Berkshire Hathaway 2017 Annual Meeting Audience Question # 29

Financial advisers as a group don’t deserve the fee they are charging

Warren Buffett:

OK, Carol?

Carol Loomis:

This question comes from Steve Haverstroll of Connecticut.

“Warren, you have made it very clear in your annual letter that you think the hedge fund compensation scheme of ‘2 and 20’ generally does not work well for the fund’s investors.”

“And in the past, you have questioned whether investors should pay, quote, ‘financial helpers,’ unquote, as much as they can. But financial helpers can create tremendous value for those they help.”

“Take Charlie Munger, for instance. In nearly every annual letter and on the movie this morning, you describe how valuable Charlie’s advice and counsel has been to you and, in turn, to the incredible rise in Berkshire’s value over time.”

“Given that, would you be willing to pay the industry standard, quote ‘financial helper’ fee of one percent on assets to Charlie? Or would you perhaps even consider ‘2 and 20’ for him? What is your judgment about this matter?”

Warren Buffett:

Yeah.

Well, I’ve said in the annual report that I’ve known maybe a dozen people in my life… and I said there are undoubtedly hundreds or maybe thousands out there.

But I’ve said that I’ve known, personally, a dozen where I would have predicted or did predict
…in a fair number of those 12 cases… I did predict that the person involved would do better than average in investing over a long period of time.

And obviously, Charlie is one of those people. So would I pay him? Sure. But would I take financial advisors as a group and pay them one percent with the idea that they would deliver results to me that were better than the S&P 500 by one percent, and thereby leave me breaking even against what I could have done on my own? You know, there’s very few.

So it’s just not a good question to ask whether, you know, I’d pay Charlie one percent. That’s like asking, you know, whether I’d have paid Babe Ruth, you know, 100,000 or whatever it was to come over from the Red Sox to the Yankees. I mean, sure I would have, but there weren’t very many people I would have paid 100,000 to in 1919, or whatever it was, to come over to the Yankees.

And so, the… it’s a fascinating situation, because the problem isn’t that the advisors are going to do so terrible. It’s just that you have an option available that doesn’t cost you anything that is going to do better than they are, in aggregate.

And it… it’s an interesting question. I mean, if you hire an obstetrician, assuming you need one, they’re going to do a better job of delivering the baby than, you know, if the spouse comes in to do it, or if they just pick somebody up off the street.

And if you go to a dentist, if you hire a plumber, in all of the professions, there is value added by the professionals as a group, compared to doing it yourself or just randomly picking laymen.
In the investment world, it isn’t true. I mean, they, the active group, the people that are professionals, in aggregate, are not, cannot do better than the aggregate of the people who just sit tight.

And if you say, “Well, in the active group there’s some person that’s terrific,” I will agree with you. But the passive people can’t all pick that person. And they wouldn’t… they don’t know how to identify them. So I…

Charlie Munger:

It’s even worse than that. The (the sound in this part of the video is inaudible)… the expert who’s really good, when he gets more and more money in, he suffers just terrible performance problems.

Warren Buffett:

Yeah. Yeah.

Charlie Munger:

And so you’ll find the person who has a long career at “2 and 20,” and if you analyze it, net, all the people who’ve lost money because some of the early people have had a good record but more money coming in later and they lose it.

So, the investing world is just, it’s a morass of wrong incentives, crazy reporting, and I’d say a fair amount of delusion.

Warren Buffett:

Yeah, if you asked me whether I… those 12 people I picked would do better than the S&P working with a hundred billion dollars, I would answer that probably none of them would. I mean, they… that would not be their prospective performance.

They’re not, but when I was talking of them, I… you know, or referencing them… and when they actually worked in practice, they dealt, generally, with pretty moderate sums. And as the sums grew, their relative advantage diminished.

It… I mean, it’s so obvious from history. The example I used in the report… I mean, the guy who made the bet with me, and incidentally all kinds of people didn’t make the bet with me because they knew better than to make the bet with me.

You know, there were hundreds, at least a couple hundred underlying hedge funds. These guys were incented to do well. The fund of fund manager was incented to pick the best ones he could pick. The guy who made the bet with me was incented to pick the best fund of funds.

You know, and tons of money, and just in with those five funds, a lot of money went to pay managers for what was subnormal performance over a long period of time. And it can’t be anything but that.

And it’s an interesting… you know, it’s an interesting profession when you have tens of thousands, or hundreds of thousands of people, who are compensated based on selling something that, in aggregate, can’t be true: superior performance. So…

But it’ll continue, and the best salespeople will tend to attract the most money. And because it’s such a big game, people will make huge sums of money, you know, far beyond what they’re going to make in medicine or you name it. I mean, you know, repairing the country’s infrastructure, I think.

I mean, the big money… huge money… is in selling people the idea that you can do something magical for them.

And if you have… if you even have a billion-dollar fund, you know, and get two percent of it… for terrible performance, you make… that’s $20 million.

In any other field, you know, it would just blow your mind. But people get so used to it, you know, in the Wall… in the field of investment that it just sort of passes along. And $10 billion, I mean, $200 million fees?

We’ve got two guys in the office, you know, that are managing $11 billion. Well, no they’re not.

I’m sorry. Yeah, they’re managing 20 billion, you know, between the two of them, 21 billion maybe.

And, you know, we pay them a million dollars a year, plus the amount by which they beat the S&P. They have to actually do something to get contingent compensation, which is much more reasonable than the 20 percent.

But how many hedge fund managers in the last 40 years have said, “I only want to get paid if I do something for you?” You know, “Unless I actually deliver something beyond what you can get yourself, you know, I don’t want to get paid.” It just doesn’t happen.

And, you know, it get back… it’s get back… it gets back to that line that I’ve used, but when I asked a guy, you know, “How can you, in good conscience, charge ‘2 and 20?’” And he said,

“Because I can’t get 3 and 30.” You know…

Any more, Charlie? Or have we used up our…

Charlie Munger:

I think you’ve beaten up on them enough.

Warren Buffett:

Yeah, well.

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