Around the Peak.

An Exposure Draft of the Global Investment Performance Standards’ (GIPS®) new Guidance Statement on Broadly Distributed Pooled Funds was recently published. The intention of this exposure draft is to seek comments from the public regarding this proposed new guidance before it is officially adopted in January of 2017.

Anyone with opinions regarding the guidance, especially with regard to questions the GIPS Technical Committee has included within the exposure draft, is encouraged to provide written feedback by 29 April 2016. Witten feedback can be submitted by emailing your comments to: standards@cfainstitute.org.

Who does the pooled fund guidance apply to?

Any GIPS compliant firm that manages and markets a “broadly distributed pooled vehicle” (which includes mutual funds or other similar vehicles) fits within the scope of this guidance.

If a firm is only responsible for managing the fund (e.g., as a sub-advisor), but has no responsibility for filing the fund’s official documents (e.g., the prospectus or KIID) or for creating fund-specific marketing materials, then this proposed guidance statement is not applicable.

The requirements set forth in the proposed guidance statement are specific to marketing pooled funds. Marketing pooled funds should not be confused with marketing a strategy or composite that contains a pooled fund. The guidance is specific to situations where the fund itself is being marketed to attract new investors within that fund.

What is the purpose of the proposed guidance?

GIPS requires firms to make every reasonable effort to provide compliant presentations to all prospective clients; however, most firms have historically interpreted this to only include new separate account prospective investors, not pooled fund investors that simply invest in a fund that is already included in a composite.

The purpose of this guidance statement is to ensure GIPS compliant firms are consistent in the way they present their pooled fund information to prospective investors. This consistency is intended to help prospective pooled fund investors make meaningful comparisons between funds. To achieve this, the exposure draft proposes requiring official fund documents, as well as all fund-specific marketing materials (i.e., materials that are specifically marketing the fund itself, not the strategy or composite), to include specific statistics and disclosures.

What does the proposed guidance require?

If adopted in its current form, the new guidance would require GIPS compliant firms to include the following in each of their funds’ official documents as well as any fund-specific marketing materials:

1. A description of the fund’s objective or strategy.
2. An indication of the risk involved in investing in the fund, which can be either qualitative or quantitative.
3. Pooled fund returns calculated according to the methodology and time periods required by local laws or regulations. If local laws or regulations do not specify a methodology or time period then firms must present the fund’s returns net of all fees and expenses for periods that are acceptable based on the current GIPS Advertising Guidelines.
4. Benchmark returns for the same periods that the fund’s performance is presented, as well as a description of the benchmark. If no appropriate benchmark exists, this can be disclosed in lieu of including benchmark performance.
5. The currency used to express performance.

There is no requirement to mention GIPS or provide (or even offer) a compliant presentation. The guidance statement does recommend, however, that firms include the following claim of compliance in their fund’s official documents and fund-specific marketing materials: “XYZ Firm, the firm managing this pooled fund, claims compliance with the Global Investment Performance Standards (GIPS®). For more information about the GIPS standards, please visit www.gipsstandards.org.”

It is important to note that this claim of compliance is new and differs from the wording used in compliant presentations or materials adhering to the GIPS Advertising Guidelines. When claiming compliance, firms must ensure that the correct claim is used and is stated verbatim from the standards.

What can firms do now to prepare for this new guidance?

Firms managing pooled funds should first determine whether they fit within the scope of the proposed guidance. If so, then your firm should review its current official fund documents and fund-specific marketing materials to determine if changes are needed in order to meet the new requirements, if adopted.

If there are material changes that are not reasonably feasible for your firm, use this opportunity to provide comments to the GIPS Technical and Executive Committees before the guidance is formally adopted.

In addition to sharing your general feedback on the guidance, responding to the specific questions the GIPS Technical Committee has included within the exposure draft will greatly help shape the final version of the guidance statement before it is officially adopted. The entire exposure draft, which includes these questions, can be reviewed here.

To learn more about the Exposure Draft of the Guidance Statement on Broadly Distributed Pooled Funds or other GIPS and performance measurement topics, please contact us.

Your firm works hard to comply with the Global Investment Performance Standards (GIPS®) and likely expects the benefits of GIPS to far outweigh any burden associated with maintaining compliance.

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Most of the policies and procedures your firm set when first becoming compliant will never need to change; however, as both the standards and your firm evolves, it is beneficial to conduct a high-level review of your GIPS compliance each year. This high-level review will help ensure that you continually refine your processes and policies to maximize the benefits of claiming compliance with GIPS year after year.

