Warren Buffett and fees

One of my favourite stories related to investment markets and investment fees comes from a story about a visitor to New York many decades ago. He looked at the waterfront impressed as he was shown the bankers’ yachts and the brokers’ yachts, before asking the awkward question (and title of Fred Schwed’s book first published in 1940) – "Where are the customers’ yachts?".

It adds an interesting dimension when thinking about the fees charged by the financial services industry.

Warren Buffett, in his role as investment sage, has always been prepared to talk frankly about the impact of fees on investments, referring more than once to the ‘helpers’ and ‘hyper-helpers’ that take fees that end up reducing the returns from investment portfolios. 

This year, in his 2019 annual letter, he again addressed the topic of fees, and helpers.

Buffett talked about his first investment in 1942, a $114.75 investment in shares. That sum of money is the equivalent of around $1850 today. He made reference to the fact that if that sum of money had been invested in a fund that replicated the S&P 500 – a hypothetical situation seeing as index funds became part of the investment landscape in the 1970s – that $114.75 investment would have grown to $606,811 dollars as at January 1, 2019.

Over this period of time, the return from the S&P 500 was 11.8 per cent per annum, not that far from long-run average returns from sharemarkets in Australia, and a reminder of how effective the sharemarket can be as a long-term source of wealth. 

His next calculation was to point out the impact of fees on returns over this period. 

If the portfolio had paid a 1 per cent fee, and therefore provided a return of 1 per cent per year less (10.8 per cent per annum), the portfolio would have grown to only $303,000.

While the letter did not do the calculation of a 2 per cent return (9.8 per cent per annum), the portfolio value drops from $606,811 to $153,000. 

There is a significant body of evidence that suggests fund managers have challenges outperforming their fees over long periods of time, so the Buffett assumption that higher fees lead to lower performance has support.

The Australian perspective

It is interesting to consider an Australian perspective on this. Take investing $10,000 in a fund that mirrored the Australian All Ordinaries Index from January 1, 1970 to the end of April 2019. This would have grown in value to $970,000. The average annual return over this period was 9.7 per cent per annum. 

Take 100 basis points off this return ( for example a 1 per cent fee) to replicate fees to ‘helpers’, and the portfolio value at the end of April falls to $616,000. 

Take 200 basis points off (which is a 2 per cent fee), and the ending portfolio value falls to $390,000. Buffett was kind enough to not include a calculation based on the 2 per cent fee in his letter, however, in Australia, there remain plenty of investments charging fees of 2 per cent or more.

Not only do fees matter in the sense that they directly impact the returns an investor receives, but they also change the risk-reward characteristic of an investment. 

Consider the period of time from 1970 until now. Shares halved in value over the first half of the 1970s, there was the 1987 sharemarket crash and another halving in the value of shares during the Global Financial Crisis. 

Add to that various recessions, currency crises and the Cold War, and it was a challenging time during which to hold your nerve and own a portfolio of shares. 

However, with a $10,000 starting investment (somewhere around two years of average earnings) turning into $970,000, or nearly 11-times current average earnings, the investor has been well rewarded for weathering the volatility. 

Pay a 2 per cent fee, however, and those rewards are significantly reduced while the volatility still remains.

What if fees were expressed differently?

A key element of the way that fees are expressed is that a percentage fee sounds very benign – 1 per cent, 2 per cent they are, after all, very small slices of the pie. 

The magic of the trickery, however, is that they are a small slice of a big pie – your investments. A 1 per cent fee on a $1,000,000 portfolio is $10,000. That is a significant sum of money, particularly as it will also be paid next year, and for the years after that. 

And yet, a fee expressed as a percentage of the assets of a portfolio, like 1 per cent per annum, doesn’t seem to demonstrate the importance that fees have in our investment experience.

A change in the way fees are expressed might be to consider fees as a percentage of expected earnings, rather than as a percentage of the whole portfolio. 

It can be argued that this is fair because when you invest the benefit you get are the investment earnings, so calculating the fee compared to expected earnings is a relevant approach.

Let’s consider an example.

Jeremy Siegel, Wharton Business School Professor, provides calculations that suggest the average sharemarket return should be around 7 per cent per annum after inflation, when the sharemarket is priced on an average price-earnings ratio of about 15.

Taking this 7 per cent per annum after inflation return, a 1 per cent fee could be more correctly shown to be 14 per cent of the expected after inflation return from investing in shares. 

A 2 per cent fee is 28 per cent of expected real returns. When fees are expressed as a percentage of future returns we can see their impact.

While a fee that is written as ‘14 per cent of expected real returns’ is significantly more confronting that just a 1 per cent per annum fee, the reality is that fees are a significant factor for us as investors, so honest information about the expected impact of fees on future returns is valuable.

Fees in investing matter. Warren Buffett reminds us of this. Calculations from the Australian sharemarket remind us of this. 

However, when fees are expressed as a percentage of the assets of the fund, we don’t seem to react to them as urgently as we should. A simple change, expressing fees as a percentage of expected returns, might help remind us that fees matter, and have a significant impact on our investment experience.