One of the biggest enemies of investors is outsized fees. The higher the fees, the higher the required gross returns of the investment just to break even.
While investment returns are variable, fund managers' fees are known and a judgment can be made as to whether the fees are worth it.
At least, that was how it used to be when fund managers charged a flat percentage fee on the pool of money managed. But in recent years more funds have been launched with performance fees. Performance fees have superficial appeal. Who can argue that a fund manager should be paid only for performance?
The problem is with how the fees are structured. Some funds have performance fee structures so complex it is difficult to know how much will be paid and impossible for investors to compare with fees from other funds.
Researcher Morningstar has been doing a lot of work on performance fees; it says investors can pay more in total fees where there is a performance fee than if there is just a single flat fee, or base fee, charged as a percentage of the investors' money.
Fund managers are notorious for how they collectively herd around the sharemarket index.
Hugging or mirroring the index leads to fund managers buying overpriced shares in companies because they have large market capitalisations that contribute most to the performance of the Australian sharemarket.
Fund managers invest closely to the market to cover their business risk - the risk that investing away from the market and competitor funds leaves them exposed at the bottom of the performance tables if they invest with conviction and get it wrong.
Big managers have always been able to rely on their marketing and the financial planners they employ to keep the money coming into their funds.
But index hugging is proving harder to get away with because of low-cost market-tracking investments and tougher rules requiring more independence by planners in investment selection.
According to fund managers, performance fees better align the interests of fund managers and investors. Fund managers argue funds with performance fees should deliver higher returns and therefore more than justify higher fees.
But the complexity of the fees makes it almost impossible for small investors to know whether they are reasonable or not.
Typically, they will charge a performance rate of between 15 per cent and 30 per cent of the returns above the benchmark, which, for large-cap Australian share funds, will be the performance of the Australian sharemarket. But managers with performance fees almost always take a base fee as well. And some fund managers
with performance fees have
base fees that are actually higher than the base fees charged by managers without performance fees. It is double-dipping on fees rather than a genuine incentive
Most funds with performance fees do have a ''hurdle'' that the fund has to clear in addition to the returns of the sharemarket before a performance fee can be taken.
The hurdle is usually at least the base fee.
That's because it is the base fee that the manager gets paid regardless of performance and so the manager should at least recover the base fee with investment returns before taking performance fees. However, not all funds have a hurdle. There are yet further twists and turns that can catch out investors. Performance fees should only be paid after the fund has recovered earlier losses.
Otherwise, the fund manager could pay itself a performance fee for the current year even though it lost money for investors, relative to the market benchmark, in the previous year.
A senior research analyst at Morningstar, Tom Whitelaw, says in most cases it is the base fee that will be the most significant cost to the investor, because it has to be paid come rain or shine.
The typical base fee on large-cap Australian share funds without a performance fee is 0.9 per cent.
But Whitelaw says funds with performance fees have sightly higher base fees, on average.
''If you really want value for money, look for a manager which has a low base fee and therefore a real incentive to perform,'' he says.
''In our view, all funds with performance fees should also have lower base fees but this is seldom the case,'' he says.
Whitelaw says the ideal type of performance fee, because it is fair to fund managers and investors, is the ''fulcrum fee''. It a symmetrical fee that rewards fund managers on the upside but equally penalises them on the downside by reducing the size of the base fee.
The way a fulcrum fee works is that it can be paid only if the returns of the fund exceed the benchmark. But if the returns fall short of the benchmark, the base fee must be reduced.
In the US, any fund manager that wants to charge a performance fee to small investors has to have it structured as a fulcrum fee.
However, Whitelaw does not expect local fund managers to voluntarily adopt fulcrum fees.
''Unfortunately, current methods of charging fees are generally considerably more profitable for fund managers, so don't expect to see the adoption of fulcrum fees unless the regulator gets involved,'' he says.