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Before getting into the specific aspects to review, you should first make sure you have the right people involved. One person or department may be responsible for managing the day-to-day tasks that maintain your GIPS compliance; however, high-level oversight from a larger group should take place to help ensure that any decisions made or policies set will integrate well with your firm’s other strategic initiatives.

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This larger group, often called a GIPS Committee, typically consists of representatives from compliance, marketing, portfolio management, operations/performance, and senior management.

Not everyone on the committee needs to be an expert in the GIPS standards. In fact, many will not be. What they will need is to be available to share their opinions and represent their department’s interests when establishing or changing key policies for your firm.

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Your GIPS expert/manager can set the agenda for your meeting and can provide any background on the requirements that will be part of the discussion. If you do not have a GIPS expert internally, or need independent advice about your policies and procedures, a GIPS consultant can be hired to help.

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High-Level GIPS Topics to Consider Annually

Once you select the right group to represent each major area of your firm, the following high-level questions can help determine if any action is necessary to improve your GIPS compliance this year:

• Have there been any changes to the GIPS standards?
• Have there been any material changes to your firm or strategies?
• Do your composites meaningfully represent your strategies or should their structure and descriptions be reconsidered?
• Are the materiality thresholds stated in your error correction policy appropriate for the type of strategies you manage and are they consistent with the thresholds set by similar firms?
• Are you satisfied with the service received from your GIPS verifier for the fee that is paid?
• Is there any due diligence you need to conduct on your verification firm?

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Changes to the GIPS Standards

It is important to consider whether there have been any changes to the GIPS standards since last year that would require your firm to take action. For example, if a new requirement is adopted, you should consider if any changes to your firm’s policies and procedures or compliant presentations are needed.

Keep in mind that GIPS compliant firms must comply with all requirements of the GIPS standards including any updates that may be published in the form of Guidance Statements, Questions & Answers (Q&As), or other written interpretations.

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If your firm is verified or works with a GIPS consultant, these GIPS experts are likely keeping you informed of any changes to the standards. The best way to check for changes yourself is to visit the “Standards & Guidance” section of www.gipsstandards.org. Specifically, you should check the “GIPS Q&A Database” where you can enter the effective date range of the previous year to see every Q&A published during this period. You should also check the “Guidance Statements” section. The guidance statements are organized by year published, so it is easy to see when new statements are added.

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Changes to Your Firm or Strategies

Similar to changes in the standards, it is important to also consider whether any changes to your firm or its strategies would require you to take action. Examples include, material changes in the way a strategy is managed, a new strategy that was launched, an existing strategy that closed, mergers or acquisitions, or anything else that would be considered a material event for your firm.

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Even if no changes were made this year, you should still read your entire policies and procedures document at least annually to make sure it adequately and accurately describes the actual practices followed by your firm.

Regulators, such as the Securities and Exchange Commission (SEC), commonly review firms’ policies and procedures to ensure 1) that the document includes actual procedures and is not simply a list of policies and 2) that the stated procedures truly represent the procedures followed by the firm. Many firms have created their policies and procedures document based on template language, so tweaks may be necessary to customize the document for your firm.

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Meaningful Composite Structure

The section of your GIPS policies and procedures requiring the most frequent adjustment is your firm’s list of composites, as you must make changes each time a new composite is added or a composite closes. However, even without adding new strategies or closing older strategies, the list of composites and their descriptions should be reviewed at least annually to ensure they are defined in a manner that best represents the strategies as you manage them today.

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Since your firm’s prospects will compare your composite results to those of similar firms, it is important that your composites provide a meaningful representation of your strategies and are easily comparable to similar composites managed by your competitors. If a review of your current list of composites leads you to realize that your strategies are defined too broadly, too narrowly, or in a way that no longer accurately describes the strategy, changes can be made (with disclosure).

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Keep in mind that changes should not be made frequently and cannot be made for the purpose of making your performance appear better. Changing your composite structure for the purpose of improving your performance results, as opposed to improving the composite’s representation of your strategy, would be considered “cherry picking.”

