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Subject:  Buffett and frictional costs Date:  3/29/2006  3:48 PM
Author:  BenGrahamMan Number:  117243 of 260775

I have been obsessed with his frictional cost mentions in the recent AR and prior. A friend of mine mentioned that WEB wrote an article where he explained the use of frictional costs. I asked if it was an article, or an interpretation of the mention in the annual report. He was certain it was an article written by Warren. is anyone aware of such an article.? Here are some snips of articles I did find of interest.


1. Buffalo News published on 3/24/06 the following (good article, WEB should own that paper ;-)

In fact, legendary investor Warren Buffett thinks some bad practices are getting worse. His major concern is investment costs. Many people, he argues, are now giving up a whopping 20 percent of their investment gains to "frictional costs" -- layer upon layer of trading commissions, advisers' fees and other expenses that, as you'll see below, are easily avoided.

That was one of the chief messages earlier the month in Buffett's annual letter to shareholders at Berkshire Hathaway, the company he runs. (Berkshire Hathaway owns The Buffalo News, and Buffett is the paper's chairman.) The section in the letter is titled "How to Minimize Investment Returns."

How could costs possibly chew up a fifth of your gains? Easy: Earn 10 percent a year and pay 2 percentage points in expenses.

The typical actively managed mutual fund that invests in stocks, for example, charges about 1.3 percent a year to pay for stock- pickers and other expenses. Buy it through a brokerage account that charges an additional 1 percent a year for giving you investment advice and you're well above Buffett's 20 percent figure, assuming the 10 percent annual return.

Earn only 5 percent a year -- about what the S&P 500 did last year -- and 2.3 percentage points of friction slashes your gains in half.

But surely all the help you get from the fund managers, brokers and any other investment advisers is paying off by adding value to your holdings, isn't it? Not necessarily, Buffett says:

"True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. And, yes, all investors 'feel' richer when stocks soar. But an owner can exit only by having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there simply is no magic -- no shower of money from outer space -- that will enable them to extract wealth from their companies beyond that created by the companies themselves.

"Indeed, owners must earn less than their businesses earn because of 'frictional' costs. And that's my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have."

By hiring pros, you can hope to become an "investor A," who gets more than his share of the pie. But how do you know that an adviser who delivered above-average returns wasn't just lucky?

If the market returned 10 percent a year and you gave up 2 points to fees, your advisers would have to earn you 12 percent just so you could match the gains of investors who didn't pay all those fees. That's tough to do.

Imagine that instead of stocks, you bought a neighborhood gas station with a competitor across the street. What would it take to make 20 percent more than he does on every gallon of gas you sold -- and to do it year after year?

Clearly, some advice can be worth paying for, such as help devising a long-term financial plan you can then implement on your own. But it's not hard to tell if professional advice is worth the cost. You can match the stock market's performance by purchasing index-style mutual funds that simply track such market gauges as the Dow and S&P 500. Buy them directly from a fund company and there's no broker's commission or adviser's fee. And annual expenses will be a miserly 0.2 percent or less.

Any investment with a higher fee is justified only if it can beat the simple indexer -- beat it, that is, after all frictional costs are taken into account.


2. daily telegraph 3/22/06 Watch out - fee hunters are about in bids frenzy INVESTMENT COLUMN

It's fitting given the site's frugality that the main subject of the letter is waste, specifically the vast sums shareholders fritter away in extortionate fees. He is right to focus on activity, the enemy of good investment returns, because, as profits from Goldman Sachs confirmed, the market is mighty busy.

...

And that is where we are today, Buffett concludes. Particularly insidious are the profit-sharing arrangements "under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with the losses - and large fixed fees to boot - when the Helpers are dumb or unlucky (or occasionally crooked).'

This is over-simplification, of course. The world's companies are not owned by one family and the discipline of the markets ensures that the world's capital is allocated more efficiently than it is in non-market economies.

But he is right that investors often pay intermediaries far too much to create the structure. And he is also right that most investors trade too frequently in a futile attempt to chase returns. As he says: "The burden of paying Helpers may cause American equity investors, overall, to earn only 80pc or so of what they would earn if they just sat still and listened to no one.'

Buffett's analogy is principally concerned with the "friction' in the day-to-day management of portfolios but he could have taken his argument further. The loss of value is even more of an issue when the Helpers in the City and on Wall Street persuade their customers not just to over-trade small stakes but to transfer ownership of whole businesses. Enter, the investment banker-helpers.

Only six years on from its most recent bout of hyperactivity, the UK corporate world is once again rushing around in a fair imitation of a headless chicken, and the bids for Prudential, the LSE, BAA, BOC and all the others are unlikely to be the end of the takeover boom. Encouraged by banker, broker and PR-Helpers, who all stand to make mouth-watering fees from all this activity, companies are casting around in an increasingly demented fashion for deals.

All the evidence is that most of these will lose money for the shareholders in the companies doing the deals and benefit disproportionately the shareholders of the businesses snapped up in the frenzy and, especially, the advisers of both parties.

If you can't be one of these, at least try to be on the receiving end of these value-destroying deals.


3. Houston Chronicle 3/20/06 Investment fees are eating up gains / Getting results from all that advice you're paying for? Take a hard look

How could costs possibly chew up a fifth of your gains? Easy: Earn 10 percent a year and pay 2 percentage points in expenses.

The typical actively managed mutual fund, for example, charges about 1.3 percent a year to pay for stock-pickers and other expenses. Buy it through a brokerage account that charges an additional 1 percent a year for giving you investment advice, and you're well above Buffett's 20 percent figure, assuming the 10 percent annual return.


......

Indeed, owners must earn less than their businesses earn because of `frictional' costs. And that's my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have."

By hiring pros, you can hope to become an "investor A," who gets more than his share of the pie. But how do you know that an adviser who delivered above-average returns wasn't just lucky?

If the market returned 10 percent a year and you gave up 2 points to fees, your advisers would have to earn you 12 percent just so you could match the gains of investors who didn't pay all those fees. That's tough to do.

Imagine that instead of stocks, you bought a neighborhood gas station with a competitor across the street. What would it take to make 20 percent more than he does on every gallon of gas you sold - and to do it year after year?

Clearly, some advice can be worth paying for, such as help devising a long-term financial plan you can then implement on your own.

But it's not hard to tell if professional advice is worth the cost. You can match the stock market's performance by purchasing index-style mutual funds that simply track such market gauges as the Dow and S&P 500. Buy them directly from a fund company and there's no broker's commission or adviser's fee. And annual expenses will be a miserly 0.2 percent or less.

Any investment with a higher fee is justified only if it can beat the simple indexer - beat it, that is, after all frictional costs are taken into account.


4. National Post - Buffett takes a shot at advisors: Berkshire Hathaway report shows how fees erode returns

Even so, in his 1996 shareholder letter, Buffett said "the best way to own common stocks is through index funds," a quote widely recirculated by proponents of index funds and exchange-traded funds.

....

Frictional costs now amount to 20% of the earnings of American business, Buffett estimates. And as a result, the Gotrocks might better be called the Hadrocks, he concludes.


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