Great idea, shame about the rules

Payment by results: everyone from teachers to football players is having to live with this kind of market discipline. So it is sensible, isn't it, that fund managers, whose business depends on making us rich, should be paid according to how well they perform that task?

The answer is only a qualified yes. Performance fees are a Good Thing which every fund manager should have. But, to be worthwhile, they have to reward good performance, penalise bad, and have safeguards which prevent them becoming too large a burden on the fund. That is harder than it sounds.

Take the examples of two technology trusts, Henderson Technology and Finsbury Technology. Both have been excellent investments, turning £100 into more than £500 in less than five years. Both have performance-related fees which are producing generous rewards for their managers. Brokers Merrill Lynch estimates that Henderson could have accrued more than £40 million in performance fees for the year which ends today, while Finsbury earned more than £10 million in the year to last November. But, the fees owe at least as much to the boom in technology shares as they do to the managers' skills. And neither fund has any limit on how far the fees could rise.

To be fair, that is not the managers' fault. When the two trusts were launched in the mid-1990s, there was no global technology index. Both, therefore, chose general international benchmarks such as the FT or the MSCI world index. Not surprisingly, they have beaten those benchmarks. But Merrill Lynch attempted to construct a global technology index - a difficult exercise - and both have done little better than keep pace with that.

The fees would have been less eye-popping if there had been a cap - the recently launched 3i European Technology, for example, puts a ceiling on its fees of 1.5 per cent of net asset value. But, when the trusts were launched, investors thought that the technology boom was over - both funds had to work hard to raise their money. No one was predicting the run of the last six months so a cap seemed academic. The trust's major shareholders are not complaining about the fees: after all, they have done at least as well as the managers.

But the directors of the Henderson trust are considering whether the current performance criteria are appropriate and Finsbury is likely to be thinking along similar lines. But, as Andrew Close of Finsbury's managers points out, if it changes to a technology index as its benchmark, it could be accused of altering the rules to suit itself - particularly if technology shares continue to underperform.

The issue is less with the fees paid to these trusts than with the structure of performance incentives in general. These must be measured against an appropriate benchmark - and if none exists, then there must be a question mark over whether a performance fee is appropriate. They must be capped. And they must penalise managers who do badly. Without all three conditions, performance fees could do more harm than good.