Fund managers are paid big bonuses for above-average returns. But what if they set performance targets that are barely above zero annual growth and then claim substantial fees for "beating" this target? Will that same manager hand back some of his or her additional earnings if the fund's growth is less than its peers?
In most cases, the answer is no. According to experts, some investment houses are creating performance-based fee structures that even financial advisers, tasked with recommending these funds to their clients, are unable to stomach.
Last week, Hargreaves Lansdown, one of the UK's largest independent financial advice firms, attacked the way that some managers charge extra for achieving suspiciously low performance benchmarks.
Peter Hargreaves, a founder of the Bristol-based company, said: "Performance fees only benefit fund-management groups. They do not benefit the client – indeed the client is normally disadvantaged by them."
Managers levying such fees include Jupiter, whose Absolute Return fund collects 15 per cent of any outperformance over the three-month Libor rate, which last week stood at just 0.44 per cent.
This means its manager, Philip Gibbs, doesn't even need to match the typical rate paid by almost all building society saving accounts before his fund collects an additional fee at the end of October each year.
This is on top of the fund's existing 1.25 per cent annual management charge and means, for example, that if the Absolute Return fund's underlying investments grow by a relatively meagre 5 per cent a year, almost two fifths of that growth could evaporate in performance fees and other annual charges.
Jupiter's fund applies a "high-water mark" to its charges. This means that if a fund's performance suffers, it must get back to that previous high level before an extra fee is levied. But it doesn't hand back any money already taken if the fund does badly.
Equally striking is Gartmore's £1.2bn European Absolute Return Fund, which levies 20 per cent of any growth in the value of the fund since the previous day, with fund valuation points every three months. This too is subject to a "high-water mark".
Meera Patel, a senior analyst at Hargreaves Lansdown, said that the firm continues to recommend more than a dozen funds in its Wealth 150 list of top funds despite their performance-based fee structures.
"Gartmore stands out in particular. The fund is managed by Roger Guy, who has an exemplary track record managing a hedge fund. It is a really tricky situation, as we know he is a talented manager. But we would like the groups to apply much fairer fees than this," she said. A spokeswoman for Gartmore said: "We believe that the charging structure [of our fund] is sufficiently transparent and consistent with treating customers fairly. This is a complex product, so the explanations are comprehensive. Any customer who does not understand it should, of course, seek advice."
In 2004, performance-related fees for UK funds were approved by the Financial Services Authority (FSA) in order to comply with European Union regulations. Robert Reid, managing director at the fee-based financial planner Syndaxi, in London, said: "I've always had doubts about these fees. The customer has no input into them and there isn't always a lot of understanding of the effect they can have. There isn't a lot of transparency in the way they are applied and if the fund's value collapses, the fee is never returned."
The danger that consumers could be treated unfairly is recognised by the fund managers' own trade body. Julie Patterson, director of authorised funds at the Investment Management Association, said: "We welcome these changes and still do. But we issued a discussion paper at the time that said if you use a 'hurdle', it should be a reasonable one and it should not be set against too short a period. We say the same today."
Patterson said some senior figures in the fund management industry are becoming "uncomfortable" with the way a few of their colleagues are structuring their fees, adding that if they are not transparent they risk falling foul of the FSA's "treating customers fairly" principle, which underlies many of the regulator's rules.
A spokeswoman for the FSA said: "We are not a price regulator. The key features document [given to investors] sets out what the annual charge is, what the benchmark would be and the performance fee on top of that, so that the customer can work out what it is. If there is something opaque in the contract, we would ask if it is a fair, level playing field."
John Chatfeild-Roberts, the chief investment officer at Jupiter Asset Management, said: "Performance fees are common practice within the absolute-return fund sector and we have structured the combined annual management fee and performance fee to be competitive in its sector. It is people who make the difference in fund management and it is not unreasonable to expect to pay more for the relatively few exceptional fund managers in the business.
"We believe that Philip Gibbs is one of those managers," he added. "The most important consideration in this debate is the return that investors are receiving after charges over the medium term and it is this outperformance that we are focused on and which only the most talented fund managers can deliver."
A spokeswoman for Jupiter said that her company's fund brochure offers a full technical explanation of how its fees work, adding: "Our overall performance-fee structure is, we believe, competitive within its sector."
However, not all financial advisers are opposed to performance fees. David Scott, a financial consultant at Alan Steel Asset Management in Linlithgow said: "Fees are one of the things you assess. But all fund managers go through a period when they underperform. If clients are aware of all the potential fees at the outset, they should have no qualms about it. Also, most managers have a lot of their own money in the funds they look after, so it is in their interest to make it work."
Your questions answered
How do performance fees work?
At its simplest, a fund manager will set a "benchmark" or a "hurdle" which it has to beat in order to receive a top-up fee. This is in addition to the standard annual management charge, itself generally between 1.25 and 1.5 per cent.
What kind of benchmarks are used?
The benchmarks used vary according to the fund. For example, Jupiter's Absolute Return fund, along with others from BlackRock and Liontrust, uses the three-month sterling Libor rate, the rate at which banks lend to each other. It currently stands at 0.44 per cent. Other funds will use share price indices, such as the FTSE All Share index, the MSCI World Equity or the FTSE First 300 index.
How much is the performance fee?
Any performance above that hurdle or benchmark is rewarded by a rise in the overall fee payable to the fund manager. This is usually set at between 15 and 20 per cent of any outperformance.
How often is the amount of performance fee assessed?
It is taken from an investor's fund once or twice a year. But the sum is calculated daily in small amounts and will often be "crystallised" every three months.
What happens if a fund's value falls?
Most funds operate a "high-water mark", above which performance fees are paid. This means, for example, if a fund falls in value over three months and then rises again next quarter, the manager cannot book a second set of performance charges. Instead, the fund must increase above the previous high-water mark before new fees can be levied.
If a performance charge is taken, is it repaid if the value of the investment falls subsequently?