Navigating Actual vs. Model Net-of-Fee Performance

One of the more common questions we get asked by firms is whether they should use model or actual fees to calculate net-of-fee composite returns.  With the soon-to-be-implemented SEC Marketing Rule requirements for net-of-fee composite performance calculations, many firms will need to reconsider their current calculation methodology to make the best decision going forward.

In 2015, a U.S. Investment Performance Committee (USIPC) and the CFA Institute survey found that 46% of respondents used actual fees, 29% used model, and 22% used some combination of the two.  More recently, we have seen the use of model fees continue to rise, and we expect the new Marketing Rule will only increase the trend.

See the full survey here.

Firms often choose to show actual net of fee composite returns because that is what their portfolio accounting system calculates.  Actual fees remains a straightforward solution for firms that have elected not to include non-feepaying accounts in composites, and for firms who have a standard fee schedule that is consistently applied across accounts, regardless of relationships with multiple accounts.

For firms using actual performance with accounts in composites that are non-feepaying, though, or charged negligible fees, the Marketing Rule will require a good bit of additional accounting to ensure the accuracy of the net-of-fee performance.  This includes non-feepaying accounts that result from a multiple account relationship where the fees are paid by only one of several accounts.

For firms that have a small number of accounts in a composite, calculating accurate actual fees may be manageable, but the resulting net performance would provide a look through to negligible fees paid by current accounts.  In this case, a firm might prefer to use model fees to provide a net performance record that reflects either the maximum fee charged by the manager or the highest fee a manager would like to be able to charge.

Actual Fees Pros and Cons, before the Marketing Rule:

Presenting model composite net-of-fee returns is a common practice for firms with any of the complexities mentioned above.  Other common challenges that have pushed firms to using model fees include having clients that negotiate performance-based fees or alternative payment schedules that are not typically offered by the firm to prospective clients.  The good news: a model fee can be applied to the composite monthly return, rather than to individual accounts, making it a much easier calculation than trying to manually adjust individual account fees.

Choosing the right model fee can be complicated.  The net-of-fee return using a model fee must be equal to or lower than those calculated using actual fees. To avoid the potential problem of overstating a model net return, the model fee can be calculated using the highest possible fee for the respective composite. This may lower the net performance by a few basis points, but it prevents running into a situation where the firm must correct a material error from overstating net performance.  For composites where most accounts are not paying the highest fee, using the highest fee can result in a more material understatement of performance.  In this case, firms can choose to calculate model fees using an asset-weighted model fee.  This methodology weights all of the portfolios in the composite by the firm’s published tiered fee schedule to come up with an “average” fee that can be applied to the composite as a whole.  This will result in higher net performance than using the highest fee, but it opens the door to calculation errors.  This method can be time consuming if the firm does not have a system to do this.

Finally, not all accounting systems have model fee functionality, so many firms are calculating composite returns in separate composite systems or using proprietary solutions, or quite often, a MS Excel spreadsheet to calculate model composite net-of-fee performance.

Model Fees Pros and Cons, before the Marketing Rule:

Using a model fee can save a lot of time when calculating monthly and quarterly composite performance.  If the composite includes accounts that have a performance-based fee and the firm is showing net of model fees, the firm will want to make sure the impact of the performance fee is taken into consideration when testing to make sure the model fee performance is not higher than actual net of fee performance.  This will require an analysis on an annual basis or more frequently if the GIPS Report is updated more than annually.

In the latest SEC Marketing Rule, net returns can be presented using the highest fee charged to the intended audience.  This opens up a new fee threshold that GIPS compliant firms can consider presenting as supplemental information, in addition to a model fee that is equal to or higher than the composite’s effective fee.   For example, if a firm that uses an 0.80% model fee is marketing its strategy to a prospective institutional client and proposing a fee of 0.65%, the firm could present net returns reduced by the 0.80% model fee and net returns reduced by the 0.65% model fee as supplemental information.  Or they can leave the GIPS Report as is and in the pitchbook, include a slide showing net returns using the 0.65% fee since this is the highest fee being charged to the intended audience.

What fees are best for your firm?  The number of accounts in the composite is the number one factor that determines which method will be the best for the firm to implement and monitor. For firms with a handful of accounts in each composite, it is relatively straightforward to use actual fees, but they need to be aware of the complexities discussed above.  When it comes to large composites, with perhaps hundreds of accounts in a given composite, actual fees become a lot more challenging.

In the fee illustration below, a firm using a 1.5% model fee in its GIPS Composite Report decided to lower its fees to be closer to 1% to be competitive with other firms.  The 1.5% model fee was no longer representative of the entire composite, so the firm completed an analysis of the members of the composite to determine if they could lower their model fee prospectively.

The net of model fee returns above were calculated by reducing the monthly composite gross returns by the 1/12th of the model fee and then geometrically linking monthly composite net returns.  Please reach out if you would like to see monthly calculation details.  In the example, the firm could use either the 1.00% model fee from their published fee schedule or an 0.80% model fee in their GIPS Reports, as long as the prospective client would qualify for an 0.80% fee (or lower).  However, the 0.65% model fee makes the annual net return of 14.42% higher than the actual return of 14.36%, and therefore could not be used unless it is shown as supplemental information alongside one of the other composite net-of-fee model return options above.

With the new SEC Marketing Rule firms will need to evaluate their practices.  We recommend establishing annual model fee review policies as well, to revisit published and actual fees and make decisions for the model fee being used based on that year’s highest effective composite fee.

Firms have unique clients and complexities, and many different considerations when deciding whether to present performance that is net of model fees or net of actual fees.  Cascade Compliance is here to help.  We have over 34 years of combined experience working with performance calculations and the GIPS standards, and our employees have worked with hundreds of firms in the U.S. and abroad.  We thrive on working with clients, sharing specialized expertise, and educating firms on industry best practices. Together, we can establish the most accurate and appropriate net-of-fee performance calculation for your firm. Whether your firm is GIPS compliant or not, we would welcome the opportunity to review and refine your firm’s current practices. Please schedule a meeting with us here.