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Two examples of cases that may require a change in your composites include:

1. A strategy has evolved and certain aspects of the way the strategy was managed and defined in the past are different from today. This can be addressed by redefining the composite. Redefining the composite requires you to disclose the date, reason, and nature of change. This disclosure will help prospects understand how the strategy was managed for each time period presented and when the shift in strategy took place. Changes like this should be made to your composite descriptions at the time of the change, but an annual review can help you address any items that may have been overlooked when the change occurred.
2. A composite is defined broadly to include all large capitalization accounts. Within this large capitalization composite, there are accounts with a growth focus and others with a value focus. If your closest competitors are separately presenting large capitalization growth and large capitalization value composites, your broadly defined large capitalization composite may be difficult for prospects to meaningfully compare to your competitors. To address this, you can create new, more narrowly defined composites to separate the accounts with the growth and value mandates. In this case, the full history will be separated and the composite creation date disclosed for these new composites will be the date you make the change. Note that this will demonstrate to prospective clients that you had the benefit of hindsight when determining the definition.

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Materiality Thresholds Stated in Your Error Correction Policy

Another section of your firm’s GIPS policies and procedures that should be reviewed in detail is your error correction policy. Your error correction policy includes thresholds that pre-determine which errors (of those that may occur in your compliant presentations) are considered material versus those deemed immaterial. These thresholds cannot be changed upon finding an error; however, they can be updated prospectively if you feel a change would improve your policy.

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Many firms had a difficult time setting these thresholds when this requirement first went into effect back at the start of 2011. Now that much more information is available to help you determine these thresholds, such as the GIPS Error Correction Survey, you may want to revisit your policy to ensure it is adequate.

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Setting and approving materiality thresholds that determine material versus immaterial errors is a task best suited for your firm’s GIPS committee rather than your GIPS department or manager. The reason for this is that opinions of what constitutes a material error will vary from one department to another. Your committee can help find a balance between those with a more conservative approach and those with a more aggressive approach to ensure the thresholds selected are appropriate.

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GIPS Verifier Selection and Due Diligence

If your firm is verified, it is important to periodically evaluate whether you are satisfied with the quality of the service received for the fees paid. You may also want to consider whether you need to conduct any periodic due diligence on your verification firm with respect to data security or other concerns important to your firm.

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All verifiers have the same general objective: to test and opine on 1) whether your firm has complied with all of the composite construction requirements of the GIPS standards and 2) whether your firm’s GIPS processes and procedures are designed to calculate and present performance in compliance with GIPS. Where they differ is in the fees charged and process followed to complete the verification.

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With regard to fees, much of the difference between verifiers is based on their level of brand recognition rather than differences in the quality of their service. For example, smaller firms specialized in GIPS verification may have more experience with the intricacies of GIPS compliance than a global accounting firm; yet, a global accounting firm will likely charge the highest fee. When selecting a higher fee firm, it is important to consider whether the higher fee is offset by the benefit your firm receives when listing their brand name as your verifier in RFPs you complete.

With regard to process, the primary difference between verification firms is whether the verification testing is done onsite or remotely. There are pros and cons to both methods and it is important for your firm to consider which works best for the team that is fielding the verification document requests.

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The onsite approach may result in finishing the verification in a shorter period, but may be disruptive to your other responsibilities while the verification team is in your office. The remote approach may be less disruptive to your other responsibilities, but likely will take longer to complete and may be less efficient as documents are exchanged back and forth over an extended period of time. Another difference is how the engagement team is structured, whether you can expect to work with the same team each year, and how much experience your main contact has.

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Regardless of whether the verification is conducted onsite or remotely, be sure to ask any verifier how your proprietary information and confidential client data is protected. If the work is done remotely, how are sensitive documents transferred between your firm and the verifier (e.g., is it through email or a secure portal) and once received by the verifier, do they have strong controls in place to ensure your data is not breached.

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If the work is done onsite, it is important to ask what documents (or copies of documents), if any, the verifier will be taking with them when they leave, and whether these documents are saved in a secure manner. Documents saved locally on a laptop are at higher risk of being compromised.

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For more information on how to maximize the benefits your firm receives from being GIPS compliant or for other investment performance and GIPS information, contact Sean Gilligan at sean@longspeakadvisory.com.

Calculating gross and net investment performance should be simple, right? Yes, however, firms often face fee-related portfolio accounting or administrative issues that cause complications, resulting in inaccurate performance. It is essential that all types of fees are accounted for correctly to ensure reported performance can be relied upon for evaluation by clients and prospective investors.

Which Fees and Expenses Reduce Investment Performance?

Gross-of-fee performance represents a portfolio’s return net of transaction costs only. Net-of-fee performance is net of transaction costs and investment management fees, so the only difference between gross and net performance is the investment management fee. According to the Global Investment Performance Standards (GIPS®), investment management fees are defined to include both asset-based and performance-based fees that are earned for managing a portfolio.

