Gross and Net of Fee Return Calculations

By David Remstein
david.m.remstein@jpmorgan.com

Performance Measurement is an integral part of institutional portfolio management and a key component in the manager selection and evaluation process. One key distinction in this process is the calculation of returns on a gross or net of fee basis. While there are some recommended industry best practices for these calculations, most plan sponsors are not required to follow one exclusive method. As plans are larger with a mixture of public and non-public assets, the performance calculations and fund accounting treatment should be designed to best communicate the plan’s performance and risk. This paper summarizes the key considerations for calculation options available to institutional investors, including pension plan sponsors.

The bedrock definitions are uncomplicated. Gross of fee means returns are calculated before the impact of fees. Net of fee returns adjust for fees in the calculations. In our opinion, plan sponsors can utilize both gross and net of fee calculations for various aspects of the portfolio management process.

Net of Fee Return Calculations

Net of fee performance is useful in the evaluation of actual performance at the manager and fund level. First, plan sponsors must determine which fees to include in the net of fee return calculation. The main fee types are: managerial, custodial and administrative. There are tradeoffs associated with which fees to include or exclude. The natural theoretical desire to disclose the most precise return possible must be weighed against costs to identify, categorize and process the fee data fields. In practical terms, management fees are usually the only fees that are large enough to have a material impact on returns.

The next decision point is where to place the fee impact. Fees could be reported at the manager level only. Treatment at the managerial level invokes the matching principal since the manager is connected directly with the fee for their advice. In evaluating historical performance of managers, it is usually preferable to focus on net of fee performance.

IAC offers various net of fee and gross of fee performance profiles in its Standard Report Package. The following is an excerpt from an actual monthly report generated on a manager, net of fees.

Another approach is to aggregate all the fees into one account and report the delta at the total plan level only. There is a practical caution to be aware of in applying the total plan approach. Private equity and hedge funds are normally reported net of fee. If the total plan level is to be the only level reporting net of fee, manual adjustments will be required to make hedge funds and private equity comparable with public asset class returns. The data consistency achieved may be at a high cost.

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Source: J.P. Morgan

In general, net performance returns reflect the real economic impact that a manager has on the overall performance of the fund. Netting provides the plan sponsor genuine insight as to the cost-benefit tradeoff of active versus passive investing. For example, in large cap core equity, the active alphas are usually so small as to not cover fees for active management. In addition, as long as manager fees are paid directly out of the fund, net reporting most likely would allow for greater consistency and completeness in reporting the cross fund results (i.e., all managers are providing net results and may not be reporting gross returns).  

Gross of Fee Return Calculations

Gross of fee performance is generally preferable for attribution, risk and other value-added reporting. Since the advent of Modern Portfolio Theory (“MPT”), plan sponsors typically evaluate managers on an alpha (value added) basis. Fees have already been disclosed prior to value added analysis. For most non-hedge fund or private equity portfolios, manager fees are already explicit in the management agreement so the sponsor already knows the cost impact when hiring that manager prior to any investment results. There is also a behavioral aspect to fees. When evaluating a manager, the fees’ magnitude in and of itself has no information value to signal or imply risk-adjusted value added. Thus when performing any quantitative analysis it is best to not incorporate fees into the analysis since the fee’s seemingly attractive or repulsive size may lead to false conclusions.

Additionally, gross of fee performance is usually preferable for manager selection and evaluation relative to a large universe of comparable managers. Importantly, return or alpha comparisons with another manager, a universe of similar risk managers, or across plans will be flawed and potentially misleading if fees are incorporated since fee magnitudes are generally scaled by asset size. Identical portfolios will always have the same gross return; however, their net returns are not the same since larger portfolios may pay less on a scale basis. Thus a larger portfolio could appear to be superior on a risk adjusted basis due only to its larger size and correspondingly lower fees.

Aggregating gross returns across a diverse asset class base can be problematic. Most non-public hedge funds, private equity, and commingled funds typically report only net of fee market valuations. Thus, plan sponsors may get a “mixed bag” of results when aggregation occurs at the plan level. This is generally not a problem for plans that have only small allocations to these asset classes. Nonetheless, plan sponsors need to be aware of how their future allocation weightings can impact their reporting needs.

Conclusions

If we assume the fund structure is built to allow both gross and net performance, it is reasonable to utilize both calculated performance returns for evaluation. The gross returns are suited for attribution and risk analysis. Even though net returns are not optimal inputs for financial economics and risk adjusted comparisons, net returns do address other kinds of questions. Net returns are a window into the health of the whole plan. They tell us what gain remains after all dollars for professional services have been expended. Performance reports should always disclose what calculation methodology is being utilized (e.g., gross versus net, accrual versus cash, etc.) and which fee types are included.