Thinking About Thinking

Should Bernie Madoff Have Charged 1% or 2% Fees?

Posted in Pop Culture by larrycheng on March 3, 2010

The short answer is it depends.  Here we go…

On a flight back from London today, my partner showed me a little blurb in the most recent Time Magazine about a bet between two scientists.  They bet $300 on whether the first person to live 150 years would be born by 2000.  They put the money into an investment account which will presumably be settled by their heirs.  So, what will the $300 be worth in 150 years?

Let’s presume the $300 was put into a Bernie Madoff-like fictional fund that generates 10% annualized returns any and every year without fail.  Let’s also presume for a moment that this is a no-load (i.e. no fees) fund.  What would the $300 be worth in 150 years? 

  • A whopping $485 million. 

Now, let’s show the impact if this Madoff fund charged an annual 1.0% fee based on assets under management.  What would the $300 be worth in 150 years? 

  • A surprisingly diminished $123 million. 

Now, let’s say Madoff charged a 2.0% annual fee.  What would the $300 be worth in 150 years?

  • A further diminished $31 million.

Before you go off on the exorbitant cost of paying fees, just note that if the $300 was put into a no load bond that generated 3.0% annualized returns, the end result would be a paltry $25,000.  So, it still pays to pay for alpha by a longshot.

Now, let’s get to the question of this post.  Should Madoff have charged 1.0% or 2.0% annual fees to maximize his fee income from this client over the investment period?

If the fee was 1.0%, the cumulative fees over the 150 years is:

  • $13 million. 

One would expect that charging 2.0% annual fees would net Madoff a much better result over 150 years.  But, here are the cumulative fees at 2.0%:

  • $7 million. 

Why in this case would charging a higher fee result in lower aggregate fees?  For the simple reason that over time, the higher fees diminish the total assets under management so dramatically, that over the long-run, it meaningfully and negatively impacts aggregate fees.  Then why does the answer depend if the math is so clear?  Because this is an unusual scenario where the term of the investment is 150 years.  As it turns out, for about the first ~75 years, it’s better to charge 2.0% fees.  After that, it crosses over and a 1.0% fee generates more cumulative fees as the assets under managements starts to meteorically rise.  Yet again, like in all things, time horizon does matter.     

8 Responses

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  1. Jay Levy said, on March 4, 2010 at 12:16 am

    Very interesting!

    now you are overlooking the interest earned on the money earned by madoff as a manager. if you reinvest that money at the same rate charging 2% will yield much higher returns.

    • larrycheng said, on March 4, 2010 at 12:17 am

      Yes, I was going to do that math – but I’m too jet lagged to do that math!

      • Jay Levy said, on March 4, 2010 at 12:35 am

        I actually just ran some numbers (i could be off as excel on mac sucks) and the interesting thing is that when you compute the interest madoff would earn on 1% vs 2% the fees wind up pretty equal in the aggregate. This does make sense as essentially the fees are a movement of wealth from one party to another.

  2. Nicholas Molnar said, on March 4, 2010 at 1:29 am

    There is one part of this equation that is woefully missing – which is odd considering that the article is about Bernie Madoff. There is a probability of default. Over 5 years, that probability may be very low, but over 150 it also adds up. It only takes one default to wipe out the portfolio. Even if you are investing in Treasury bills, nobody can guarantee that the US Government will stay solvent continuously for that long.

    If even for one wrong year the fund manager invests heavily into something like Madoff’s Ponzi scheme the total could be much closer to 0 than $485M.

  3. Richard Friedman said, on March 4, 2010 at 8:24 am

    I’m a CPA, which pretty much causes a mandatory statement like, what about the impact of income taxes, projecting a a maximum tax rate of 40%, NYS of 7%.

    This gets a bit messy but its just something else to throw in the mix.

  4. pgb said, on March 16, 2010 at 7:11 pm

    Enough with Madoff already. I saw there’s even a Madoff COLORING book on Amazon.

  5. Ralph said, on April 26, 2010 at 4:28 pm

    Enough with Madoff. He’s caused so much grief. The fact that we continue to bring him up is news enough for how much pain he has caused.

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