Warren Buffett released his annual letter to Berkshire Hathaway’s (NYSE: BRK.A) shareholders. As a shareholder and avid investor, his letters are my one must-read source of investing wisdom each year. If I could read only one piece each year on investing, it would be Buffett’s annual letter. When he's no longer writing them, I'll re-read them from past years.
This year he took to task investment fees. He foreshadowed his view on fees early in his letter. When the market suffers major declines, he said we should not forget two things: “First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well.” (italics are Mr. Buffett’s; the bold is mine.)
Beginning on page 21 of the letter, Mr. Buffett turns to “The Bet.” Here are the details of the wager:
I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?
At first, there were no takers. Then Ted Seides, co-manager of Protégé Partners, stepped up to the plate. The bet concludes at the end of this year. Through 2016, the S&P 500 has enjoyed a compound annual increase of 7.1% to the collective hedge funds’ 2.2%.
As Buffett describes in his letter, the key problem facing hedge funds is fees. Buffett estimates that over the nine-year period thus far in the bet, a full 60% of all gains achieved by the hedge funds have gone to managers in the form of fees. He then summarizes the effect fees have on investment results:
So that was my argument – and now let me put it into a simple equation. If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe, and B is destined to achieve average results before costs, so, too, must A. Whichever group has the lower costs will win. (The academic in me requires me to mention that there is a very minor point – not worth detailing – that slightly modifies this formulation.) And if Group A has exorbitant costs, its shortfall will be substantial.
Like the prophet crying in the wilderness, Buffett’s wisdom is lost on many. Investors, particularly the well-heeled, are attracted to exotic investments, high-priced advisors, complex insurance products, and other chimeras. Why?
Here we come to the most fascinating section in Buffett’s letter. He first notes that his friends with modest means usually follow his advice. They invest in low-cost index funds like those offered by Vanguard. It’s the “mega-rich, institutions or pension funds” that have lost their way. For some reason, they believe their wealth warrants something special. And it’s here that we see the problem with most fee-only investment advisors.
While there are some that recommend low-fee index funds, many advisors charging AUM fees recommend complex portfolios comprised of expensive, actively managed mutual funds. Why is that? Buffett has the answer—“Can you imagine an investment consultant telling clients, year after year, to keep adding to an index fund replicating the S&P 500? That would be career suicide. Large fees flow to these hyper-helpers, however, if they recommend small managerial shifts every year or so.That advice is often delivered in esoteric gibberish that explains why fashionable investment “styles” or current economic trends make the shift appropriate.”
Amen.
The simple fact is that even a one percent advisor fee ties an anchor to an investment portfolio's returns. To see this in your own portfolio, check out this fee analyzer. What's worse is that, like a wolf in sheep's clothing, it appears harmless. One percent is less than many cash back credit card rewards. How deleterious can it be?
Yet over a lifetime of investing it can easily cost hundreds of thousands of dollars. The compounding effect of that small one percent fee shreds a portfolio's value. Like cancer, it starts small and undetected. Left untreated, however, it ravages the body.
Investment advisors don't like to hear this. I've received plenty of correspondence from fee-only advisors complaining that I'm not telling the whole story. A common refrain is that in addition to asset management, they also provide financial planning. Fair enough. So charge by the hour for financial planning. Why in the world would anybody pay one percent of their wealth each and every year for a few hours of financial planning?
If you don't believe me, re-read Mr. Buffett's letter.
