A growing number of investment trust and fund management companies have surreptitiously been adding an extra layer of costs to their annual management charges (AMCs) in recent years in the form of performance fees.

These fees, which are linked to a fund’s returns, can more than double, or even quadruple, the total annual charges deducted from the funds.

The latest available figures show that investors in the Octopus Absolute UK Equity investment fund, which has a typical AMC of 1.5 per cent, actually suffered total expense deductions of more than 10 per cent when performance fees were taken into account. Similarly, specialist investment company International Public Partnerships clocked up total charges including performance fees of more than 8 per cent last year.

A major problem with performance fees is that they come in such a huge variety of forms that it is virtually impossible for investors to compare the likely cost of one fund with another, or to work out how much they will actually pay the managers at the year end.

However, the argument used by managers to justify performance fees is that they align the interests of investors and managers because managers have a greater incentive to perform well – which in turn means better returns for investors.

One of the problems with this argument, though, is that managers’ fees already increase in absolute terms when they do well, especially in open-ended funds, because they are a percentage of the fund, so they grow as the fund grows.

Nevertheless, if it were true that funds perform better when performance fees are included in the charging stuctures then investors would undoubtedly be happy to pay the extra fees. But, is there any evidence to support this theory?

First of all, it is important to go back a step and consider the basis on which performance fees are awarded because they obviously need to be set at the right level in order to produce the desired effect for investors.

If the yardsticks against which they are measured are too easy for the managers to achieve then investors would not necessarily be better off.

Surprisingly, since its current mantra is that financial providers must focus on treating customers fairly, the Financial Services Authority has ducked the issue of the fairness of fees. While it made some suggestions about how performance fees should be constructed when it first lifted the ban on the fees being charged on open-ended funds in 2004, managers are not obliged to follow them.

Among the FSA’s suggestions were that a fee ‘may be based on performance above a defined positive rate of return’; that ‘disclosure should be given in plain language together with examples of the operation of the performance fee’; and that the ‘benchmark must be reasonable given the investment objectives of the authorised fund’.

However, in the end the FSA shirked its responsibilities, declaring in 2007 that ‘we do not act as a price regulator’.

Managers are not even obliged to set a ‘high water mark’, although most do so. This means the price of the fund must exceed a previous high point before it can start clocking up more performance fees, otherwise managers could charge performance fees twice for covering the same ground if a fund falls back and then rises again.

Instead, it has been left to managers to decide how they construct their performance fees. As Ed Moisson, head of consulting at Lipper FMI, recently highlighted in his report Paying for Pain or Pleasure, they appear to have disregarded most of the FSA’s guidelines.

For example, instead of being rewarded for producing a positive rate of return, two-thirds of UK open-ended funds with performance fees can charge an extra fee when they have lost money for investors because they measure their performance against stock market indices, such as the FTSE All-Share, which may have fallen. So if the index drops by, say, 20 per cent and the fund only falls 10 per cent, the managers can still take a performance fee for outperforming.

The appropriateness of the performance benchmark is also crucial. An increasing number of fund managers, especially those aiming for an ‘absolute return’, have adopted cash-interest benchmarks, such as the Bank of England base rate or a Libor (London Inter Bank Offered Rate) hurdle.

Moisson questions this practice. ‘The use of such benchmarks by equity-based funds should surely give pause for thought – and not a little concern.’

With interest rates at current low levels – base rate has been at 0.5 per cent for more than 20 months – the performance bar for these funds is not exactly high. And it also means that if share prices rise generally in excess of interest rates, managers will be able to claim additional fees for no added value on their part – and even if they are underperforming their peer group. What’s more, there is no limit on what they can charge as there is no legal requirement to put a cap on fees.

In 2008, the FSA bemoaned the fact consumers unfamiliar with performance fees ‘may not be able to make appropriate comparisons or understand their impact on net returns in the absence of a significant improvement in standards of disclosure or literature.’

