High Fees

So, I was taking to a friend who has a million dollars in a large cap stock fund. The fund happens to be the Fidelity Magellan fund. The fund is very famous for being the ship that Peter Lynch navigated. But years later, it's just another generic, closet-index/large cap fund.  I don't follow mutual funds too closely, but my initial thought was that there is basically no chance of Magellan outperforming the S&P 500 index over time.

And, of course, the expense was almost 1%.  That is kind of shocking.

When you read gambling and trading books, they always tell you not to think of money as real money. When you are betting in poker and you see the $70,000 of cash in the pot as a BMW,  you will make really bad decisions and will play poorly. If you see the loss on your portfolio as two years of your kid's college education, you will freak out and make irrational moves. (Actually, if you really need that cash for your kid's education in the near future, then maybe you should freak out, and maybe you shouldn't have that cash in risk assets!)

But let's do the opposite now.  I said to the friend, gee, well, do you have a reason to believe that the Magellan fund will outperform the S&P 500 index over time? Not really. OK, then why are you basically writing a check for $10,000 per year? That's almost $1,000/month.  That's a lot of money for a retired person. Why would you write a $1,000 check every single month for nothing?

In ten years, that's $100,000 gone. Poof.  For absolutely no reason at all. That's more than most people have in their IRA's.

It's hard to notice these things as they are just deducted from the account so you don't actually write a check every month. If you did, you would probably think about it a lot harder.

1% Too High?
Mutual fund fees are too high for most funds. There are some funds that may be worth the fee, especially some of the value funds with long term track records.

But with expected equity returns of around 5-6% going forward, we have to wonder about 1% fees. It's one thing charging 1% fees in a 10% equity return world, but it's a whole different world now. Maybe fees should be restructured so that the fee is minimized to cover overhead and bulk of fee comes from outperforming a benchmark index.  I don't know. I actually don't own any funds so it's not really an issue for me, but something interesting to think about.

Speaking of high fees and having watched the Berkshire Annual Meeting video, it reminded me of a fund with really high fees.

Wintergreen
Some people believe that there is no bad publicity, but in this case, maybe it was bad publicity. David Winters of the Wintergreen Fund criticized Coke for their egregious stock compensation plan and even criticized Warren Buffett for not speaking out against the plan and even went so far as to sell Berkshire Hathaway stock in a huff saying that Warren Buffett no longer looks out for his shareholders.

This was kind of shocking for a few reasons.  First of all, when Winters talked about the massive wealth transfer, his number was totally off. I talked about it here, and Buffett said the numbers were also way off. So it means either that Winters is not a very good analyst, or is simply dishonest and threw out a huge number deliberately to get attention. I don't know which is worse, but either way is not very encouraging for his shareholders (take your pick: incompetence or dishonesty). He also sold off Berkshire Hathaway because of this. This seemed to me he was taking all of this personally and getting too emotionally involved. I don't know. But that's what it seemed like.

This lead Buffett to mention at an annual meeting that Winters charges very high fees for bad performance. Ouch. A lot of people love to go on CNBC because it's free advertising. But sometimes it backfires, particularly when you criticize a giant with no track record to back it up (and charge fees much higher than anyone else!).

First of all, this all happened in 2014. Winters sold his BRK in the 1Q of 2014. His fund is in red, BRK is blue and the S&P 500 index is the green line.

The Wintergreen Fund had assets of $1.6 billion in Dec 2007, but still had more than $1.2 billion as recently as the end of 2013. But as of the end of 2016, AUM was down to $300 million.  There is some AUM in the institutional class too but that is down a lot too.

Here is the performance of the fund:

That's a pretty huge underperformance no matter how you slice it.

OK, that's not so uncommon these days with active managers underperforming.

But here's the shocker. Look at the fees charged on this fund:

That's 2%! First of all, the fund underperforms in all long term time periods. In a 5-6% return equity world, the fund is basically charging 33%-40% of expected return!  But that's assuming the fund keeps up with the index, which historically hasn't been the case. If the fund lagged 1%/year on a gross basis that comes to more like 40-50% of expected returns going to the manager. That's truly insane.

And looking at this on a real cash basis, if you had $1 million in this fund, you would be writing a check for almost $20,000 per year! That's some real money.  Over 10 years, that's $200,000!?  You had better be sure someone will outperform the index if you are going to be writing checks that big every year.

One may argue that the benchmark is wrong; Wintergreen owns non-U.S. stocks. Actually, as an investor, that shouldn't matter. The fund doesn't have an explicit mandate that they must invest internationally or anything like that. If they invest in non-U.S. stocks, it has to be because they think non-U.S. stocks are more attractive; that they will outperform U.S. stocks. Or else why bother, right? So in that sense, benchmarking against a completely neutral S&P 500 is fine.

It's kind of crazy what people get away with.

I know people will immediately respond by saying, yeah, but you like all those alternative managers with even higher fees!  Well, most alternative guys charge too much too, but the ones I tend to like do have really good long term records.

Mutual Funds Sticky
Here's the thing about mutual funds versus alternative funds. I think a lot of mutual fund assets are really sticky due to the indifference of many investors. They just leave it and don't think about it, which is the correct approach to investing, generally. But the downside is that many don't realize how much is being sucked out of their net worth from these fees for no return.

Hedge funds, private equity funds, on the other hand, have investors who are more active in tracking performance etc. If you perform poorly, you will lose assets more quickly and go out of business as many hedge funds have seen in the last few years. Mutual funds can last forever on dreadful performance.

