I was asked this question yesterday and thought it worthy of comment.
First, to clarify, "net" means after the fee is removed, while "gross" means before the fee is deducted.
There are generally two reasons we show IRR. First, in cases where the client controls the cash flows we show it to provide the client with THEIR return; that is, the return that takes into consideration not only the manager's performance but also the impact of the client's cash flow decisions. Why wouldn't we want to show "net"? This would truly reflect how they are doing, after (a) the impact of the manager's decisions, (b) the impact of their cash flow decisions, and (c) the impact of the advisory fee. So I'd say use "net."
The second occasion would be when the manager controls cash flows. As noted in yesterday's blog, I argue for IRR whenever this is the case, not just for private equity managers. Here we're showing the impact of the manager's entire range of decisions, from their management of the portfolio to their cash flow timing decisions. Net would reflect the entire impact and so this would generally be the better return, I would say. However, when the manager is providing their performance to prospects then both gross and net would be ideal. So in these cases, I'd say show both.
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Quite frankly, the idea that a gross return fairly represents the manager's skill (since the fee is a firm decision) is simply wrong. First, it is inconsistent with the GIPS ideal that "performance belongs to the firm." After all, performance belongs to the firm (since they choose the managers) and since fees are also set by the firm, then the return that the investor actually receives is the result of these two decisions by the firm. So, when we evaluate the manager, we are actually evaluating the firm, both in terms of its manager selection and its operating efficiency.
ReplyDeleteSecond, the duty of loyalty to clients requires a fair representation of performance. We all know that "It's not what you make, it's what you keep." This applies not only to taxes (the original context of this quote) but also to fees. Gross returns are a fiction. Do you know anyone who gets to keep their gross return? That's about as big a fib as telling someone that the price you pay for something is the cost before taxes.
Third, if you want to evaluate various investment managers on the "level playing field" that GIPS has as its goal, then we MUST provide net returns. Otherwise, institutional accounts and mutual funds cannot be fairly evaluated, since mutual funds are required to post net returns. There's a good reason for this - clients must be given the return that reflects their true change in wealth. That is the essential question that clients want answered: "What return shows me how my wealth has changed? " To answer this honestly and accurately, you need a NET IRR.
If you simply want to evaluate the impact that managers have on client wealth, then you need a NET TWR.