You reap what you sow, so what do investors get for all the charges?

Many people may pay a premium for their fund management but receive weak returns, reports Sam Shaw

Shelling out: Investors aren't paying peanuts so they should expect a decent performance (AFP/Getty Images)

The old adage goes that if you pay peanuts, you get monkeys. But what about when the opposite applies, when you pay a premium but are only given peanut-like returns?

In a low-interest-rate environment, where returns on cash deposits are pretty pathetic – and, if our new Bank of England governor is to be believed, will remain so for at least another three years – there are questions to be asked about where you should put your money, and what it should cost.

At one end of the funds world are hedge funds, and their close cousins, using sophisticated investment strategies, often called absolute return funds, or some such variation. Many of these have applied what are referred to as performance fees, where the manager sets a target and if they beat it, you pay them more. These can vary in amounts and are often pegged to Libor, the rate at which banks lend to one another.

But there are plenty more ifs, buts, and maybes to consider.

Most performance fees are subject to a "high water mark" – this means the fund must exceed a certain size, or the performance fee will not apply. A manager whose fund is haemorrhaging assets will not be rewarded with a performance-related fee until they return the fund to its former glory.

Also beware the timeframe to which the fee applies. This is known as a crystallisation period, and can be quite short. In a world that often insists on longer track records "in the job" in order to judge whether a fund manager is skilled or just lucky, and simultaneously encourages investors to take a longer investment horizon, a quarterly bonus structure seems rather contrary and fails to lock in the talent you're paying for.

Hargreaves Lansdown research director Mark Dampier agrees, adding: "I have no problem paying for performance. I just don't like the way these are structured. A good manager will take in assets and, due to the annual management charge (AMC), as the fund goes up in size, they will make more money anyway.

But, Mr Dampier suggests, those who can actually justify charging an additional fee for performance are few and far between.

"Martin Taylor's Eastern Europe fund at Thames River has slaughtered the competition so there are exceptions to the rule. If you wanted to cap the fund you might design a different fee structure because you will be turning away money, so in some respects a better manager could warrant paying more."

Star status

It makes sense; after all similar approaches exist across most industries; lawyers, surgeons, or even hairdressers – the more experience you bring, the more expensive your services. But what happens when they move on? Jupiter recently announced its intention to remove the performance fee on its Absolute Return fund, as outgoing star manager Philip Gibbs prepares to hand the reins. Jupiter said it was stripping the fee to bring the fund in line with the rest of its range (bar one), adding the fund should fare better in the competitive Absolute Return sector, as the AMC remains at 1.25 per cent.

"We do not believe the price is the most important factor to consider when choosing investments," says head of UK retail PR Despina Constantinides. "If a fund manager produces outperformance over the medium term after charges, it is worth paying more for him or her."

But Gina Miller, founding partner at SCM Private, who also launched the Trueandfaircalculator.com in a bid to expose so-called hidden charges on investment funds thinks many charges are out of touch.

Sidestep the costs

To avoid higher charges, many investors are turning to passive funds, which track an index, but a closer look shows these may be as guilty as the more active players.

Of the list of tracker funds available to UK investors, the AMCs varied widely. At the higher end sat funds from Legal & General (1.25 per cent), while Virgin and M&S posted AMCs of 1 per cent. While the Legal & General Global Environmental Enterprises fund ran against a bespoke benchmark run by a specialist partner firm, the Virgin and M&S products simply represented the FTSE All-Share and FTSE 100, respectively.

Most other UK trackers, also running against straightforward FTSE indices, held AMCs between just 0.07 per cent and 0.5 per cent.

"Cost is important but not the only consideration," argues Virgin Money PR manager Jule Wilson. "Smaller investment amounts are costlier to administer and we've opened up the market to a whole host of people who previously would have been excluded from investing in the stock market."

But Mr Dampier believes people often prefer buying into a brand rather than cost and performance: "If you were to go to one shop and buy a can of soup, then you found the same can of soup somewhere else for half the price, you'd do something about that. For some reason in financial services we don't apply the same logic."

Many investors are turning to exchange-traded products for their comparable returns but delivered at a fraction of the headline cost. But Dennis Hall, managing director at Yellowtail Financial Planning, thinks the underlying dealing costs are too high, a result of being able to trade throughout the day, outweighing any outperformance or cost savings.

On the flipside are those funds which market themselves as actively managed, meaning the manager takes a deliberate view on the stocks held in their portfolio with little regard for whether these reflect the broader index or not. Active funds tend to charge more for this, but many are quite close in make-up and performance to their benchmark indices. These can be called index-huggers, or closet-trackers.

Trueandfaircalculator.com looked at funds over £100m in the leading domestic fund sector, UK All Companies, and stacked up three comparable charges. It compared their stated AMC (fund manager charge), their ongoing charges (such as investment management and administration costs) and the True and Fair cost. This last calculation combines the AMC, adviser charge, fee for any administration tool, and that of any applicable tax wrapper.

Of the 10 most expensive by True and Fair cost, their average AMC was 1.55 per cent. Ongoing charges were averaged at 1.762 per cent and the True and Fair figure was 3.21 per cent, over twice the headline charge.

It falls to the investor to decide whether they pay peanuts or premiums.