Street Capitalist: Event Driven Value Investments

Waiting for Buffett’s letter to shareholders was a little exciting, and I’m not even a Berkshire Hathaway shareholder. I enjoy reading what Buffett writes and now more than ever I was looking for some of his insights on what has been happening in markets today. Here was his answer to the CNBC question:

I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double- digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently
direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.

This is why I like Buffett so much, who else can use a children’s story and use it as a means of attacking a group of highly paid professionals? Not many I’d think.

I don’t entirely agree with Buffett’s assertion. I’ve interned and been around financial advisers, and for the most part the ones I met were good. They didn’t seem to go out to their way to peddle poor products onto novice investors, they weren’t coaxing them into buying the latest investment craze. Maybe they really did learn from the dot com bubble.

But still, there can be some problems. Inherently, the financial advisory industry is built around commissions based on products sold. The problem is, they’re not paid according to how those financial products actually perform. They could have sold you a mutual fund that specialized in sub-prime mortgages and they would have made something up front before you made anything.

Ultimately in this situation the type of fees the adviser is extracting is probably small, the bulk of the fees will be taken by the mutual fund itself, but still – isn’t it still wrong for you to profit by selling a product that fails for the person you’re advising?

I think the most logical thing would be to put an emphasis on properly educating the advisers on the type of products they’re peddling so that they can accurately describe their intricacies to their clients/investors. With the trend in finance, new products keep being invented and they keep becoming more complex. Eventually, we will see a major issue where a party was not properly advised on the type of products they were purchasing and a major legal conflict will arise out of it. Arguably, we’re already at that period.

Some non-profits and municipalities claim they were duped into purchasing mortgage-related products that were thought of to be as safe as treasuries. Who know where we’ll be five years from now?

As long as the big banks spend more time educating their advisers on the products they’re selling and more importantly, how to explain those products to clients — things should be fine. I used to think that advisers should be paid more or less based on how well the products they sell their clients perform, but I think this is actually a bad idea. In client driven industries, they are going to be instances where “the client is always right”. i can really imagine that there will be points in time where a client wants to do something that goes against common sense, or is not prudent. It is his money and it is his choice to make though. Those are the kinds of instances where you should not be penalized for your client’s poor performance.

Advisers aren’t the only ones who face these kinds of incentive issues. Hedge fund and private equity managers can create issues through the kinds of fees they charge. Specifically with management fees, if a fund is charging 1% or 2% as a management fee, and manages $5 billion, right off the top you’re skimming $50 to $100 million dollars. If you’re employing 100 people that’s $500,000 dollars per person at the short end. Not to mention, some well-known firms employ even less employees. This has the ability of taking making the management fee a good safety net against performance going bad, which hampers the whole incentive aspect.

An interesting system could be a management fee that has an inverse relationship with assets under management. This way, a certain target fee would be extracted to cover the expenses needed to run your operation, yet not overcompensate you so that when your performance falls your compensation actually represents a significant fall.

Lastly, some fault should go to investors. They too have their own issues. A lack of pessimism or unending optimism during periods when the market is performing really well is usually a recipe for disaster. They need to act as a skeptic once in a while, to at least question their adviser’s rationale, like Buffett mentions. If not, investors/clients leave themselves open to going along with what their adviser or investment manager tells them, even when it goes against common sense.