If your firm is GIPS compliant, it is important to reduce performance by both types of fees when calculating net-of-fee performance. For non-GIPS compliant firms, this is still considered best practice; however, it is common for firms with both types of fees to report performance reduced only by the asset-based fee as “Net” and performance reduced by both the asset-based fee and performance-based fee as “Net Net.”

Administrative fees, such as custody fees, do not reduce performance. This is the typical practice because clients have some control over selecting a custodian and, therefore, the administrative fees charged to their portfolio. For this reason, administrative fees are excluded from performance calculations and instead are treated like external cash flows that do not reduce their return.

The most common exception to this is net performance reported for mutual funds, which is typically calculated based on the change in the fund’s net asset value (NAV), resulting in performance that is net of all fees and expenses. Mutual fund investors do not have control over the custodian used or administrative fees charged (i.e., the manager selects the custodian), so these fees do reduce performance when calculating net returns for mutual funds.

What Are the Most Common Fee-Related Administrative Issues and How Can They Be Addressed?

The most common administrative issues that affect performance results usually are derived from:

1. Clients paying their management fee by check or from another outside source
2. Accounts with bundled fee structures (e.g., wrap accounts)
3. Accounts paying asset-based fees for transactions in lieu of per-trade commissions

We will examine each of these issues below.

1.  Clients Paying Their Management Fee by Check or from Another Outside Source

In an ideal world all clients would have their management fees directly debited from the account that earned the fee; however, this is not always the case. Some clients prefer to pay their management fees by check or out of one of their multiple accounts managed by your firm. Since many firms record their accounts receivable in an accounting system separate from their portfolio accounting system (which calculates performance), a matching entry must be added to the portfolio accounting system when fees are paid. If this fee is not recorded in the portfolio accounting system, the client’s gross and net returns will be equal (neither being reduced by the management fee), which is inaccurate.

How to Add Adjusting Accounting Entries to Ensure Net-of-Fee Performance Is Accurate

When a client pays their fee by check, to correctly record this, two entries are needed in the portfolio accounting system:

1. An external cash inflow matching the management fees paid by check.
2. A management fee expense for the same amount.

After these two transactions are made, the portfolio’s market value will be the same as it was before entering these transactions since the two transactions offset each other. While these entries do not change the value of the portfolio, an expense is recorded that will allow the system to report the correct net-of-fee performance for the period.

Similarly, when the management fee is directly debited from another account, adjustments need to be made to both the account that paid the fee and the account that earned the fee. The account that paid the management fee will need two accounting entries:

1. A negative management fee expense for fees paid on behalf of a different account.
2. An external cash outflow for the same amount.

The account that earned the management fee will also need two accounting entries (note that these are the same as the entries when paid by check):

1. An external cash inflow matching the fees paid by the other account.
2. A management fee expense for the same amount.

Again, these transactions will not change the market value of any account as these entries simultaneously adjust cash and management fee expense by the same amount. While this has no effect on the total portfolio’s market value, it will allow net-of fee performance to be accurately reported, regardless of the source or method of the actual payment.

Forgetting to make these adjustments is very common and often leads to erroneously overstating net-of-fee performance for clients paying their fees from an outside source. It will also result in an overstatement of net-of-fee performance for any composite that includes these accounts. To avoid regulatory deficiencies or non-compliance with GIPS requirements, it is best to look into whether your firm has accounts paying management fees from outside sources and ensure proper adjustments are made.

2.  Accounts with Bundled Fee Structures, Such as Wrap Accounts

As previously discussed, gross-of-fee performance is reduced by transaction costs and net-of-fee performance is reduced by transaction costs and management fees. This can become complicated when fees and expenses are bundled together and accounted for as one bundled fee.

What to Do If Fees and Expenses Are Bundled Together and Cannot Be Separated

If fees and expenses cannot be separated, gross-of-fee performance is calculated by reducing performance by transaction costs and any fees or expenses that cannot be separated from those transaction costs. Net-of-fee performance is then calculated by reducing performance by transaction costs and management fees, as well as any fees or expenses that cannot be separated from the transaction costs or management fees. This often results in identical gross-of fee and net-of-fee performance, as both performance measures are reduced by the entire bundled fee.

This most commonly occurs with wrap accounts, where the client pays one bundled fee and the individual fees for transaction costs, management fees, etc. cannot be separately determined. When this occurs, disclosures should be included with the performance to clarify if any fees other than transaction costs and management fees have been used to reduce performance.