KO
And speaking of KO, it was also in 2014, I think, that Kent (KO CEO back then) started talking about zero-based budgeting. I was skeptical about this at the time; a lot of CEO's would just grab the latest buzzword and throw it in their presentations just to show how hip they are to the current state of the world (Now it seems to be AI, machine learning, big data etc... Well, that's all over Dimon's letter too, but financials have been big into these areas for a while...).

Anyway, KO is too big for most to make a run at it so there is no real sense of urgency there so you know nothing is going to happen, not to mention the arrogance there from a century of dominance. I have made the case that for anything to change at KO, it's going to have to come from the outside. Internal people will not be able to make big changes; they can't pull off the band-aid as it would hurt too many 'friends'.

Look at margin trends since they claimed they started using zero-based budgeting:

Analysis of Consolidated Statements of Income

													Percent Change
Year Ended December 31,	2016				2015				2014				2016 vs. 2015			2015 vs. 2014
(In millions except percentages and per share data)
NET OPERATING REVENUES	$	41,863			$	44,294			$	45,998			(5	)%		(4	)%
Cost of goods sold	16,465				17,482				17,889				(6	)		(2	)
GROSS PROFIT	25,398				26,812				28,109				(5	)		(5	)
GROSS PROFIT MARGIN	60.7		%		60.5		%		61.1		%
Selling, general and administrative expenses	15,262				16,427				17,218				(7	)		(5	)
Other operating charges	1,510				1,657				1,183				(9	)		40
OPERATING INCOME	8,626				8,728				9,708				(1	)		(10	)
OPERATING MARGIN	20.6		%		19.7		%		21.1		%

Operating margins are actually down from 2014.  So much for zero-based budgeting!

Munger indicated that a $150 billion deal would be huge for Berkshire Hathaway, so it is unlikely that BRK could make a run for KO on it's own. But in some sort of combination with BUD, KHC or some other 3G entity, who knows what will happen.


Berkshire Hathaway Annual Meeting Last Question
By the way, the last question on the Yahoo video was about CEO's social responsibility; should companies move jobs overseas to increase profits at the expense of local communities, domestic jobs etc.?

This was really a good question and I think about that sort of thing all the time. Do we always have to be the most efficient and lowest cost at all times? Do we really need to be increasing productivity all the time? Why can't we come to some stable status quo and not keep trying to grow or increase profits all the time?

And I always seem to go back to Japan. Japan is a country where companies usually do act responsibly and really doesn't want to fire people. And Japan is in terrible shape, I think, large due to that. Long time Canon CEO, Fujio Mitarai, explained that Japan can't compete well in many industries because they operate under the system of corporate socialism. The Japanese government won't provide unemployment and other social safety nets; Japanese corporations are expected to take care of redundant workers (by not firing them) etc.

You can protect people for a while like that, but at some point, the burden gets too big and the corporation will collapse.

Panasonic was one of those intensely socially responsible companies; Konnosuke Matsushita, the founder, strongly believed that it was the responsibility of the company to take care of their employees. He never wanted to fire anyone. It's a great concept and noble, but I don't believe it works.

McIlhenny Company (Tabasco sauce) was like that early on; they had an island they wanted to be self-sustaining. They wanted their employees to live there, they built schools, stores etc. But over time it just doesn't work. I think Henry Ford, Hershey and others tried similar things too when it was believed that if they created a company town with everything necessary for employees to raise a family and live comfortably, they can create a sort of self-sustaining utopia.

It just doesn't work. It also reminds me of the pre-Thatcher Britain; it didn't work at the national level either.

And besides, more of a threat to the domestic work force than globalization is technology. I haven't done much research in the area, but technology is probably more responsible for job losses than globalization (moving production to low wage countries).

And do we really want to limit or stop technology? Japan will make large advances in that area due to their shrinking population. They need nurses and other workers to take care of the increasingly aging (and dwindling) population.

If the U.S. slows technological progress for the sake of maintaining low unemployment, then the Japanese will ultimately rule the future and we will have a large, unemployed (and unemployable) population.

Related to all this, just by chance, I happen to be reading the new Kasparov book. I'm not done with it yet, but it is really fascinating. True, he's a former chess world champion so what does he really know? He is a voracious reader and runs around meeting and talking to interesting people all over the world so he has interesting insights into many things.

He points out that every time we have technological advancement, people fear this or that.  For example, the elevator operators union had 17,000+ members in 1920. The technology existed in 1900 but wasn't widely used (automatic elevators) until 1930 due to people's fear of riding operator-less elevators (similar to fear of driverless cars today; but people's fear is not what is holding back driverless cars today...).

Anyway, I am not a believer in holding anything back for the sake of maintaining employment; it will only delay the day of reckoning, and at that point the negative impact might be much worse.

Since technology is advancing so quickly, retraining won't be able to keep up, so something like a universal basic income is probably the only way to go at some point. I know I sound like a communist when I say that, but I can't think of any other way.

Anyway, this veers far away from the topic of this blog, so let's get back on topic.

Conclusion
If you are one of those people who have a bunch of mutual funds in your IRA/401K or whatever, I would actually go in and do the work to calculate how much you are actually paying in real dollars. Is it really worth it? Same with financial advisors. When fees are just deducted from your account, you may not realize how much you are paying. Calculate what your are paying. Is it really worth it?

Let's say you have $5 million and most of it is in tax-free money market funds and the S&P 500 index funds. With a 2% fee, that's $100,000 per year! Why would anyone pay that? Is it really worth it? Can your advisor really pick stocks and funds better than some simple passive portfolio?

I don't know. When you look at it in real dollars like that, it is really insane.