Net-of-fee returns: what to do with the denominator

A colleague recently brought to my attention wording that appears in the 1993 edition of the Performance Presentation Standards, published by AIMR (Association for Investment Management and Research; the former name of the CFA Institute). On page 25, under a section titled "Net-of-Fee Calculation" we find: "In a net-of-fee calculation, when fees are paid from the corpus of the fund, the payments should be included as a withdrawal of capital in F (flows) and in FW (weighted flows). In addition, performance results are reduced by deducting fees as negative income [a positive number] in the numerator." The accompanying formula (that appears on 26) has the fees removed, separate from their treatment as a flow.

What this essentially means is that the fees cancel out in the numerator (which is the same as my recommendation to ignore them). The AIMR-PPS's denominator has them as a weighted flow; I recommend not doing this. Their result is a higher NOF return (since the denominator is reduced by the weighted flow). I believe ignoring the fees entirely is correct.

As I pointed out in an article for the CFA Institute, as well as in our firm's newsletter and this blog, we should completely ignore net-of-fee payments that come from the corpus of the account; we treat them as flows for gross-of-fee returns.

Note: this is MY (i.e., Dave Spaulding's) view on this matter, but I believe that logic and the results show that it makes sense. But chime in with your thoughts, by inserting a comment below! In reality, whether you treat them as a weighted flow or not, the difference is probably de minimis.

More on composite returns

Brian Chapman (of KPMG, London) reminded me that the AIMR-PPS(R)'s view of composite return is that it's "a single value that reflects the overall performance (the 'central tendency') of the set. The objective in reporting the returns of composites is to use a method for reporting the composite return that will give the same value achieved if the composite were treated as one master portfolio. That is, the value being calculated is the same value that would result if all of the assets and transactions of the individual portfolios/classes were combined and the return were computed using the procedures discussed earlier." [page 27 of the '93 version] Actually, I hadn't so much forgotten this, but rather was unable to locate a definition in the '93 or '97 editions of the AIMR-PPS (neither of their indexes provide easy passage to what Brian located, and I wasn't as diligent as he in trying to locate it).

When I taught classes for the CFA Institute (and prior to that, AIMR) on the standards (AIMR-PPS and GIPS(R)) the explanations regarding the math more often than not fell to me, and I would explain that asset weighting is used so that the return looks like it's coming from a single portfolio. I guess I hadn't really given this explanation a whole lot of thought: I had first heard it in 1992, when a debate was occurring on this subject, with the ICAA and IMCA challenging the approach that AIMR was implementing. The arguments against asset weighting were that it would cause larger accounts to overly influence the results; however, with the aggregate method we don't actually see this, since we end up with a mix of all accounts' holdings tossed together, with no reference or link to their source.

Further research is in order to understand "why" AIMR (and then the CFA Institute, and arguably now the GIPS Executive Committee, by default) would favor this approach. Is the blending of assets from a variety of accounts truly what we want?

It's somewhat ironic, I think, that the only method that AIMR came up with in their '93 edition fails at achieving the definition they laid out, as it provides an asset weighted average of returns (what IMCA and the ICAA objected to), not a result which truly represents the composite as if it was a single portfolio (though some would argue that it is an approximation of this).

If by now you're growing tired of this topic, I apologize. But I happen to find this somewhat fascinating.