article about a 1965 investment in Berkshire's worth now with a 2 and 20 fee

[Guest hpmst3]

e

[biaggio]

wow, the power of compound interest, I normally would take 14% over the next 50 years, but I would have never guessed there would be such a discrepency with the 2 + 20 overhead. Over the long run, it would seem that the managers are making more money without putting up any capital. Does not seem right.

[Uccmal]

If you went through it year by year using book value then you would may find that the 2 and 20% would eat even greater into the outcome. 

 

My rationale for this is that the 2 and 20% take a greater haul on your good years.  Then there is the actual down years where you still pay 2% of AUM, but your losses are not 20% repaid.  Then there is trading taxes which Buffett has shielded Berkshire holders from. 

 

Does this make sense mathematically or am I out to lunch?

 

Any mathematicians out there.  We need is Marilyn Vos Savant when we need her?

[jjsto]

Well, I think the most important concept here is noting the huge difference a few percentage points just above or below 20% compounded annually will make over a 40+ year time frame.  For example, $1,000 @ 22.5% in 45 years becomes $9,249,622 while $1,000 @ 17.5% is only $1,418,090.  (The difference between 22.5% and 17.5% is just a little more than the 20% fee.)  So, for those of us who are young and therefore have a 40+ year investment horizon each basis point in the average annualized rate is extremely important.  It makes little sense to invest over long periods of time with a hedge fund and pay those types of fees. 

[netnet]

It makes little sense to invest over long periods of time with a hedge fund and pay those types of fees. 

Unless, it's your own hedge fund ;)

 

If you went through it year by year using book value then you would may find that the 2 and 20% would eat even greater into the outcome.

 

My rationale for this is that the 2 and 20% take a greater haul on your good years.  Then there is the actual down years where you still pay 2% of AUM, but your losses are not 20% repaid.  Then there is trading taxes which Buffett has shielded Berkshire holders from.

 

Does this make sense mathematically or am I out to lunch?

It depends whether the book value or the stock price is more volatile--and whether there are any so called high water provisions along with the 2 and 20.  On a straight 2 and 20 with no high water, the investors get creamed.

[scorpioncapital]

This assumes the hedge fund fee is paid yearly. However, how would a fund , mimicing Berkshire, pay 20% of unrealized gains in any given year? Buffet partnership paid the fee in the form of share dilution by increasing Buffett's ownership interest, by not taking it out in cash he actually created a better return, even though the fee was the same.

[Uccmal]

Hi netnet,  I was thinking that using Berkshires annual book value growth, or stock price, for that matter will make a difference versus using the average bv or stock price.  The volatility will actually work against you with the 2 and 20 system when it is calculated annually versus using the average growth number of 21%.

 

To verify this I would need to plug in brks book value and set up a year end 2 and 20 spreadsheet and do a side by side analysis. 

 

A.

 

A more interesting comparison might be the average hedge fund results, versus the average mutual fund results over a 15 year period, versus the S&P 500.

 

 

[Crip1]

A few facts to add to the discussion:

 

* The compounding effect is magnified dramatically over a longer time period.

* The good "analyst" can basically make the math work to support their position.

 

To illustrate the first point, let's be honest, the average investor does not leave their monies with the same money manager for 45 years, not even close. Let's look at the cumulative returns on $1,000 with more realistic timeframes:

 

Quantity - Years                Berkshire          Berkshire less 2%/20%  

45                                   $4,804,896          $401,723

25                                   $  111,015           $ 27,996

20                                   $    43,282           $ 14,365

15                                   $    16,874           $  7,379

10                                   $      6,579           $  3,790

5                                     $      2,565          $  1,947

 

Over more realistic time periods, it is clear that the 2/20 methodology robs far less of the return than 45 years. The author fully was aware of this, but used the 45 years and the good name of Warren Buffett to make his point. Now, for what it’s worth, I happen to agree with the author that the 2/20 methodology is more beneficial to the money manager than the investor, but his example was designed to attract eyeballs AND make his point, not illustrate realistic situations.

 

To further illustrate the effect of 45 years and how a good analyst can make numbers support their position, Buffett’s 25% above the 6% bogey (25/6) methodology is looked at by many board members, myself included, as fair and equitable for all. Let’s see how this analysis plays out over similar timeframes:

 

Quantity - Years                Berkshire          Berkshire less 25/6  

45                                   $4,804,896          $1,192,055

25                                   $  111,015           $   51,174

20                                   $    43,282           $   23,294

15                                   $    16,874           $   10,603

10                                   $      6,579           $    4,826

5                                     $      2,565          $    2,197

 

Over 45 years, Buffett would have “robbed’ his investors of 75% of their return in what is arguably an equitable arrangement. This is certainly more advantageous for the investor (and less so for the manager) then the 2/20, but it is clear that using the 45 year time frame, the returns are skewed to the money manager at the expense of the investor. Unquestionably, this demonstrates clearly why many very bright people look to money management as a vocation opposed to being a doctor, engineer, teacher, etc.

 

The most important point is the behavior that these compensation plans drive. Driven by annual return, these compensation plans drive risky behavior on part of the money manager, effectively a “heads I win, tails I don’t lose much” situation (except that continual losses will cause clients to flee). The key is that the investor needs to be VERY AWARE of the money manager’s mentality and character. Will the money manager inappropriately risk the client’s principal in order to attain superior returns/compensation? That is difficult to assess, but is key for investors.

 

-Crip

 

P. S. The bonus plan for Senior Management of Markel is about as good as any I’ve seen as it is based on a rolling 5 year CAGR of book value.

 

 

 

 

[Partner24]

Crip, excellent post. I have nothing to add.

 

Cheers!

[stephentaub]

Great  info.....

 

Regards

 

Stephen Taub,canada

[twacowfca]

b

I think that you would not need each year's stock price, because it goes up by 20.73% annually.

 

So $1,000 multiplied by 20.73% = $207.30     :that is the return for the year

 

.20 x $207.30 = $41.46                                 :that is the 20% fee on the return

 

$207.30 - $41.46 = $165.84                           :that is the return less the 20% fee

 

$1,000 + $165.84 = $1,165.84                        :that is the total assets before the 2% of assets fee

 

$1,165.84 x .02 = $23.31                               :that is the 2% of assets fee

 

$1,165.84 - 23.31 = $1,142.53                        :that is what is left after the 2 and 20 fee in year 1

 

$1,000 present value, after one year you have future value of $1,142.53 leaving you with a return of 14.25% for the first year. (142.53/1,000= 14.25%).  That leaves you with a future value in 45 years of $401,355.66

 

I used a present value calculator for the last calculation.  PV= $1,000, 45 years, 14.25% interest per year, = future value of $401,355.66

 

I think that this is right.

 

Hugh

 

 

 

 

 

Hugh, I very much appreciate your posts.  I knew that the effect of a compounding incentive fee structure would tend to increase a fund manager's earnings and assets relative to the funds he managed, but I didn't realize quite how dramatic the difference could be.

 

I do think it matters whether or not the annual returns are even or lumpy in relation to how much the fund manager may gobble up his clients' potential asset growth over the years as a result of the incentive.  Let's consider the case when there is only an incentive fee of say 20% for outperformance, however defined, disregarding any management fee.

 

Let's look at an extreme situation, as lumpy as possible, when the performance fee was earned only in the first year of the contract by outperforming by 4,800 times, equal to Buffett's performance managing BRK over 45 years.  Then assume that the fund manager merely equaled the hurdle rate in the remaining 44 years of the contract.  In this case, a fund manager would take home only 20% of the assets under management, less the client's relatively small original investment .