Performance Perspectives Blog

Deriving net rates of return

by | Dec 15, 2011

There has been a bit of a debate on one of the Linkedin groups lately, regarding the proper way to derive net-of-fee returns, when the fees come out of the corpus of the account. I happen to like this topic, and wrote an article on it for the CFA Institute some time ago.

To put it simply, fees are technically cash flows, but when it comes to calculating net- or gross-of-fee returns, we need rules on what to do with them. When we calculate gross-of-fee returns, we treat the fees as a flow; when we calculate net-of-fee return, they’re ignored (i.e., they do not show up in our calculation at all).

The Linkedin question was simply whether one should always include the fee (as a cash flow) in the denominator, regardless of whether you’re calculating a net or gross return. One individual suggested that since the manager controls the timing of the flows (recall that in the Modified Dietz formula, cash flows are weighted based on timing, and this weighting is done in the denominator), that they should always be included (sorry about the run-on sentence…quite a mouthful!). I failed to see the logic behind “controlling the timing” and whether to include them. My interpretation of the statement was that this “control” might be used to advantage them somehow, even though one never knows how the month will end, so why would this matter?

Anyway, I stick by my simple rule:

  • Gross-of-fee: treat fees as a cash flow (in the denominator AND numerator)
  • Net-of-fee: ignore everywhere.

This, of course, is for fees taken from the corpus; fees paid from outside the account are treated differently. We’ll address this at another time.

Free Subscription!

The Journal of Performance Measurement

The Performance Measurement Resource.

Click to Subscribe