Principles of Finance: Unit 8, The Fee Structure of Funds

The fee structure of funds…à la Shmoop.

CoursesFinance Concepts
Principles of Finance
FinanceFinancial Responsibility
Personal Finance
Finance and EconomicsPrinciples of Finance
LanguageEnglish Language
Life SkillsPersonal Finance
SubjectsFinance and Economics

Transcript

00:20

give these people money to make more money Bigger fatter

00:23

more er each of the above flavors is just a

00:26

different investing style in which to make that money each

00:29

investing style And each fund features its own unique set

00:32

of structures and or fees That's the money that you

00:36

the investor pay the money managers to go make you

00:38

more money but okay first thing's first it all starts

00:41

with a big bag of money Say a doctor opened

00:43

a chain of exam clinics and she ended up owning

00:46

the real estate under those clinics And then a decade

00:49

or so later she sold the whole thing for eighty

00:51

million dollars when she was still young enough to enjoy

00:54

her winnings after tax that eighty million dollars in the

00:57

blue state in which she lived became fifty million bucks

01:00

Well she bought a nice home A small ranch a

01:02

small jet and had twenty million dollars left over to

01:05

invest Well half of that money went to a nice

01:07

conservative dividend loving mutual fund The other half went to

01:11

spice spice or alternative investments That's what those things are

01:16

the fancy names we gave you at the beginning here

01:18

they're any of the not mutual or not index fund

01:22

flavors those air vehicles through which rich people invest what's

01:26

the difference Well we'll start with the fees that the

01:28

managers charge people you know like the good doctor of

01:31

a fee structure in these kinds of funds is vastly

01:34

different among the asset classes and vastly more expensive like

01:39

you can expect to pay And one percent a year

01:41

for a mutual fund maybe half a percent a year

01:43

for an index fund while the venture private equity hedge

01:46

funds those guys are ten to one hundred times that

01:49

price Why Well in theory they make a lot more

01:52

money in practice They don't So here we go The

01:55

most common fee structure is what's called a two and

01:59

twenty fee structure and that exists in pretty much all

02:02

hedge funds So given hedge fund has ah billion dollars

02:05

Under management they take two percent a year twenty million

02:08

dollars for the pleasure of just managing the money That's

02:11

If they break even they start with a billion dollars

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and then they make two percent on their money At

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the end of the year they have a billion dollars

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That two percent that they made all went to them

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The money managers to keep is their fees They don't

02:21

get rich on that two percent and it costs a

02:23

lot of money to employ lawyers and secretaries and auditors

02:26

and send out those fancy beautiful lambskin mailers and all

02:29

the other crap They have to file with the sec

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and trading stations and on and on and on all

02:34

that costs money and that's it two percent covers But

02:36

then if they have a great year like they're up

02:38

fifty percent that billion dollars goes to a billion five

02:42

Well then after they paid their two percent that's ah

02:45

you know we'll throw that in there as a forget

02:47

it because it makes the math harder Here we have

02:49

five hundred million dollars in profits While that hedge fund

02:52

the twenties twenty percent of profits they keep twenty percent

02:55

Of that five hundred million or one hundred million dollars

02:59

that's what their take is so you the investor or

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or at least your fund ends up being worth a

03:03

billion four not a billion five when they clip their

03:06

coupon for their fees and most clipped them quarterly or

03:10

thereabouts anyway That's how it works So when you hear

03:12

two and twenty that's what it means in the venture

03:14

capital elite in silicon valley make two and thirty meaning

03:18

they take to present management fee and thirty percent of

03:21

profits So yeah it's just crazy Expensive yet when you

03:24

compared with the mutual fund at one percent and an

03:26

index fund and a third of a percent and the

03:28

reality is there's no such thing as a venture capital

03:31

fund for example there's a half a dozen maybe a

03:34

dozen who are really good and produce good returns for

03:36

investors year after year But then there's like a thousand

03:39

who suck But everyone wants to buy a lottery ticket

03:42

and people spend a lot of money buying lottery tickets

03:44

Real world an actual lottery tickets Why wouldn't rich people

03:48

be the same You're a doctor who made all your

03:50

money Probing your fingers into people's private places why would

03:53

you know anything about finance particularly venture capital which is

03:57

an arcane random difficult to understand highly technical technological area

04:01

of the world But you like lottery tickets You like

04:04

jets and love Hearing stories about the founders of google

04:06

love buying islands Ex army votes to land their planes

04:10

on stuff like that So why not roll the dice

04:12

right Yeah it's Great until you lose all your money

04:15

Let's dig into this venture firm thing than as a

04:18

deeper example Here that doctor are friendly prober gives five

04:22

million dollars to ah to in twenty five venture firms

04:25

that's like a middle tier venture firm which turns it

04:27

into a ten point seven million dollars a seven years

04:31

later Five in ten point seven Well the firm clips

04:33

a two percent per year fee from her five million

04:36

dollars that as she is paying them one hundred thousand

04:38

dollars a year to manage her five million So in

04:40

the beginning of the fund or a five million dollar

04:42

value is slowly destroyed Its worth four point nine million

04:45

after year one if no investments are made and then

04:48

they make a few and while they pray a lot

04:50

and then they get lucky and they find a winner

04:51

which pulls up the whole fund worth double Well in

04:54

the process of those seven years to manage her five

04:57

million dollars she paid them yes Seven hundred thousand dollars

05:01

in guaranteed fees And then when the firm showed ten

05:03

point seven million dollars in net gains well after subtracting

05:07

the seven hundred thousand dollars in fees the original investment

05:10

of five million dollars yeah there was five million left

05:13

for attribution to carry or profit participation Will the fund

05:17

was set off is a two and twenty five here

05:19

So the general partners keep twenty five percent of the

05:22

five million in profits or one point two Five million

05:24

dollars as their quote incentive to work hard bonus So

05:27

the doctor put in five million She made a twelve

05:29

percent per year return on her investment Slightly better than

05:33

an average s and p five hundred run With dividends

05:36

reinvested she was lucky to be in the top ten

05:38

percent performing venture capital fund Yes that's what the top

05:41

ten percent does not very impressive And in the course

05:44

Of those seven years on a five million dollar investment

05:46

she paid the firm one point Two Five million dollars

05:48

in kerry lost seven hundred thousand dollars or about one

05:52

point nine Five million dollars in fees Sound a bit

05:55

steve to you and this was a top ten percent

05:58

performer Most venture funds still collect the fees but don't

06:01

even return capital invested That is the expected case would

06:05

be for the doc put in five million bucks and

06:07

after seven years and i get about three point eight

06:10

million dollars back if that be the median return So

06:12

why on earth would anyone then be an investor in

06:16

the venture capital business lottery tickets every now and then

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there's a fund that turns fifty or a hundred times 00:06:22.433 --> [endTime] capital maybe more Rich people love them some lotteries