In what has now become an anticipated ritual in the world of finance, every February/March Buffett pens down an annual letter to Berkshire Hathaway shareholders detailing his insights & opinions on things past, present, and future.
At the start of every letter is Berkshire’s historical performance measured by % change in book value and % change in share price, along with the benchmark S&P500 index returns for that year. Since taking over Berkshire Hathaway in 1965, the world’s most successful investor has made billions of dollars for his shareholders and himself, boasting a ~20% CAGR over the last 53 years. Let that sink in — 53 years!
Berkshire’s book value has grown at an average CAGR of 19.1% between 1965 and 2017. Over the same period, the S&P500 returned 9.9%, including dividends. The wealth created over these years is a massive 10,893x — that is, a ₹10,000 investment in Berkshire would have grown to a mind-boggling ₹10.89 crores over this time, net of all costs.
However, if instead of running Berkshire Hathaway as a company in which Buffett co-invests with you, had he set it up as a hedge fund and charged the usual hedge fund fee structure of 2/20 (i.e. 2% management fee + 20% of any gains), then the ₹10,000 investment would’ve only become ₹89 lakhs — the balance ₹10 crores would’ve been pocketed by Buffett as fees!
Few points/assumptions to note here:
- Management fee is deducted at the start of each year
- The performance fee of 20% is paid (on the gains) at the end of each year the Buffett fund outperforms the S&P500. This deduction is reflected at the start of the following year.
- The fees earned are reinvested in the fund and earn the same returns as the fund . This rarely happens in practice as the money is spent, bonuses are paid out, etc. — however, it still shows the value lost by the investor
- In reality, people care more about the change in share price rather than the book value — in which case, the difference between fees earned & value generated would’ve been even higher with the 2/20 fee structure
- Detailed calculations are stored here; note there might be rounding errors
Prior to getting involved with Berkshire Hathaway, Warren Buffett ran multiple investment partnerships (the last of which he liquidated in 1969, before taking full-control and becoming Chairman of Berkshire). It’s hard to believe this today, but Buffett had a 0/25 fee structure — that is, he didn’t charge any management fees and was entitled to 25% of gains above a hurdle rate of 6%. A similar 0/20 fee structure was employed by Alfred Jones, creator of the first hedge fund in 1949, and often called the “father of the hedge fund industry”.
Between then & now, I’m not sure how or why the 2/20 fee structure became the standard for Hedge Funds, Alternative Investment Funds like PE & VCs, Portfolio Management Services, and even most mutual funds (the 2% bit, they are banned from charging a performance fee in most countries). In fact, fee structures have become so complex nowadays that often times investors don’t even know what they are exactly paying and why.
In recent years, institutional investors and advisors in developed markets have started stressing on fees, using their scale and power to drive down costs. Retail investors in such countries have also benefitted from this trend, with many ETFs and mutual funds now charging less than 0.10%. Interestingly, one of the biggest advocates of low-cost funds has been Warren Buffett himself, and this is one investment advice that he’s consistently offered. In fact, in his 2013 annual letter, he mentioned this is primarily how he’d like the trustee managing his wife’s money to invest after his death:
“My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will…My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds & 90% in a very low-cost S&P 500 index fund. I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”
Such is Warren Buffett’s confidence in this low-cost strategy, that in 2007 he even took on a very public $1 million bet against a hedge fund manager, saying that hedge funds wouldn’t outperform an S&P index fund over the next 10 year period. Unsurprisingly, he won that bet at the start of this year.
I had to do the above “Buffett’s hedge fund” analysis as student in Professor Ludovic’s Asset Management class back in 2015, when I was finishing the MSc. in Financial Economics at Oxford University & Saïd Business School. And it ingrained in me two critical lessons — the power of compounding over time, and the uber importance of reducing any fees/costs.
While many of us are familiar with both these concepts, a lot of us don’t take it as seriously as we should, especially the impact of reducing fees. This is even more prevalent in India, where the focus has historically been on absolute returns and active management has outperformed the benchmark for most parts. However, investors would do well to research & question the fees they are paying and assessing whether proportionate value is being added.
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