Skimming

Michael Lewis at Portfolio.com:

As a group, professional money managers control more than 90 percent of the U.S. stock market. By definition, the money they invest yields returns equal to those of the market as a whole, minus whatever fees investors pay them for their services. This simple math, you might think, would lead investors to pay professional money managers less and less. Instead, they pay them more and more. Twenty-five years ago, the most successful among them took home a few million dollars a year; in 2006, more than 100 money managers made more than $100 million, and a handful made more than $1 billion. A vast industry of stockbrokers, financial planners, and investment advisers skims a fortune for themselves off the top in exchange for passing their clients’ money on to people who, as a group, cannot possibly outperform the market.

(via Yglesias)

Reminds me of a book I read and wrote about a while back: Battle for the Soul of Capitalism, by John Bogle…

Battle for the Soul of Capitalism

First thought: would it have been possible to come up with a more grandiose title? It sound like something Ayn Rand would have written after a religious conversion. Fortunately, the book is much better than the title. Bogle is the septuagenarian founder of the low-fee Vanguard funds and thinks that the vast majority of owners (of both mutual funds and stocks) have been ripped-off by outrageous fees and compensation paid to managers and executives. This constitutes a “battle for the soul of capitalism” because it distorts markets, creates a society of “have and have-nots”, and diverts the gains of investment from owners, the people who put up the money and take the risks, to the managers, the people who should be defending the owners’ interests.

He thinks this has happened because these days most companies are not managed by the same people that own them. Unlike the owner-manager model of capitalism set forth by Adam Smith in Economics 101 companies today are owned by a large, diffuse group of people who have delegated management to professional managers. Noting that the owners aren’t paying much attention those managers have exploited the owner’s inattention

Mutual Funds: “Imagine the efficiencies that must have been gained from computerization of this industry over the last fifty years…yet none of those costs saving have ever been passed on to shareholders.”

to essentially steal from the company. They pay themselves outrageous fees and compensation. Bogle suggests that owner’s need to “keep an eye on these geniuses”. Not a bad suggestion.

One area of rip-off is the mutual fund industry. Despite the remarkable growth of equities under management by mutual funds in the last fifty years—$4 trillion now vs. $2.5 billion back in 1950—management fees have increased even faster—0.92% of assets now, vs. 0.60% back then. Imagine the efficiencies that must have been gained from computerization of this industry over the last fifty years. No more legions of people maintaining paper ledgers; lower commissions, electronic research, fast, low-cost communications. The list of cost savings goes on and on. Yet, apparently none of these savings was ever passed on to shareholders. In fact, fees increased! And be careful to note this: fees are stated not in dollar terms, but as a percentage of assets. Over this period mutual fund assets grew 1600 times; fees, as a percentage of assets grew 2400 times.

Why a percentage of assets, we might ask, when, as Bogle notes, “There is no evidence that… it takes any more security analysts and portfolio managers to run a fund with, say, $5 billion of assets than a fund with $1 billion of assets.” The answer is, of course, it makes it easier for managers to justify exorbitant fees to the owners. In dollars the fees are enormous; the percentage looks tiny.

But it’s really worse than that. Although 0.92% seems way high when looked at from an historical perspective—when all fees are added in (sales loads, 12b-1 fees and brokerage commissions), Bogle estimates that the total cost paid by the owners of mutual funds over the last 20 years has been around 2.5% of assets per year. Bogle tests this hypothesis by comparing total stock market return over the past twenty years to total return for all equity mutual funds for the same period. Sure enough, mutual funds trailed total stock market return by 2.8%.

What does that mean in dollars? The investor who put $10,000 in the stock market in 1985 would have $119,800 today. The same investor putting his money in the average mutual fund in 1985 would have $72,900 today, or $46,900 less. In Bogle’s words:

“If this example does not represent the triumph of managers’ capitalism over owners’ capitalism in mutual fund America, it is hard to imagine what would. Almost half of the fund owner’s money was siphoned away by those who quite literally had everything to gain and nothing to lose.”

Even this understates the problem. As he points out elsewhere in his book the return on stocks is artificially low because of exorbitant salaries paid to executives. But that’s another story.

Bottom line: if you invest, be careful, and buy index funds. If you make a lot of money in the financial services sector or as a corporate CEO, don’t complain about high taxes, you’ve got a good deal.

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