Investors are being warned about paying over the odds for average performance on a new breed of funds – funds that pay performance fees to their managers.
Peter Hargreaves, the outspoken chief of financial advisers Hargreaves Lansdown, has lambasted performance fees, saying they were designed to benefit only the manager and provided no advantages for investors.
One of Mr Hargreaves' main criticisms was that while managers that charge performance fees benefit when their funds do well, there is no penalty when funds do badly.
Philippa Gee of financial adviser Philippa Gee Wealth Management was also critical. "Let's be honest, if a fund were to deliver top-decile performance [in the best 10pc of funds] consistently over a five to 10-year period, and charged a performance fee that was not so ridiculously high as to eat into the extra returns, then most people would be happy to invest. But in reality it is not like that," she said.
"There are plenty of attractive funds to consider and most do not charge performance fees, so I would always tend to avoid recommending any fund that does charge them. There would have to be a very special reason to recommend a fund that comes with a performance fee and I haven't yet come across that reason."
The number of fund managers using performance fees has increased over the past couple of years and now includes companies such as JO Hambro Capital Management, Alliance Trust, Cazenove, Liontrust, Neptune, Octopus, Odey and SVM.
Performance fees are usually charged as a percentage of returns above a particular benchmark, such as an index or interest rate measure, so while you won't find yourself paying fees for underperformance, you could find yourself paying extra fees for ordinary or average performance.
According to research by Lipper, of about 40 open-ended funds that charge performance-related fees, more than half charge 15pc of net gains as their base fee and just two, Hiscox Global Financials and SVM Funds Global Opportunities, charge 10pc. The remaining funds have performance fees of 20pc. Some 135 investment trusts charge performance fees.
Ian Sayers, director general of the Association of Investment Companies, said: "Performance fees have a place. Some investors would rather pay when performance has been good than pay a flat fee regardless of how the fund has performed. The construction of the fee is, of course, extremely important, and they can become complicated, but that is often because the manager is trying to do the right thing."
Mark Dampier of Hargreaves Lansdown said that in some cases the ''hurdle'' rate that managers had to overcome before they could charge a fee was so low that it was easy to beat. "It's not unreasonable to expect investors to pay for superior performance, but managers should have a fee that relates to a high hurdle rate – often they are next to nothing," he said.
For example, some unit trusts' performance hurdle is to beat Libor – the rate that banks charge to lend to each other – which is currently at just 0.73pc for one month and 0.57pc for three months. Funds that use the three-month sterling Libor rate as a hurdle include BlackRock UK Absolute Alpha, SVM UK Absolute and Jupiter Absolute.
Tony Stenning of BlackRock said: "We consulted extensively with advisers in order to devise a methodology that was as fair and equitable to investors as practicably possible, while still providing a reasonable incentive to the fund's manager.
''Ultimately we decided the hurdle should be based on the key tool used to control economic conditions, that is, short-term interest rates. This would rise when arguably it could be easier to add value to the fund and vice versa when conditions are less benign."
The BlackRock fund also uses a "high water mark", meaning that the fund must beat the previous peak in net asset value before the performance fee kicks in again.
Darius McDermott, the managing director of discount brokers Chelsea Financial Services, said he was not against performance fees provided that managers offered value for money.
"The BlackRock UK Absolute Alpha fund has delivered 26.2pc over five years compared with the average UK All Companies fund of 20.4pc. This has been achieved with a low correlation to the UK market and in a much less volatile manner," he said. "Similarly, Gartmore UK Absolute Return is up by just under 10pc since it launched in April 2009.
"Both managers charge a performance fee but they have given investors good returns."
The same cannot be said of Bedlam Asset Management, which placed performance fees at the centre of its launch eight years ago. The group, named after the east London lunatic asylum, attacked fund management groups that charge investors even when they perform badly.
It opted for a no-gain, no-fee charging structure. If the net asset value of shares has increased by less than 1.25pc in a given quarter, then no fee applies for that quarter. If the return is above 1.25pc then a charge of up to 1.25pc is applied. However, it will not be charged if the fee taken would cause the return to be less than 1.25pc.
Bedlam's fund performance has been less than impressive, but at least investors have not had to pay through the nose. According to Morningstar, its UK fund returned 57.8pc, well behind the FTSE All Share index, which has risen by 86.7pc over the same period. Bedlam's worst performer is its Emerging Markets fund, which has returned 133.2pc since 2002, while its benchmark rose by 311.8pc.
If you are considering a fund with a performance fee, make sure you understand how it works. "If you went to buy a car, you wouldn't just say 'I'll take the red one' and walk out, you'd look under the bonnet and find out all about it," Mr Dampier said. "You need to go into any fund with your eyes open so you know exactly what the fund manager will get out of it and what you will be paying."
Check to see what the performance benchmark is and whether a high water mark applies. Clive Beagles, senior fund manager of the JO Hambro Capital Management UK Equity Income fund, said: "Performance-related fees are an important part of the incentive package for our fund managers and help us to attract high-calibre managers capable of generating outperformance for our clients over the long term. Critically, we apply a high water mark so that any fund underperformance is carried forward and no fee is payable until the underperformance has been recovered."
Remember, too, that total expense ratios, which show all yearly costs, often exclude performance fees, so check the small print to find what you will be paying. You should also see whether there are similar funds available that don't charge performance fees.
Ms Gee said: "Consistency is an important part of meeting investor expectations and the investment industry has to appreciate that the mistrust of the financial world is not aimed just at banking institutions and certain rogue financial advisers, but at fund management groups as well. They should tread very carefully in terms of how much of the cake they want to eat."
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