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The Art of Evaluating Investment Manager Fees

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by David Remstein
JPMorgan Investment Analytics and Consulting
david.m.remstein@jpmorgan.com

Investors focus on gross returns when evaluating and comparing the performance of investment managers. However, the timing and amount of fees paid can have a material effect on each manager's ultimate contribution to a pension plan or other institutional portfolio. In our view, investors would be well-advised to analyze net returns to gain a complete picture of any manager's contribution to bottom line results.

Gross of Fee vs. Net of Fee

The universal process of evaluating investment manager performance normally centers on gross returns. The gross-of-fee return is important because it isolates the manager's ability to manage assets with no fee impacts. The resulting comparability of returns permits investors to cross-compare manager outcomes on a fair basis. Net-of-fee returns cannot be blindly applied across all investors since the fees assessed will vary materially from investor to investor as the assets under management vary. In addition, the very largest clients are able to negotiate lower fees more readily than smaller clients.

Net Returns do play a vital role. Net results tell you how much is left in your pocket after all the overhead is discharged. The size and timing of the fees have a profound impact on the final bottom line. The raw unapplied expense ratio almost never reflects the real expense impact.

Illustration

Consider a portfolio with an 18.37% gross return and a 1% stated expense ratio. The investor's real experience will be a product of when the expenses are applied and how much is discharged per application. In the chart below, we illustrate gross and net returns based on four timing schemes.

Comparison of Gross and Net Returns

Source: JPMorgan estimates.

As shown above, the net fee impact can vary from 1.00% to 1.17% based merely on the timing of payments. Ultimately, the net return varies from 17.37% to 17.20% based on the payment scheme.

What is usually unappreciated in comparing gross and net returns is the compounding effect that occurs when linking periods. Under compounding, the timing of a fee can have a very substantial impact on the final size of net performance. Of course, the actual percentage impact will also be affected by market conditions.

The returns series are affected materially by simple market movements and the contractual decision on when and how to pay expenses. On the one hand, an argument could be made by the investor for paying the entire fee as late as possible. On the other hand, the manager may prefer to receive most of the fee early and thus shift more risk to the investor. In any case, the investor should avoid paying all expenses upfront in the first period since the fee impact would be the largest at that time.

Conclusion

Net-of-fee returns are useful as a rough directional indicator of what returns to your pocket. The focus of manager investment evaluation should rely on the gross return. Also, investors should utilize the net expense dollar amount for informational purposes.