Many funds offer a terrible deal.
Performance can be disappointing, costs and charges can be too high, and incentives are too often skewed in favour of management firms rather than the end client.
It should be no surprise that cheap tracker funds have been a runaway success and the Financial Conduct Authority has targeted the fund management industry for greater scrutiny.
The solution is less obvious. In principle, linking fund fees to performance has intuitive appeal.
Unfortunately ‘performance fees’ have developed a dreadful reputation thanks to a history of poorly designed fee structures that have only served to enrich managers without enhancing outcomes.
The infamous “heads we win, tails you lose” proposition has meant that relating fees to real results, in which managers are only paid for delivering outperformance, has taken on some toxic connotations.
The industry’s standard pricing model is not much better.
Charging a fixed percentage fee regardless of the value added by a fund’s manager incentivises a slew of poor behaviours, ranging from benchmark hugging to asset gathering, even if it comes at the expense of performance.
In a perfect world, a client would pay no fees until they redeem, at which time they would pay the fund manager for an amount proportional to the total value added.
In the real world, however, managers have bills to pay, which makes such an idealised structure unrealistic.
Some fresh thinking is needed to fundamentally improve the deal that advisers and their clients can expect.
Rather than focusing solely on the fee paid, the industry should be looking at creating a fairer, more attractive deal which better aligns the interests of fund managers with the end client.
A new deal could, and should, include refunds when performance falters, better incentives, co-investment alongside clients and a focus on transparency.
The good news is that real innovation is starting to happen, with the advent of fee structures with far more sensible incentives than the performance fees of old.
Some of the better examples include a ‘zero fee’ component in which managers get nothing if they fail to deliver value.
A fund fee structure that is truly related to results, with managers receiving no fee for underperforming a benchmark, is far fairer for clients.
This is precisely the message that Japan’s mammoth government pension scheme sent to its external investment managers last year.
It is an incredibly powerful move because it shifts the ‘fee risk’ onto the investment management firm instead of the client and their ultimate beneficiaries – in this case Japanese pensioners.
What’s also remarkable is that its £1.4trn heft has helped shift the debate to the mainstream.