However, there has been little improvement. Fund managers will happily disclose a fund’s AMC in their marketing literature but this is relatively meaningless as there is no common standard for calculating this charge. But when it comes to performance fees the only way investors will be able to find out how they work in detail is by looking in a fund’s prospectus.

Besides their complexity, other reasons for the unpopularity of performance fees among some financial advisers, such as Peter Hargreaves, the recently retired chief executive of Hargreaves Lansdown, is the short periods on which they are based, sometimes just three months.

Hargreaves, who called for a boycott of performance fees, says: ‘If you look at how markets move, there is every chance that over a short period of time the fund manager will outperform, whereas they should only benefit over a long period of time or the money will go from the fund and there will be less money to achieve results for the client.’

There certainly does seem some schizophrenia in managers’ attitudes as they normally tell investors to adopt at least a three- to five-year time horizon when it comes to investing in the stock market and, if their performance is judged over shorter periods, they complain.

However, possibly the largest single bone of contention is that performance fees are usually a one-way bet for managers. According to Lipper, only a minority of funds with performance fees charge less than the typical management fee of 1.5 per cent. The vast majority of managers charge 1.5 per cent or more, which means that even if they perform abysmally they are no worse off.

As David Thomson, investment director at VWM Wealth Management, says: ‘The reason I don’t like performance fees is that it is often a case of heads the managers win and tails they do not lose.’

All these problems might be forgiven, however, if funds with performance fees consistently outperformed their rivals. Unfortunately, most still have relatively short-term records so the evidence is relatively limited. 

In the investment trust industry,performance fees have been around for longer. But because it is normal practice for the management charges of trusts to be reviewed every few years it has been possible for managers to introduce them for many existing trusts. As a result, some 55 per cent of mainstream Association of Investment Companies (AIC) member trusts now have performance fees.

On average, investment trusts have lower annual management charges than open-ended funds, especially the older trusts, so at least managers get less when their performance is poor.

Recent research by the AIC showed that 30 per cent of trusts had basic charges, as measured by their total expense ratios, of less than 1 per cent, and 58 per cent have charges of less than 1.5 per cent.

But there has been an increase in the number of specialist investment companies with higher charges, notably property companies and hedge funds. This has led to an increase in the overall average TER to 1.76 per cent, compared to 1.41 per cent in October 2008. When performance fees are added to the equation, the average TER increases to 1.83 per cent.

Commenting on performance fees, Ian Overgage, acting AIC communications director, admits: ‘There is a wide array of opinions on whether they are a good or a bad thing. Our key issue is disclosure and the need for performance fees to be explained explicitly in clear terms that the audience will understand. That extends to total expense ratios – which obviously should reflect performance fees where appropriate.’

Unfortunately, as with open-ended funds, such explanation appears lacking. For example, investors who want to find out how the British Assets Trust’s performance fees, introduced a couple of years ago, are calculated, will have to delve into the annual accounts to find a less than clear description.

Investors have also seen little benefit. Charles Cade, head of investment companies research at stockbroker Numis, and a long-time observer of the industry, admits: ‘There is no evidence that performance fees have enhanced or added to shareholders returns. All they have done is increased managers’ remuneration.’

Sometimes performance fees are outlined in the so-called simplified prospectus. But managers, such as Gartmore and Neptune, hide the details of their performance fees even further from view in the appendices of their full prospectuses.

Although Neptune mentions performance fees on its Max Alpha range of funds in its simplified prospectus, the wording is guaranteed to put off all but the most intrepid investors. It runs as follows: ‘The amount of any performance fee due to be paid is a proportion (the participation rate) of the increase in the net asset value (NAV) per share of the relevant class of shares in excess of the notional gain (be it positive or negative) that would have been made had the share increased or decreased at the same rate as a defined hurdle investment rate (where such a hurdle exists, or otherwise a simple proportion of the increase in the net asset value per share of that class). Further details of the performance fee may be found in the full prospectus.’

Not very 'simplified', then.