Many investors do not realise how growing competition is radically transforming the way the fund management business is run

INVESTMENTS

What are the lessons of this week's Morgan Grenfell affair? As with all such scandals, the full story of what went wrong - prompting the regulators to move in and suspend three of its unit trusts - has yet to emerge. But it is clear already that it is bound to lead to some tightening of the rules governing how unit trusts are managed and regulated. It has also brought into stark relief the problems which the fund management business is creating for itself with its growing, dangerous obsession with shortterm performance.

It is not entirely a coincidence that Morgan Grenfell's problems should stem from its best performing unit trust. Its European Growth fund was not only the biggest fund its unit trust division managed, but also its most successful. It attracted a huge following precisely because its record appeared so good.

In the five years to the end of last year, it was ranked as the best performer out of more than 110 unit trusts investing in the European sector - by a remarkable margin. pounds 100 invested would have nearly doubled in that time. None of its rivals managed more than 50 per cent growth over the same period.

What the investigation at Morgan Grenfell is about is how it achieved that record. Peter Young, the 38-year-old high-flier who took over the running of the fund two years ago, had managed to keep his place at the top of the performance rankings, but only - so it now appears - by adopting a high-risk and possibly illegal investment strategy. In apparent breach of the regulations governing how unit trusts may invest, his fund had at one point more than a quarter of its assets in unlisted securities, many in obscure Scandinavian companies. Unlike quoted shares, where the market price is always available, there is obvious scope for manipulation of the valuation of unlisted shares - which is why unit trusts are not normally allowed to have more than 10 per cent of their assets in unquoted shares. The implication of course is that the fund's performance may not have been quite as good as it had been made out to be.

Just as pertinent is the question of how Mr Young was investing his funds. The published list of his main holdings shows that he was adopting a high- risk strategy, investing heavily in speculative technology stocks and second-tier markets like Norway. This may or may not have been the most appropriate investment strategy: but for a mainstream unit trust, sold to 90,000 individuals, it appears unlikely. Most investors, one suspects, were sold the trust on the basis of its track record without enquiring too closely how it had been achieved.

Now we are finding out - and it should not be entirely a surprise that it seems to have been achieved through a distinctly high-risk approach. The sharp fall in European Growth's asset value this year, prompted by the falling value of several of its larger holdings, had already begun to expose the dangers in Mr Young's strategy.

Many ordinary investors probably do not realise how growing competition is radically transforming the way that the fund management business is run. It is hard to avoid the conclusion that it is creating dangerous conflicts of interest in the process. Unit trusts had sales last year of pounds 18bn. More than pounds 110bn of investors' money is now held in this form, compared to just pounds 20bn 10 years ago. If you assume an average annual management fee of 1 per cent - and many funds charge more - we are looking at a business which generates something like pounds 1bn a year in annual income for those who manage the funds, as well as hundreds of millions of pounds in commissions for those who sell them.

Morgan Grenfell itself only entered the business in 1988 - ironically, partly as a way of restoring its tarnished reputation after its involvement in the Guinness affair three years previously. It has since grown to be the seventh largest unit trust manager and one of the big five in pension fund management. European Growth alone accounted for 40 per cent of its unit trust funds under management.

One of the consequences of the industry's rapid growth has been the emergence of a cult of performance in which fund managers are deemed to be in a permanent state of competition against their rivals. As nothing helps to sell a unit trust more than a good track record, anyone who can put together a string of good performances is guaranteed to become a star - and be rewarded accordingly.

As a result, fund managers who can deliver above-average performance in their particular sectors are able to command high salaries and even transfer fees when they move - as they do increasingly - from one fund management house to another.

Whereas 10 years ago, fund management was still regarded as something of a backwater in City career terms, now it is one of the first places that ambitious young Turks head to try and make their name.

The turnover in the business is absurdly high: 50 per cent of fund managers in the unit trust business have been managing that particular fund for two years or less. Many manage several different funds at the same time. It is a high-stress, high-reward business. Nobody should be surprised if somewhere along the line the interests of the investor become subordinated to the interests of the fund managers themselves.

The moral for investors from this episode seem clear. It always pays to enquire where apparently superior performance comes from. Make sure that the funds you are buying are appropriate for the objectives you have as an investor. And don't assume that just because a fund is managed by an apparently famous and reputable house, it is immune from things going wrong. The sad lesson of recent events -from the Barings collapse to last month's announcement of a heavy fine for Jardine Fleming in Hong Kong - is that this conclusion can no longer safely be drawn.