Money Warehouse

Towers Watson Revisits the Gotrocks Family

Money Warehouse

In his 2005 shareholder letter, Warren Buffett envisioned a hypothetical family (the Gotrocks) who just happened to own all the companies in America. While each family member could have been content to simply collect their dividends, some of them hired “helpers” to assist them in outwitting other family members by trading companies with them. The other family members responded by hiring more expensive helpers with fancier titles. The cycle continued, and before they knew it, a substantial chunk of their collective income was going to the helpers. Buffett used the Gotrocks as an allegory to describe the position of American investors who spend hundreds of billions of dollars on financial intermediaries who, as a whole and perhaps by definition, add no value.

Towers Watson recently issued a white paper called "There Are Too Many Active Managers" in which the authors performed a similar thought experiment. They imagined the existence of a gigantic warehouse filled with all the securities in the world—stock certificates, bonds, real estate deeds, etc. Periodically, the warehouse doors open and a fork lift truck delivers a big pile of cash representing the dividends, coupon payments, and rents earned by the securities. It really doesn't matter whether we assume that every investor owns a piece of the entire warehouse or owns the specific securities appropriate to his or her situation. All investors together collectively own the warehouse along with the periodic deliveries of the cash.

Here is where the fun begins. The authors assume that 15% of the assets are indexed, 80% are actively managed in mutual funds, and the remaining 5% are actively managed in hedge funds. They also assume that the fees of actively managed mutual funds are 7.5 times higher than index funds, and the fees of hedge funds are 45 times higher than index funds. We won't argue with either assumption. Simple arithmetic implies that of the total costs paid for asset management, 1.8% goes to index funds (including ETFs), 71.4% goes to actively managed mutual funds, and 26.8% goes to hedge funds. The table below summarizes their assumptions.

The authors acknowledge that some of the active managers perform the socially useful functions of price discovery and weeding out worthless securities, so when they say there are "too many" of them, they are only advocating a reduction in number rather than a complete eradication.

The authors contemplate a specific reduction of transferring 70% of the assets under active mutual fund managers to index managers. Again, simple arithmetic implies a 41% reduction in annual costs to investors. The authors estimate this savings in dollar terms between $74 billion and $144 billion. Of course, this savings is equivalent to a revenue reduction for the asset management industry. In addressing this issue, the authors note, "Capitalism has shown a remarkably consistent ability to recycle jobs and simultaneously raise living standards. In other words asset manager employees could end up in more value adding roles elsewhere in finance, or even in the wider economy."

Overall, the authors express optimism that things are heading in the right direction, as we have noted many times in articles such as this one. The fact that one of the world's largest and most influential consulting firms is now thinking this way is gratifying to us. We hope that their clients will pay heed and exclusively implement low-cost index funds (combined with proper investor education) for their retirement plans.