Encouraged by Bollinger, lobster and caviar, the chat among guests is of fat fees, healthy commissions and the best way to cash in on the latest stock market trends.

"It's the most lavish bash in the business," said a regular at the party, which is an annual reward for financial advisers, stockbrokers and friends of Perpetual, one of Britain's biggest unit trust companies.

Perpetual certainly has money to burn. The immaculate double-fronted Queen Anne house that serves as its corporate headquarters is a monument to corporate wealth. Furnished with antique walnut sideboards, marble fireplaces and a sweeping staircase, its walls are lined with antique paintings and engravings.

Martyn Arbib, Perpetual's chairman, founded the company in the 1970s. Today it manages more than £11 billion for 750,000 small investors with products such as Peps, Isas and personal pensions. Arbib is worth an estimated £485m.

Even by City standards, retail fund management is a profitable business. An investigation by The Sunday Times has found that top unit trust companies such as Perpetual, Jupiter and Schroders charge more for unit trust savings plans than some insurance firms do for 25-year endowment policies, which have been widely criticised for their cost.

Worse, they - like their colleagues in the insurance industry - are raking off billions of pounds from investors' funds in undisclosed "dealing fees". Charges levied on a typical unit trust are so high that the firms running them pocket half of every pound's worth of investment growth they achieve.

Nick and Bolla Tulip are typical of the 16m Britons who have money invested in the stock market. Like most ordinary investors, they lack the time, expertise and inclination to manage a portfolio of shares. Instead, they have invested in unit trusts and other collective funds through Peps and Isas.

Their money has helped the unit trust sector to boom, with the value of funds under management leaping from £36 billion in 1987 to £254 billion today.

Like almost all the estimated 4m Britons with holdings in unit trusts, the Tulips were told that there were just two charges to pay: an initial charge of between 5% and 6% and an "annual management fee" of between 1% and 1.5%.

The initial charge, they were told, was to cover the cost of setting up the investment, including their adviser's commission. The annual charge - which has the greatest long-term impact - paid for the fund's day-to-day running and included the manager's profit.

"We were told that unit trusts were competitively priced and much cheaper than endowment policies," said Bolla last week. "We were reassured because the charging structure appeared to be simple and transparent."

Unit trusts are, however, not competitive, simple and transparent. The Sunday Times has discovered that, like the life assurance industry before it, the unit trust sector has been quietly lifting its charges to mop up the tax breaks the chancellor intended for investors.

Such is the scale of the cover-up that the charges which all fund managers must disclose under Financial Services Authority (FSA) rules amount to only half the true cost.

Under a little-known FSA exemption, firms do not have to reveal dealing costs. Kevin James, a senior FSA economist, said: "It is unfortunate, but our disclosure regime does not currently reveal the full extent of the charges investors are subjected to. When a unit trust manager tells you that a typical fund's total annual charges and expenses amount to around 1.4% a year, what he should say is about 2.7%.

"That equates to an extra £3 billion being taken from investors' funds each year by the unit trust industry. Life assurance and pensions companies have the same problem."

These missing billions are accounted for by what fund managers refer to as "dealing fees" - the money they pay brokers for buying and selling shares.

FSA experts believe that on a typical unit trust these fees equate to an extra annual charge of 1.3% on the fund. But nowhere is this extra charge disclosed to investors. Instead, it is quietly subtracted from the trust's annual investment performance.

"Every time a fund manager dips in or out of the market more of these charges accumulate," admitted one unit trust insider. "None of it is disclosed to investors, most of whom assume - not unreasonably - that such costs are covered by the manager's disclosed 'annual management fee'."

The situation becomes even murkier when the incestuous nature of the financial services business is examined. No fool-proof checks are made to ensure that unit trust managers do not exaggerate the cost of their undisclosed dealing fees. Often a stockbroker that is used will turn out to be another division of the same company.

Backhanders, or "soft commissions", are also allowed by the regulators. "Soft commission arrangements are common between fund managers and stockbrokers," said Justin Urquart Stewart, a director of Barclays Stockbrokers. "Basically, it is payment in kind in return for the fund manager giving the broker his business."

James, a former official of America's Securities and Exchange Commission, is the first insider to blow the whistle on the scandal in Britain. In a little-noticed paper earlier this year, he concluded that in order to invest £1 a private individual must spend £1.50. James ex-pected the 50p difference to be accounted for by the charges fund managers are obliged to disclose. Instead, he found disclosed charges accounted for little more than half of it.

James's calculations have been checked by the FSA and a host of independent experts. The undisclosed charges levied by unit trust managers amount to an extra charge on small investors of about £3 billion a year. If fund managers in the life assurance and pensions industry are included, the total bill for undisclosed dealing fees exceeds £10 billion a year.

Because unit trusts are popularly regarded as offering much better value for money than insurance products such as endowments, their spread has been encouraged uncritically by most financial commentators and politicians. The government is so enthralled with unit trusts that its new stakeholder pension has been designed around them.

However, a question mark now hangs over the decision by Gordon Brown, the chancellor, to continue encouraging investment in unit trusts through tax-free products such as Isas and personal pension plans.

Documents produced by the FSA and passed to The Sunday Times show the average unit trust savings scheme is now even more expensive than the average endowment policy - a product so widely derided that it is considered a joke by most financial commentators.

The comparisons reveal that the disclosed charges on the average actively managed unit trust savings schemes are now nearly 20% higher than those for a typical endowment policy over 25 years. An investor putting £100 a month into both schemes would see the endowment deliver £2,604 more than the unit trust after 25 years, assuming investment growth of 7% a year.

"The annual charges on unit trusts have been creeping up because the people who sell them are being paid more commission," said one FSA expert.

Further evidence that unit trust managers are ripping off small investors comes in comparisons with their American equivalents. A second survey conducted for The Sunday Times shows British consumers are being charged about 20% more than Americans.

Among the most expensive British unit trusts are those sold by the most respected City names: Premier Asset Management, Global Asset Management and Jupiter International - the latter part of a group of companies that employs Lord Lamont, the former Tory chancellor.

Another who has made a small fortune out of the unit trust boom is the Tory MP Howard Flight, a shadow Treasury spokesman. Flight, a director of Investec Asset Management, and Arbib, of Perpetual, play down their companies' charges, arguing that these are of little consequence if investors get a good return on their money. Why worry if our experts can make more for you by investing wisely, they ask.

This does not wash. As dozens of academic studies have repeatedly proved, it is luck rather than managers' expertise that causes some funds to do better than others.

The FSA made the point earlier this year when, after reviewing all the literature, it concluded: "Past performance is of no use in predicting future performance . . . repeat performance (if there is any) is both small in size and short-lived."

William Sharpe, finance professor at Stanford University in California and a Nobel prizewinner for his work on the economics of the stock market, believes most investors should reject active unit trusts. Instead, he says, they should buy index tracker funds that replicate the stock market's performance and have charges that are up to 75% lower.

"The laws of arithmetic have been suspended for the convenience of those who pursue their careers as active managers," he said.