How to slash fund managers' fees

The mainstream media seems obsessed with the size of bankers' bonuses. And rightly so. As I discussed here, investment bankers earn poor returns for shareholders while taking large risks.

Yet another key part of the City machine that deserves just as much criticism largely escapes attention. I'm talking about fund managers - the people who manage our savings pots and retirement funds. They are another bunch of supposedly talented people who get paid too much money for delivering too little.

High fees are bad for your wealth

Fund managers are supposed to make you money. Not only that, they argue that their talents can deliver better returns than the stock market as a whole. In return for this, savers pay the managers an annual fee. For most unit trusts this is usually 1.5% of the value of the customer's fund.

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However, while there are some notable exceptions, most fund managers fail to deliver acceptable performance year in, year out. This is down to two key things.

Firstly, the excessive fees. Let's say you invest £11,280 in a self-select individual savings account (Isa) in April 2012. You leave the fund invested for 30 years earning annual returns of 6%. During this time, you pay a stockbroking firm a very small, capped fee for looking after your fund (collecting dividends etc). At the end of 30 years your pot has grown to £61,940.

A fund manager delivering the same performance but charging a 1.5% fee every year generates an equivalent pot of £41,169 34% less. In fact, we are underestimating the difference here, as fund managers also pay lots of other costs (such as the cost of buying and selling shares) that lower the returns to investors even further.

Managers don't do their job very well either

That's all bad enough. But what's even worse is the way that many managers invest your money. You see, fund management has become an asset-gathering business of epic proportions.

The rationale for acting this way is very simple. By accumulating more funds and multiplying them by an annual fee they make more money a percentage of £1bn is a lot more than a percentage of £500m. This allows them to pay big money to fund managers, but it's not very good for our savings.

Why not? Well, once asset-gathering, rather than outperformance as your main goal, your incentives change. Rather than beating the market, or delivering a positive return, fund managers just focus on beating each other.

To any sensible person, risk relates to the chances of losing money. To fund managers, however, it is underperforming the market (ie falling by more than the market falls, or failing to rise by as much as the market rises). What this means is that lots of fund managers build a portfolio that is very similar in make-up to the market they are investing in.

They will aim to beat the market by a small amount if possible, but their main focus will be on avoiding underperforming by large amounts. Underperformance means a loss of assets, income and probably the fund manager's job.

Have a look at the top of holdings of many UK fund managers. More often than not you will see the names of Shell, BP, HSBC, Glaxo and Vodafone the five biggest stocks in the market. It's not always the case, but most of the time, this is a signal that the fund is a very expensive closet index tracker.

And what exactly is the fund manager tracking? If you're talking about the UK, then it's going to be the FTSE All-Share. And that's an index that is heavily concentrated in a few stocks and a few industries such as mining and natural resources.

It also means buying shares when they are at their most expensive, and thus riding high in the index so you'd have piled into a basket of worthless dot-com shares at the end of the 1990s, for example. Far from being risk free, this looks like a very bad way to manage other people's money (it is also one of the main arguments against buying traditional index funds).

Replicate these strategies across thousands of funds and you get the main reasons why most professional investors offer poor value for money. There has to be a better way.

A new proposal for the active fund management industry

There's a better way for fund managers to charge their customers. It will not only cost investors less, but will change the way that professional investors manage our money. Their interests will be aligned with their customers they will only get paid if they make money.

Here's how it would work. Firstly, fund managers should not be expected to work for nothing. They incur costs on our behalf for administering funds that need to be paid for. This is what you pay for when you invest in a self-invested personal pension (Sipp).

For example, my Sipp charges a fee of 0.5% of the fund's value, capped at £240 per year. The beauty of this is that you do not pay more just because your fund keeps growing past a certain point in this case above £48,000. All investors should therefore pay a modest, capped administration fee.

The remainder of the fund manager's income should come from performance fees. So they would only get paid if they make money for their investors. By far the best example of an appropriate fee structure I've seen is the one Warren Buffet used when he ran his own investment business.

In this case, he had to earn a 6% return annually before he was paid a fee. He would keep 25% of any return above 6% subject to an agreed maximum. So, if the fund returned 10%, the investor would get 9% and Buffett 1%.

On top of that, any returns below 6% would have to be recovered in future years before the manager could take a fee. The fund manager would also have to invest a significant sum of their own money in the fund.

This seems like an honest and fair way to charge customers, but there is a more powerful impact to consider. To adopt this fee structure, active fund managers would have to change the way they managed money. They would first focus on not losing money. Secondly, it would encourage the managers to concentrate portfolios in good businesses that were undervalued rather than trying to mimic an index.

We think that very few active fund managers could adopt this strategy because most are not good enough to do so. It would turn active fund management into a cottage industry - where it rightly belongs - without the huge infrastructure and costs that presently exist.

Of course, there is no perfect fund charging structure. But what's clear is that the current ones are too high. Under my proposal, the active fund management sector would shrink dramatically. Most investors could still invest in cheap tracking funds with the option of paying for active management but under this structure, at least they might actually get what they pay for.