Two bakers in 1900 each bake 1000 loaves and, on selling them, place the proceeds in the stock market. In 1900 a loaf of bread sold for 10c so they each had US$100 to invest. The elder brother went straight to the stock market and bought directly into the share index. The younger brother had heard of high performance hedge funds, so put his US$100 with a reputable fund.

Both brothers forgot about their investments until their great great grandchildren were short of cash and decided to sell the investments.

The elder brother’s index fund was now worth US$11,983. After paying the taxes the descendant was able to take home USD10,125. Passing a bakery on the way home she thought how, with loafs costing USD3.05 she could now buy 3000 loaves. So in 112 years the investment had trebled. This seemed kind of low but she shrugged and headed home.

The next day she went to liquidate the other investment. The younger brother’s hedge fund had been up and down. Some good years they made as much as 21%. In bad years they lost 2%. The brochure she took home with her showed that overall the return had averaged an impressive 9.3% every year for over a century, beating the share price index which had done 5.6%. But when she received her cheque it was USD9,086, even less than indexed fund.

She went back and talked to the Hedge Fund receptionist. The receptionist was no fool, and honestly explained what had happened.  She showed the lady the small print on the Hedge Fund Term Sheet and pointed to the 2.5% annual management fee and 20% performance fee in successful years. The lady said, these sounded reasonable enough. The receptionist paused, then pulled out her calculator.

Lets assume, she said, that each year the hedge fund manager has invested your management and performance fees directly into the share Index. Your manager now has US$56,308 dollars in the index which he owns himself, and has been created purely on the back of these fees.

The two morals of this story are, in three generations a 2% management fee can transfer the wealth and power of an investor into the hands of the bank that holds that wealth for him. Fight tooth and nail for every BPS!  Secondly, a steady return over time always outperforms the more volatile higher yielding option.