Imagine you are a software developer and you do freelance and have clients all over the world – companies, government bodies, etc. They hire you for consultancy for their software and their product.

It’s a very busy and fulfilling life. You enjoy development. You are awesome in it and you earn well. You are making the world a better place with your services and have a positive impact on the world. So, you have large savings, but no idea how to invest in it.

But, since you have very little free time, and you just want to spend this time with your family, and don’t want to spend this time researching stocks and studying financial statements.

You have two choices here:

First, you invest in market indices (SENSEX/NIFTY) index fund and grow your investment with the market rate. Historically, in the Indian Markets, this has been 16% per year plus maybe some dividends.

The second choice is you let a fund manager handle your investment. They might get you a better rate of returns than the index fund, but they will charge you a fee.

What are the components of these fees? There are mainly three components in percentage: a fixed component (F), a variable component(V), and a hurdle component(H).

It will look like this:

Let’s take an example.

Say you invest 10 Lakh rupees with a fund manager who charges F = 2% fixed fee and V = 15% of all the profits with an H = 5% hurdle rate.

So {F,V,H} = {2,15,5)

Say, the stocks chosen by this manager go up 12% in year 1.

Then, your year 1 return after the feed will be

This is the problem when you go with the fund managers as their fees will eat up big chunks of your returns.

A standard practice by the fund managers around the world, he/she would charge “2 and 20” i.e. F = 2% and V = 20% meaning a 2% fixed fee plus 20% variable of all profits – no hurdle.

Here is a small simulation on excel where I have assumed the market will return 16% over the next 30 years.

Also, let’s say you know a really bright fund manager, Shyam.

Shyam is capable of “6% Alpha” and his picks will give a 22% (16+6) return over the next 30 years.

But Shyam charges {F, V} = (2,20}.

Suppose you had 10Lakhs of savings to start with.

Will you be better off investing 10 Lakhs in a low-cost index fund, or with Shyam (the second choice)

Thus, even a brilliant fund manager with 6% alpha over 30 years – cannot beat the market for you with this fee structure. Either his fees should be lower, or his alpha should be higher. Else, his clients are better off with an index fund because the alpha is getting disappeared after the fees.

Of course, not all the funds are like that. Medallion Fund for example, with their {F,V} = {5,44} fee, their alpha was able to generate more for their clients even after their atrocious fee structure. But, it’s an exception.

Here is the quotation from Buffett’s 2006 letter and his thoughts on the {2,20} fee structure.

“In 2006, promises and fees hit new highs. A flood of the 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.”

It’s just amazing to see that Warren Buffett who is the world’s most famous fund manager, called his bets on passive investing i.e. returns approximately equal to the index but without a fund manager.

Reference: https://www.berkshirehathaway.com/letters/2006ltr.pdf