Equity Edge Wealth

Imagine that over a lifetime of investing, two individual investors have the same average annual return before expenses. The first investor spends just 1.5% more on annual investment expenses than the second investor each year.

In this case, over an investment horizon of fifty years, the second investor would end up with twice as much money. Over seventy years, the second investor with lower fees would end up with three times as much money. Here are a few actual examples:

Comparison of Fees

See Table below for more examples:

Total investment costs are especially important. The examples above include management and custody fees and any other administrative costs but do not include either direct trading costs (eg. brokerage commissions) or indirect trading costs (buying or selling illiquid securities lacking a deep market, which are very difficult to estimate much less verify). Many investors do not even bother to monitor manager and custody costs, especially when managers take a percent of profits. This is an unforced error.

Total investment costs of 2.5% a year may sound high, but are actually common, especially for institutions or individuals employing the university investment model, which I co-developed with colleagues and clients. The university investment model added asset classes such as foreign, venture, buyouts, real estate, hedge funds, and hard assets, among others to “plain vanilla” U.S. stocks and bonds and for many years produced excellent returns. Although this approach creates the highest costs, even A LOWER 1% per year of investment expense would have reduced by a quarter the long-term real return (return minus consumer price inflation) of stocks in the United States since the inception of the S&P 500 in 1926.

Foundations Estimated To Pay 3% Year

Charlie Munger, Warren Buffett’s partner in Berkshire Hathaway, estimated in a speech in 1998 that foundations were paying 3% a year in total investment costs. He described the Cambridge Associates (which I earlier co-founded) or university style of investing, as a “fund of funds” approach with too many layers [of assets], too much complexity, too much investment turnover, and this led to excessively high costs.

Munger noted that HIS FIRM, Berkshire Hathaway, had reduced investment costs below 1/10 of 1% per year, an unheard of figure. He further noted that LBO funds, that is, leveraged buyout funds, now more commonly called buyout or private equity funds, in addition to a great deal of leverage, had two layers of promotional carry, one for company management and another for the general partners of the LBO fund, along with a great deal of leverage, which might blow up if we faced a serious recession, much less a depression.

Munger continued:

“In the United States, the person or institution with almost all wealth invested long-term in just three fine domestic corporations is securely rich…Why should such an owner care if at any time most other investors are faring somewhat better or worse?…Particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices…I think it can be a rational choice, in some situations, for a family or a foundation to remain 90% concentrated in one equity…It would be interesting to calculate just how all American foundations would have fared if they had never sold a share of founder’s stock [forbidden by current law].
“[Nor do I] consider it foolish, stupid, evil, or illegal for a foundation to greatly concentrate investment in what it admires or even loves. Indeed, Ben Franklin required just such an investment practice for the charitable endowment created by his will.”

An interesting Munger style digression follows:

“All the good in the world is not done by foundation donations. Much more good is done through the ordinary business operations of the corporations in which the foundations invest…”

Munger might have added that institutional investors today typically adopt multi-asset “policy portfolios” against which to compare their actual portfolio and managers. If the policy portfolio target is X percent in private equity, this creates intense pressure to put money into private equity regardless of current conditions and regardless of what private equity managers are offering in fees or partnership agreement terms. In some cases the partnership agreement is sent out so late that investors may lack time to review the document or show it to a lawyer. The whole review effort is just pro forma. No wonder that fee clawback provisions, which in the past prevented managers from winning in good times and never losing in bad times, have increasingly disappeared. In this way, masses of money flow into size constrained investment niches, private and public.

Too much money chasing too few deals at too high an investment cost in turn invalidates the return assumptions on which the policy portfolio was based.

Index Funds And Fees

As Charlie Munger observed, the university investment model is complex and expansive. Index funds have emerged as the answer to this problem because they seem to be the opposite: simple and inexpensive. Unfortunately, they are often promoted as a way to reduce costs and otherwise provide an answer to problems posed by the university model, but pose their own issues, some of them serious, such as capitalization weighting, which drives new money into the stocks that have recently risen the most. What is supposed to be passive investing is thus converted into “momentum” investing, which favors popular stocks over unpopular. In addition, the stocks that new money flows into may have just been selected by the S&P 500 Committee without any particular rhyme or reason other than recent popularity.

Beyond these structural issues, we might also want to note a Morningstar study focusing on index fund returns for the ten years ending November 2019. This found that index funds as a group had outperformed active marketable funds only by the difference in fees. Another Morningstar study showed active funds outperforming index funds before fees but again falling behind net of fees. Moreover, most index fund investors pay another fee (on top of the index fund fee) to an adviser, either a person or a “robo” system, who/which selects the index funds. If the indexes are specialized, not just standard S&P 500 fare, the charges are typically much higher. For example, Yale economist Robert Shiller’s company Macro Markets created exchange traded funds that allow you to be long or short on crude oil. UCR is long while DCR is short. Investor expenses run 1.6% a year.

The ETF version of index or other funds offers lower taxes than mutual funds. But the reduction in taxes derives from a tax loophole, which Congress could close. A leading senator has proposed doing so.

Highest Active Management Fees Charged By Hedge Funds

The highest active management fees are charged by hedge funds. These can reach 2% a year of invested capital and as much as 50% of the profits, although 20% of the profits is more typical. Some of these funds have produced excellent returns net of fee.

Major institutional investors began in the 1960s to move their money from low cost bank managers to higher fee banks such as Morgan Guaranty or to independent investment counsel firms, then to higher fee firms (many charging 1 %), finally to the hedge funds charging the highest fees. This was not likely to pay off for all or even most.

By the 1990’s, many funds had four or more active managers representing different investment “styles,” all charging high fees. Despite the style differences, there tended to be a common focus on middle capitalization companies (typically $1-10 billion). Whatever diversification (and thus risk reduction) was achieved by hiring multiple managers made it more, not less, difficult to overcome the high fees. In some cases, especially as time went on, the fund hired so many managers that collectively it began to resemble a high-cost version of an S&P 500 index fund. Some managers even tried to limit their career risk of losing the account by intentionally creating S&P 500 mimicking portfolios, which would never fall too far behind the benchmark. This became known as “closet indexing.” Vanguard’s Jack Bogle liked to point this out in marketing his real (and cheap) S&P 500 index fund.

Incentive Fees

As these issues became better understood, some active managers that had not become hedge funds began to promote an “incentive fee” to replace the standard percent of assets fee. The “incentive fee” would only be paid out if the firm hit an agreed upon investment target.

This sounds better than it is. In most cases, the fine print favors the manager who understands the contract better than the client and ultimately ends up making more money without much increasing the firm’s revenue risk.

One issue is that incentive fees must be calculated against an index, and it is extremely difficult to find a suitable benchmark. If the benchmark is capitalization weighted, as noted above, that will drive the manager toward momentum investing. If the index fund is a mid-cap index fund, what definition of a mid-cap stock will be used? Very importantly, over what period of time will the return be measured? And will there be “claw backs” if the manager has been paid and then returns go south? In general, what incentives are being created? Are they the right incentives? These issues are so difficult they usually cannot be resolved in a satisfactory way.

Our Conclusion: Keep Fees Simple

Our conclusion from both the math and the history of investing: Keep fees simple. Keep total costs down. Try to keep them below 1% a year. That provides investors with their best chance of earning excellent long-term returns.