Investors set to benefit from fund success fees

Investors who feel they pay far too much in fund management charges, particularly when stock market returns are disappointing, may be interested to learn that performance-related fees are to become more common.

Investors who feel they pay far too much in fund management charges, particularly when stock market returns are disappointing, may be interested to learn that performance-related fees are to become more common.

From next month, a shake-up prompted by the Financial Services Authority, the City watchdog, will let managers offer variable annual fees based on the performance of their funds.

At the moment, most managers rely on a flat annual charge - usually 1.5 per cent - which is levied regardless of how well or badly the fund fares. Few offer performance-related fees because existing rules mean the manager must first impose a high, flat, annual fee - making it unattractive to investors. Only if the fund's performance puts it in the top 25 per cent of funds in its sector, say, would the investor get any sort of rebate. And this is ploughed back into the fund rather than handed back.

However, the FSA's ruling should usher in a new flexibility. Independent financial adviser (IFA) Bestinvest says the rules have long been draconian and believes the changes will encourage fierce rivalry on performance fees.

"There are very few doing this at the moment but there will be enough competition, over time, to get [fund] groups doing this and others will follow," says Justin Modray, investment manager at Bestinvest.

He warns however, that investors should pay close attention to how the fee is calculated. He would like to see a "sensible" system where investment houses split it into two: one part made up of a fixed basic fee to cover costs, and the second slice a fee linked to performance.

The Investment Management Association, the trade body for UK fund managers, is working with research company Fitz- rovia to draw up a model to put to members. How long this will take is unclear.

Concerns remain over performance-related fees, such as whether fund managers will take undue risks to meet targets. "We would be a little bit nervous if managers had to 'go for broke' to make up the returns," adds Mr Modray at Bestinvest.

It is also important to ensure that managers don't pick easy target benchmarks and to check that there are "watermark" levels. If fund managers don't have a watermark - a minimum performance point - to reach in each analysed investment spell, they might choose simply to rely on bursts of outperformance following bad months, rather than aim for consistency.

The FSA's move is an opportunity for the fund management industry to align the interests of the individual managers running funds with those of the investors putting their cash - and trust - in their hands.

Three weeks ago, a Treasury Select Committee report into the endowment mortgage market pulled no punches in its condemnation of fees charged, irrespective of how well industry products performed. It described the nub of the problem as one where the biggest rewards came from higher volumes of clients rather than from good performance.

"The challenge is to develop a fee structure that reinforces the industry's duty of care to the saver, by directly rewarding good investment returns and client retention rather than simply paying out high rewards for client acquisition," it said.