22 March 2012
I recently attended a talk by Mr Terry Smith, Chief Executive of Fundsmith LLP, which was given to the Conservative Muslim Forum.
One of the points he made is that management charges can have a big impact upon your investment outcome. To illustrate this he referred to Berkshire Hathaway, the investment company that since 1965 has been managed by Warren Buffett. He said that if you had invested $1,000 in Berkshire Hathaway when Warren Buffett took over, by now it would be worth over $4 million. That did not surprise me, as the statistic is well known. Such sustained performance over such a long period demonstrates Warren Buffett to be one of the greatest investors of all time.
Mr Smith went on to explain what would have happened if Warren Buffett had made the same charge for his services as many hedge fund managers, namely 2/20. As probably the greatest investment manager in the world, it would not be unreasonable for him to charge such a fee. 2/20 means charging an annual management fee of 2% of assets, and an performance fee equal to 20% of any positive growth. Mr Smith stated that if these charges had been made, instead of over $4 million you would only have about $400,000.
The other 90% of the growth would have ended up with Warren Buffett if he had chosen to reinvest his management fee income back into Berkshire Hathaway. (Even if Warren Buffett spent the management fees, you would still only have $400,000!)
While I had no doubts that Mr Smith's calculations would be correct, as someone who likes playing with spreadsheets I decided to build my own Excel model, which can be downloaded, if you want to examine it. In my experience, building and flexing spreadsheets can help you to understand a numerical situation much better. In this case you can change the assumptions about the level of charges to any numbers you consider appropriate.
Berkshire Hathaway's performance data is readily available in its annual accounts. I used the 2010 annual accounts, and the data is on page 4 using the PDF numbering.
The calculations without charges, representing the real Berkshire Hathaway, show that $1,000 invested at the start of the period would have become $4,908,538 with all calculations being rounded to the nearest dollar.
In comparison, if you had paid a management charge of 2% of the asset value brought forward each year, and a performance fee of 20% of any positive performance each year (with no offset for the management fee), at the end of the period you would only have $459,023.
While some hedge fund managers may charge a 20% performance fee on all positive growth, it is more normal to have a hurdle rate, so that the performance fee is only payable if the investment manager beats the hurdle. The hurdle rate would be set at the expected rate of return from the fund in the absence of any special skill on the part of the manager. In the case of equities, that might be, say, 8%, which is the rate of return many US state and local pension funds assume their investments will earn.
Putting in a hurdle rate increases the amount of money you have at the end of the period, since it reduces the performance fees paid. However, even with an 8% hurdle, you are only left with $815,656 compared to the $4,908,538 if there were no charges.
The only way you can avoid charges is to manage all of your investments by yourself. Few of us can do that successfully.
If the person charging you can add more value with his skill than you lose in charges, then you will be ahead. The purpose of this numerical exercise is to encourage you to think critically about the charges that you are about to sign up for.
As an illustration from a different investment area, there are many "passive" investment funds that aim to track an index. However one finds different funds tracking the same index while having very different levels of charges. Logically if all of the funds can track the index equally well (that is not always true unfortunately) then one would need special reasons to buy any fund other than the one with the lowest cost.
Each page of my website carries a disclaimer at the foot of the page. Given the subject matter of this page, I particularly want to refer readers to the disclaimer.
My wife and I have a small shareholding in Berkshire Hathaway, and my wife is a customer of Fundsmith LLP. Nothing in this article should be regarded as a recommendation of either organisation.
The sole purpose of this page, as with all other pages of my website, is to educate readers and to encourage them to think critically.