Why you should steer clear of venture capital trusts

You want to save yourself a bit of tax? Well, of course you do. Tax is the greatest personal wealth destroyer there is. So you do all you can to pay as little of it as possible. You put money into your pension. You use your full Isa allowance. You buy Aim-traded shares that are exempt from inheritance tax and stamp duty. And you think about investing in things such as venture capital trusts (VCTs) and enterprise investment schemes.

But here's a question for you. How much of any tax you save are you prepared to give up in fees to the guy who structured the tax-saving product?

With Isas and Sipps you don't have to worry too much about this you don't pay much extra for the wrappers and transparency is gradually competing prices down anyway. The tax saved goes directly to you. But look to the rest, and it is another matter altogether.

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VCTs were designed to encourage UK investors to invest in unquoted companies. You hand over up to £200,000 and you get 30% income tax relief on it; any dividends come tax free, and if you hold for five years, capital gains do too.

For investors the attractions are obvious. UK tax rates are high and likely to get higher and the amounts we can save into pensions are being cut.

But put money in a VCT and, once you have added up the reliefs, you can afford to make a great deal less on the investment than you would have on a regular investment, but still be better off.

Say you expect to pay £70,000 in income tax this year. You invest £200,000 in a VCT. You can claim £60,000 back straight away an instant effective return on your money of 30%, courtesy of HMRC.

For providers, the attraction is also more about the structure than the product. They know you just made 30% for doing nothing. And they know that you have to stay with them for five years to keep it and that as long as you stay ahead, you either won't mind or won't notice that you're sharing your 30%. That puts them in a better position than most fund managers to fleece you.

So to the charges. Most VCTs come with management fees of 2-3% a year. They also have initial charges of about 5%t, though platforms may discount some of this.

Then there are 'normal annual running costs'. Add up the management costs and the other 'normal' costs and it can come to 3.5%. Next there are 'arrangement fees'.

You may think that arranging investments should be covered by the annual management charge, but it isn't. There is a fee of something like 2% for each investment actually made.

You get the picture. Over five years, all this is going to eat up close to the 30% you saved on income tax. The running costs alone will do over half the job.

But you'll have made loads of money, right? Not necessarily. Average VCT performance isn't madly impressive. Even if it is, we must look to the performance fees that are the icing on your manager's cash-take cake. I get a lot of complaints from readers (note to industry: my readers are your clients) about this.

A recent one concerned VCT manager Albion Ventures. Last year, at the same time as proposing a sensible merger between two of its funds, it suggested that the incentive arrangements for the managers be changed.

One of the funds had a performance fee that was to pay out at a rate of 20% of any rise in net asset value above 8% in any one year, providing that the firm's net asset value was above its launch value. Now, I hate all performance fees, but this one did at least have the virtue of being relatively difficult to achieve.

The managers clearly thought so too. So they changed it to RPI (retail price index) plus 2%. I hardly know where to start with this.It's less than a bank account offers in normal times.

Performance fees are supposed to be paid out for genuinely superior performance, but for an investment as risky and volatile as a VCT, 2% over inflation isn't superior. It isn't even acceptable. For that kind of risk, you should be insisting on inflation plus 5-6%.

I asked Albion about this. They were helpful. They said they know it is a "sensitive issue". So, to "help" shareholders, they aren't now going to take 20% of the "excess performance" should they ever improve performance enough to hit even their newly enfeebled targets. Only 15%.

Albion's definition of what is and what is not exceptional is not, I'm afraid, an outlier. Another reader writes in to complain about a ProVen VCT. It has a complicated performance fee, but it boils down to the managers having to produce a total return of about 26% from the level of net asset value in 2011 or a return of the base rate plus 1% from the same start date whichever is greater.

I think we can all agree that 26% is a perfectly reasonable hurdle over the medium term, but it is worth noting that if the UK base rate ever normalises (if), it wouldn't take too many years before the base rate plus 1% was more than 26%.

It's still not the long-term inflation plus 5-6% that I think makes sense at this kind of risk level. Note that you can get 3% on a five-year fixed-rate cash Isa with Leeds Building Society for no risk at all.

One day someone will set up a good VCT. Its prospectus won't justify high and complicated fees by blathering on about "industry norms" and "normal VCT practice", but will be set out in a clear and comparable way.

There won't be a performance fee based on matching cash Isas. And it will be sold on the basis that the investments are exciting, rather than on the basis that it will save you tax. On that day, investing might be a good idea. Before then, I'd steer clear.

A press release out this week said funds were pouring into VCTs as investors "become much more comfortable with the sector". That may be so. But anyone becoming comfortable clearly isn't reading the small print.

This article was first published in the Financial Times.

This article was adjusted on 24 February 2014 to add more detail on the ProVen VCT fee structure. If you want more detail, you can read all about it on page 26 here.