Should the dispersion which is shown on a GIPS presentation be based on net or gross of fee returns?
Excellent question, I believe. The Standards, to my knowledge, don't address this nor have I been able to find any Q&As on it. And so I would say that it's "open to interpretation." In reality, it really shouldn't matter that much, assuming that the fee percentage is relatively consistent across the period, we wouldn't expect to see much in the way of a difference between the dispersion for gross or net-of-fee returns. The differences would be de minimis.
Must you disclose across which return it's measured? There is no requirement to do this, though it would probably be advisable. Since you probably have a statement in your disclosures which reads something like "Dispersion is calculated using standard deviation," to amend it with "Dispersion of gross-of-fee returns is calculated ..." wouldn't be difficult.
What would I recommend the dispersion be relative to? Gross-of-fee returns. I place little benefit in net-of-fee returns as they don't provide the same value to the reader as the gross returns (because most firms have a mix of fees in place, so the net return is difficult to decipher; one can always take the gross return and adjust it by the fee they expect to pay to arrive at the approximate net return they would have had). But again, it's up to you to decide.
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There's an old saying about investments: "It's not what you make - it's what you keep." This was originally applied to municipal bonds, indicating that the return you retain after taxes is what really matters to investors. This is true, not just for bonds but for all of one's investments.
ReplyDeleteKnow what this statement also applies to? FEES! After all, the gross return of a manager is an abstraction and a distraction. What matters to clients is how their wealth grew. This is by definition a net of fees question, and it requires a net of fees answer. All this talk about complexity is exaggerated and misplaced. Managers report net fees for mutual funds every day so it's not really complicated.
Interesting that net fees are reported when that is the return that's required, but managers report gross fees when they can get away with it. The honest answer to THE CLIENT'S REAL QUESTION is the net return. An even better answer is the net return after taxes. The best answer is the net return after taxes and adjusted for inflation, or the "real, after-tax net return."
If we really intend to serve the client and act with integrity, then this is the return we will show to clients. Why waste time trying to rationalize anything else?
Steve, I agree ... net-of-fee returns is best for the investor. But for a prospect, if the net-of-fee return is a mix of fees and is therefore not clear as to what it would be for the prospect, I would argue for gross-of-fee returns along with the fee schedule. The prospect can then derive what their net-of-fee return would have been.
ReplyDeleteDefinitely an interesting point, though. As you no doubt know, the SEC requires net-of-fee for mutual fund returns and for separate account returns when being shown on more than a one-on-one basis. The FAF (Financial Analysts Federation) originally wanted to mandate gross-of-fee returns (1986), but the SEC jumped in and said "sorry, but this aint gonna happen." Therefore, the AIMR-PPS adjusted to the SEC requirements. GIPS, of course, isn't beholden to GIPS, though SEC-registered firms who claim compliance are.
I agree that a variety of fees would be confusing to prospects. However, there is only one management fee that a money manager uses, and this usually reflects a "sliding scale" depending on the size of the client's account. There is no complexity involved; the manager simply charges each level of investment at the appropriate fee and then summarizes the client's total fee (e.g. 50 bps on first $50 million, 35 bps on the next $50, 25 bps on all additional amounts.) Each client has only a single amount allocated to the prospective manager's product, and it is the manager's responsibility to show the fee in basis points and to calculate the net returns. In reality, the accounts fall into just a few categories or "buckets" with a single fee for each bucket. There is not an infinite number of categories; there might be half a dozen at most. The manager simply needs to show the appropriate net return to the client. With this in mind, the issue of complexity seems more of an excuse than a justification for showing unrealistic and unrepresentative gross returns to clients.
ReplyDeleteBy the way, the same is true for benchmarks. No one invests in benchmarks for free; index products carry costs. These costs vary by product, with highly standardized index products (such as an S&P 500 product) having fees in the 10 - 20 bps range (for very large institutional sized accounts) but substantially higher fees for more complex and illiquid indices (70 bps being the cost for emerging markets equity.) Again the question is: why do we show gross returns for indexes, unfairly biasing against active managers? One can justify gross returns on indexes since there truly are a variety of fees that might be paid. But once again, an individual client knows which index product would serve as a proxy for a market segment, and could use the appropriate net returns so that the true "opportunity cost" of active management is measured.
It seems to me that all of the wasted time and effort that is currently invested in the rather diminimus aspects of GIPS, or in efforts to calculate attribution daily, or to investigate the impact of every security in a portfolio, or in abstractions such as linking algorithms - (whew!) would be better spent in simply reporting to clients the true return that they have earned (net of fees and taxes, and then adjusted for the impact of inflation) and doing the same for the market benchmark.
Steve, again, no disagreement. But mixing what we report to clients with what we report to prospects is the issue I am addressing from a fee perspective. A net-of-fee composite return which is based on a mix of fees, where we have no idea what the weighted average fee is (which was a requirement under the AIMR-PPS to show when showing net-of-fee returns) provides us with a return which is a bit of a mystery. It isn't that hard to derive the appropriate NOF return for the prospect, once we know what their fee will be. And for client reporting, yes, NOF is the way to go.
ReplyDeleteInteresting point about indexes; yes, there's an imbalance. If one WERE to invest in an index, their fee would presumably be lower than what they're paying to the active manager, and backing away what the likely fee might be (e.g., 15 bps) would provide a more realistic comparison. And of course there are no transaction costs in the index, but even an index manager has these expenses, so the comparison is biased even further. Great points! Thanks!