Hedge fund fees: a sucker’s game

From a friend at Barclays, this:

There was a very interesting article in the Telegraph which uses Buffett’s record to show just how unfair the typical “2 and 20” is to fund investors.

Buffett of course ran a partnership where he received no performance fees until exceeding a minimum threshold. If he didn’t perform, he didn’t get paid. The “2 and 20” of today ensures that the hedge fund manager always gets paid and paid extremely well if he/she performs.

Here is the article, the impact on amount of wealth compounded is staggering:

“If you think the row about fund management charges is a tedious technicality then prepare for a rude awakening.Terry Smith is the latest outspoken multi-millionaire to lob a hand grenade into this debate which will shake the City to its foundations and could bring several institutions crashing down.

He claims investors are left with less than a tenth of the total returns some fund managers receive – and usesWarren Buffett’s famous Berkshire Hathaway fund to illustrate the impact charges can have on long-term returns. Mr Smith says he is “not so much shocked as flabbergasted by the number of people who do not realise the impact of these performance fee structures”.

Taking typical hedge fund fees as an example – but widening his attack to performance fees charged by rising numbers of unit trusts and open-ended investment companies (OEICs) – Mr Smith said: “”As you are aware,Warren Buffett has produced a stellar investment performance over the past 45 years, compounding returns at 20.46 per cent per annum. If you had invested $1,000 in the shares of Berkshire Hathaway when Buffett began running it in 1965, by the end of 2009 your investment would have been worth $4.8m.

“However, if instead of running Berkshire Hathaway as a company in which he co-invests with you, Buffett had set it up as a hedge fund and charged 2 per cent of the value of the funds as an annual fee plus 20 per cent of any gains, of that $4.8m, $4.4m would belong to him as manager and only $400,000 would belong to you, the investor. And this is the result you would get if your hedge fund manager had equalled Warren Buffett’s performance. Believe me, he or she won’t.

“Two and twenty does not work. That does not mean that 1.5 per cent and 15 per cent is OK, or even 1 per cent and 10 per cent. Performance fees do not work. They extract too much of the return and encourage risky behaviour.”

7 Comments

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7 responses to “Hedge fund fees: a sucker’s game

  1. Cos Cobber

    what about realtor commissions? I kid, they are worth every penny….ha!

  2. Anonymous

    No one is forced to sign up for any fees or to outsource one’s investing decisions
    DIY investing w/cheap index funds and ETFs is always an option for any semi-literate, common-sensical adult
    Besides, far cheaper to trade/invest online than in era of “full-service” brokerage commissions of pre-Net era or using some actively managed mutual fund which likely will destroy one’s capital (vs S&P 500/Treasuries index investing)

  3. out looking in

    Oh- how wonderful is hindsight bias. let’s say you are john Q average investor, and instead of choosing Berkshire, you bought shares in down the tubes inc…o% and 0% would not help your ass out. But to take $1k and turn it into $400k, or $1mm with lower fees, is somehow theft? I would say that Warren worked for peanuts…and most investors that entered the markets in 1997-98 in the US or 87-88 in Japan are shit out of luck, with or without fees….

  4. anon

    yeah, let’s do the math on realtor commissions… If I put down $200k and bought a house for $1mm and sold it for $1.5mm a few years later (assuming prices of Greenwich real estate never go down – the old normal), that would be a $500,00 profit on my $200K. But if I paid a realtor 5%, or $75K in commish, my profit would only be $425K… So 15% of my profit goes to the realtor in this case. Almost the same as a hedge fund manager, except a realtor doesn’t need to work a whole year to make his vig – only a couple of weeks since most houses sell in bidding wars (again, I’m assuming the old days of Greenwich real estate).

    Now let’s assume I bought the house in 2007 and I can only sell it for $800K. I owe the realtor $40K in commish, in addition to the $200K down payment that I lost. So the realtor makes a nice pay day for himself even if I lose. That’s a better deal than the hedge fund manager since the hedgie only gets paid above his high water mark.

    Maybe somebody should write an article about how evil realtors are instead of vilifying Wall Street “Fat Cats” which Obama made popular.

    On a different note, this guys doesn’t seem to like Obama too much: http://gawker.com/5654757/vanity-license-plates-political-discourse-intersect-at-lowest-point-for-each

  5. out looking in

    yeah anon- and surgeons! If you die on the OR table, you still have to pay the friggin bill! Now that really takes the cake!!!

  6. Sanjay Bigglesworth

    But a real estate agent won’t collect $400 million in fees and lose all of your money the next year and tell you with a shrug, “Sorry ’bout that. But you can invest in our next fund if you want.”

    This falls under the title, “But where are the client’s yachts?”

  7. Hey

    It’s not a fair comparison, since you’re looking at Buffet’s performance after fees and then a hedgie’s before.

    Buffet isn’t running Berk for free. He gets paid a (minimal) salary and owns shares. Berk also pays for all sorts of management salaries, rent, etc. It’s just baked into the firm’s expenses/ownership structure.

    2 and 20 is done because of the partnership structure, a product of the tax system. Pension funds, foundations, etc are non-taxable so they prefer getting the full income stream from a partnership instead of getting a dividend which has been taxed at the corporate level. An individual investing for his own cash account (no one can put their SAC holding in their 401(k)) generally doesn’t care, since they’re paying tax either way (this obviously gets very complicated in the specific case and you can play it 19 ways to Sunday, whatever).

    Hedgies have their compensation in headlines while the founder/CEO has it baked into the footnotes (as with any options). You pay for high quality management either way – just as you pay for shitty management by seeing your investment go down in flames.