the best -- if not the best -- at investing exceptionally well yet charging others little for it. I wouldn't expect his extraordinarily low compensation (considering the size of the job and the performance) to become the norm but it would seem a more reasonable equilibrium could exist between the two extremes.

"The way to wealth, it turns out, is to avoid the high-cost, high-turnover, opportunistic marketing modalities that characterize today's financial service system and rely on the magic of compounding returns. While the interests of the business are served by the aphorism 'Don't just stand there. Do something!' the interests of investors are served by an approach that is its diametrical opposite: 'Don't do something. Just stand there!'" - John Bogle in a commentary on CNBC

When high fees are tolerated "the magic of compounding returns" becomes something much less magical via "the tyranny of compounding costs".


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

Related posts:
Buffett on Bogle
Innovators, Imitators, & the Swarming Incompetents
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
Newton's Fourth Law
Investor Overconfidence
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
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

* For Berkshire, even as large as it is, ~ $ 9 billion of additional costs would be a real hit to the company's earning power. If those fees were to actually become an ongoing cost it'd basically be a wealth transfer to Buffett but the intrinsic value of Berkshire -- of which Buffett is the largest shareholder -- would be materially reduced. In many ways it'd be like moving his wealth from one pocket to another while hurting all the other shareholders (and, somewhat weirdly, even himself). Buffett's wealth has come about alongside his investors instead of from his investors. For too many that's just not the case. Best case it's usually a bit of both.

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