The structure of performance-based fees is increasingly coming under fire.

Investors who put money into hedge funds, long-short equity funds or other alternative assets in recent years are almost certainly paying too much in investment-management fees.

A couple of research reports highlight the excessive performance fees managers of these types of funds charge and warn that investors will lose much of the increased return they hope to make as a result of the fees.

The head of investment consulting in Australia at Towers Watson, Graeme Miller, says one outcome of the bull market from 2003 to the end of 2007 was that it brought a large number of new investment managers into the field and encouraged the development of an increasingly exotic array of investments.

Miller says there was increasing demand for hedge funds, private equity and other alternatives. Such funds typically charge a higher base fee - up to 2 per cent a year - and performance fees of 15 per cent to 20 per cent of any return over a hurdle rate.

Consultants such as Miller divide market returns into alpha and beta. Beta is the return the market produces; an index equity fund is all beta. Alpha is the return above the index that can be attributed to manager skill.

In a rising market such as the bull run up to the end of 2007, it can be hard to separate the alpha from the beta, especially for small investors who do not have the analytical tools of institutional investors. Investors see good returns and are happy to pay extra fees, believing their manager is achieving the claimed alpha.

Miller says in most cases the main driver of returns in that period was the strength of the markets, not the skill of the managers. He says in many cases managers achieved high returns by using leverage (derivatives and other forms of gearing). "Anyone can use leverage. You don't pay high fees for that," Miller says.

Towers Watson's view is investors paid alpha fees for beta performance. During the past two years the high market returns have become harder to achieve but managers are still charging high fees.

According to Towers Watson, investment management fees went up 50 per cent in the five years to 2008.

Another consulting group that believes fees are too high is van Eyk. Last month it put out a report that is critical of "excessive performance fees" charged by Australian long-short equity managers.

A long-short fund manager can short-sell stock as well as use the more traditional buy and hold strategy (go long).

Van Eyk's view is different from Towers Watson's; it argues that long-short managers have added value but it says investors are giving away too much of those higher returns in performance fees. Van Eyk analyst Chris Bigg says the outperformance of the group of managers he surveyed was 7.7 per cent over equity market benchmark the S&P/ASX 300 in the year to September 30, 2009. He says the longer-term record of long-short managers has also been good.

What Bigg and Miller agree on is that managers must be able to clearly demonstrate that outperformance was due to manager skill and they must set appropriate hurdles for the payment of performance fees.

Bigg says: "The majority of the hurdle rates we looked at were unacceptable. If a fund manager has a core equity fund with a goal of beating the index by 2, 3 or 4 per cent, then the extension [long-short] manager should set the hurdle rate at that target level, if not higher. Instead, many of them set their hurdle at the index return.

"Let's say the extension [long-short] fund produces a return that is 4 per cent above the index and the performance fee is 15 per cent of the return above the index. Then the performance fee would knock the return down to 3.4 per cent before the investor has paid the base fee. You would be better off staying in a core fund, not paying performance fees and not exposing yourself to the extra risk."

Miller says: "Hurdle rates will be different depending on the objectives of the fund. What we say is that the hurdle rate should be significantly in excess of what can be achieved without much risk. A hurdle set at the cash rate is unacceptable. What we see too often is managers being rewarded for taking risk, not for exhibiting superior skill."

He says the way performance fees are structured encourages investment managers to be risk-takers.

"Performance fees have what we call an asymmetrical pay-off. There is no limit to the performance fee the manager can earn if the fund does very well, so the upside is uncapped. The downside risk for the manager is limited to the base fee.

"The more volatile the performance of the fund, the greater the option value of the performance fee. That structure has the potential to encourage managers to take excessive risk."

Miller says Towers Watson has been working with its clients to reduce fees and has had some success. But for many investors the issue is still one that needs to be addressed.

Avoid sky-high fees

Investors should be convinced that high returns have been achieved as a result of the manager's skills.

The performance fee should have the following features:

An appropriate performance hurdle: if the manager is paying itself after performance exceeds the relevant equity index or the cash rate, the investor will end up giving away too much performance.

High-water mark: the manager does not receive performance fees until previous underperformance has been recouped.