The charges laid against us
By John Kay
Published: January 30 2009 18:26 | Last updated: January 30 2009 18:26
Over the 42 years that Warren Buffett has been in charge of Berkshire Hathaway, the company has earned an average compound rate of return of 20 per cent per year. For himself. But also for his investors. The lucky people who have been his fellow shareholders through all that time have enjoyed just the same rate of return
as he has. The fortune he has accumulated is the result of the rise in the value of his share of the collective fund.
But suppose that Buffett had deducted from the returns on his own investment – his own, not that of his fellow shareholders – a notional investment management fee, based on the standard 2 per cent annual charge and 20 per cent of gains formula of the hedge fund and private equity business. There would then be two pots: one created by reinvestment of the fees Buffett was charging himself; and one created by the growth in the value of Buffett’s own original investment. Call the first pot the wealth of Buffett Investment Management, the second pot the wealth of the Buffett Foundation.
How much of Buffett’s $62bn would be the property of Buffett Investment Management and how much the property of the Buffett Foundation? The – completely astonishing – answer is that Buffett Investment Management would have $57bn and the Buffett Foundation $5bn. The cumulative effect of “two and twenty” over 42 years is so large that the earnings of the investment manager completely overshadow the earnings of the investor. That sum tells you why it was the giants of the financial services industry, not the customers, who owned the yachts.
So the least risky way to increase returns from investments is to minimise agency costs – to ensure that the return on the underlying investments goes into your pocket rather than someone else’s.
The effect of these costs on returns depends on the frequency with which you deal. Online trading is so inexpensive and easy that you may be tempted to trade often. But only one thing eats up investment returns faster than fees and commissions, and that is frequent trading. Do not succumb. Do not accept the invitation to subscribe to level two platforms or direct market access. The total costs of running your own portfolio should be less than 1 per cent per year.
Investing in actively-managed funds will cost you more. The choice of funds, both open and closed-end, is unbelievably wide. There are more funds investing in shares than there are shares to invest in. This situation doesn’t make sense, and is both cause and effect of the high charges. Costs need to be high to recover the expenses of running so many different, mainly small, funds that all do much the same thing. At the same time, the high level of charges encourages financial services companies to set up even more funds.
The proliferation of funds means that choosing a fund may be no easier than choosing individual investments. The problem seems to multiply itself, as do the fees. The fees attract more advisers, and so on. This plethora of choice would be less confusing if all funds, managers and advisers were excellent, but most are not.
The underlying problem is one of information asymmetry. The marketing of financial services emphasises quality, not price, and for good reasons. It would be worth paying more – a lot more – to get a good fund manager. But since it is hard to identify a good fund manager, good and bad managers all charge high fees, with the consequences described above.
If you own a mainstream British unit trust for five years, it is likely that the direct and indirect costs and charges you incur in buying, holding and selling that investment will total 3 per cent a year. Other investment funds may cost you more. The total charges on a fund of hedge funds are such that it might yield less than a government bond even if the underlying investments returned more than 10 per cent per year.
There may be hope of better value from funds. In the US, the Vanguard Group, a not-for-profit company with a messianic founder, John Bogle, has become market leader in retail fund management with charges substantially lower than the norm.
The most attractive equity-based funds for small investors are generally indexed funds, exchange traded funds, and investment trusts (closed-end funds) with low charges and significant discounts to underlying assets. These funds provide more than sufficient choice for normal purposes. All of them can be accessed through your online execution-only share-dealing account.
Extracted from John Kay’s new book ‘The Long and the Short of It: Finance and Investment for Normally Intelligent People who are not in the Industry’, published by Erasmus Press. Next week: Diversifying
Copyright The Financial Times Limited 2009
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