There's a better way to manage funds

The press is obsessed with bankers' bonuses. And rightly so. 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. Fund managers are supposed to make you money. They argue that their talents can deliver better returns than the stockmarket as a whole. In return, savers pay an annual fee. For most unit trusts this is around 1.5% of the value of the customer's fund. However, with a few notable exceptions, most managers fail to deliver an acceptable performance.

Why? Firstly, the fees. Say you invest £11,280 in a self-select individual savings account. You leave the fund invested for 30 years earning 6% a year. You pay a stockbroking firm a small, capped fee for looking after the 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 1.5% a year generates an equivalent pot of £41,169 34% less.

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That's bad enough. But what's even worse is the way that many managers invest your money. Fund management has become an asset-gathering business of epic proportions. By accumulating more funds, fund management firms make more money 1.5% of £1bn is a lot more than 1.5% of £500m. This allows fund management groups to pay big money to managers and financial advisers (in the form of commission). But it's not very good for our savings.

Why not? Because if asset-gathering rather than outperformance is the main goal, the managers' incentives change. To any sensible person, the biggest risk is losing money. To fund managers, however, the big risk is that they underperform the market and their peers (ie, their fund falls by more than the market does, or it fails to rise by as much as the market rises).

What this means is that lots of managers build a portfolio that is very similar in make-up to the index they are investing in. They will aim to beat it if possible, but their main goal is to avoid underperforming by large amounts. Underperformance means a loss of assets, income and probably the manager's job.

Just look at the top holdings of many British fund managers. More often than not you will see the names of Shell, BP, HSBC, GlaxoSmithKline and Vodafone the five biggest stocks in the market. 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, 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 dotcom 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.

So how could we improve things? By changing the way that fund managers charge their customers. Here's a system that would not only cost investors less, but would also align managers' interests with those of their customers, which should boost performance too. 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. 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 manager's income should come from performance fees. So managers 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 Buffett used when he ran his own investment business. He had to earn 6% a year before he was paid a fee. He kept 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 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. Better still, active managers would have to change the way they managed money. They would first focus on not losing money. And it would encourage them to concentrate on finding good businesses that were undervalued, rather than trying to mimic an index.

Of course, many managers would struggle under this model. But this would reduce the size of the overall business, and cut its costs, turning active fund management into a cottage industry, where it rightly belongs. There is no perfect fund charging structure. But what's clear is that current fees are too high. Under this model, most investors could still invest in cheap trackers with the option of paying for active management but at least they might actually get what they pay for.