Gotrocks

Warren Buffet just released his annual letter to shareholders which is available on the Berkshire Hathaway website. An excerpt from the letter follows which is interesting especially the last few lines.

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Meanwhile, Wall Street’s Pied Pipers of Performance will have encouraged the futile hopes of the
family. The hapless Gotrocks will be assured that they all can achieve above-average investment
performance – but only by paying ever-higher fees. Call this promise the adult version of Lake Woebegon.
In 2006, promises and fees hit new highs. A flood of money went from institutional investors to
the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby
2% of your principal is paid each year to the manager even if he accomplishes nothing – or, for that matter,
loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success
is due simply to a rising tide. For example, a manager who achieves a gross return of 10% in a year will
keep 3.6 percentage points – two points off the top plus 20% of the residual 8 points – leaving only 6.4
percentage points for his investors. On a $3 billion fund, this 6.4% net “performance” will deliver the
manager a cool $108 million. He will receive this bonanza even though an index fund might have returned
15% to investors in the same period and charged them only a token fee.

The inexorable math of this grotesque arrangement is certain to make the Gotrocks family poorer
over time than it would have been had it never heard of these “hyper-helpers.” Even so, the 2-and-20
action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to
someone with money, too often the fellow with money ends up with the experience, and the fellow with
experience ends up with the money.

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