Monday, October 04, 2010

Equity Mutual Funds: Invest And Lose

Highlighted by BB, an editorial on UK Telegraph blog: Warren Buffett 'fund' illustrates rip off management charges

That article link of course is interesting. For example take the following 2 paragraphs.

  • .. 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.

Yes.. in a more simplified manner.

An investment in Berkshire without fees.

  • A $1000 investment would turn into $4.8 million after 45 years. ( Annualised return of 20.73%)

An investment in Berkshire with fees ( assume simple 2 and 20 fees is charged.)

  • A $1000 investment would turn into $400,000 after 45 years! ( Annualised return of 14.24%)

And needless to say, it's so glaring! If fees were charged, the fund investor would have lost a whopping $4.4 million to fees!

The calculations is simple.

Berkshire Hathaway grew at a compounded rate of 20.73%.

Say I invested in 1965 an investment of $1000 into Berkshire. By end of the first year my investment would have grown into $1207.30. (1000 x 20.73%)

The fund charges 20% for any gains. This means the investor gets to keep only 80% of the return. So 80% of the gain of $207.30 = $165.84. (0.8 x 207.3)

Now 2% annual fee is charged based on the value of the fund.

The value of the fund less the initial 20% charged for any gain = $1000 + $165.84 = $1165.84. Less 2% = $1142.52.

Which means the fund 'ate' 1207.3 - 1142.52 = $64.78 of your profit or a return of 14.52%.

So a 20.73% return would turn into a return of just 14.52% only.

And if you compound it 45 years, an investment of 1000 would turn into 446.334 after 45 years!

Yeah.. the 4.4 million... it went into the fund management heaven! LOL!

The article then continues..

  • “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.”

Let's see the impact of a 1% and 10% fee charges based on Berkshire example.

A $1000 investment would have turned into 1207.30 in the very first year.

10% is charged on the gains. So the investor gets to keep 90% of the gain or 0.9 x 207.3 = 186.57.

And so the value of the fund after the first year = 1186,57.

1% annual fee based on the value of the fund = 0.99 x 1186.57 = 1174.70.

Which means a return of 17.47%.

Compound that 45 years, would see the value of the fund becomes 1.4 million.

Remember, without fees, the fund would have returned 4.8 million. Which means the fund 'ate' 4.8-1.4 = $3.4 million!

Yes! I fully agree that "Performance fees do not work. They extract too much of the return and encourage risky behaviour.”


Interested in investing in a equity fund? I suggest you to read the load charges and understand the implications of the charges and fees imposed by the fund management.


bullbear said...

Why Investment Risk Increases Over Time

A small percentage difference over many years transform into a big figure.

Big Sea said...

A very interesting article.

Not quite agree on the statement "of the 4.8M, 4.4M belongs to fund manager". Rather, of the 4.8M, 4.4M will not materialized.

As for the " encourage risky behaviour", this is something that we need to pay more attention.

Really looks like a rip off for investors !

lmenwe said...

No wonder none of the mutual fund investor get rich! Almost all the return was ate by fund manager. Almost all of my family member keep on pressuring me to let fund manager invest for me! Sigh!