Alternative Presentation Options for Gross-of-Fee and Net-of-Fee Performance With Bundled Fees

Instead of presenting gross-of-fee performance that is equal to net-of-fee performance, firms often only include net returns as their official performance, but then also present “pure gross” returns as supplemental information. Pure gross returns are gross of all fees and expenses and must be disclosed as such.

3.  Accounts That Pay Asset-Based Fees for Transactions in Lieu of Per-Trade Commissions

As discussed earlier, gross-of-fee performance is reduced by transaction costs. Typically these transaction costs are the commissions tied to each executed trade; however, there has been a trend towards using asset-based fee structures for transaction costs, instead of per-trade commissions.

If an account is actively managed and trades frequently enough that an asset-based fee structure results in lower expenses than paying commissions on each trade, an asset-based fee structure may be a good option for your client. However, properly accounting for this kind of fee structure in your portfolio accounting system may be challenging, as many portfolio accounting systems have not caught up with this trend, leading to errors in the client’s reported performance.

With a commission-based structure, portfolio accounting systems typically account for each trade net of commissions, which ensures that gross-of-fee performance is net of transaction costs. All other fees and expenses are recorded as separate line items that are coded as either “performance affecting” (e.g., management fees, which reduce performance to arrive at net-of fee-returns), or “non-performance affecting” (e.g., administrative fees, which are treated as external cash flows that do not have an effect on performance).

When asset-based fee structures replace per-trade commissions, the asset-based fee is commonly accounted for as a line item, similar to management fees or other administrative expenses. The problem with this is that neither of the two options available (“performance-affecting” or “non-performance-affecting”) reduce gross-of-fee performance to account for trading costs. Instead, these options were only designed to reduce net-of-fee performance or reduce neither performance measure (i.e., there is often no transaction code that only reduces gross-of-fee performance).

How to Make Adjustments to Properly Account for Asset-Based Transaction Costs

Many systems have not created a solution for asset-based transaction costs, leaving firms to develop their own workarounds to reduce gross-of-fee returns. One example of a workaround that firms use is to record these fees as negative dividends, which results in the desired effect of reducing gross-of-fee performance. While this approach works, it is not ideal since the dividend transaction code is not intended to be used for this purpose, and should only be used as a short-term solution until your portfolio accounting system provider can offer an appropriate transaction code that will properly account for this type of fee.

Firms that have accounts with this type of fee structure for transaction costs should check with their portfolio accounting system provider to confirm if there is a way to ensure these fees are accounted for properly. Ideally, this should be addressed with a system developer or senior representative from your system provider, as this question is likely beyond the knowledge of a typical helpdesk associate, and may not be addressed in the reference materials they have available to them.

While this post is focused on fee-related administrative issues that affect performance, there are many other fee-related issues that firms face in reporting investment performance. We intend to cover additional fee-related topics in future posts, including: determining whether to use cash basis or accrual accounting for management fees, and considerations for determining when it is appropriate to use hypothetical or model management fees instead of actual management fees to calculate net-of-fee performance. If you would like to receive periodic information on these kinds of topics, please subscribe to our blog by submitting your email at the bottom of the webpage or check back frequently for new posts.

For more information on fee-related administrative issues or to discuss other investment performance or GIPS® topics, please contact Sean Gilligan at sean@longspeakadvisory.com.

The Global Investment Performance Standards (GIPS®) are an ethical framework that standardize how investment managers calculate and report their investment performance to prospective investors. Standardized presentations help ensure the information presented is meaningful, complete, and comparable to performance presentations of other GIPS compliant firms, regardless of location or regulatory jurisdiction.

This comparability helps simplify the due diligence process for prospective investors as it allows them to make an “apples-to-apples” comparison of similar strategies managed by different investment managers regardless of their location. Currently, there are 37 countries that have officially adopted GIPS, making it a true global standard.

https://www.youtube.com/watch?v=GSBUGRNoZII&feature=emb_logo

Why are the GIPS Standards Necessary?

GIPS is designed to address potentially misleading practices employed by some investment managers when presenting investment performance to prospective clients. Examples of misleading practices include:

• “Cherry-picking” accounts – Showing a strategy’s best performer as a representation of how the strategy performed as a whole
• Using selective time periods – Presenting the performance of a strategy only for the period it performed the best
• Utilizing model or back-tested results when results of actual managed accounts could have been used
• Survivorship bias – Excluding accounts that have closed (often the worst performing accounts) from performance calculations

Under GIPS, discretionary accounts are grouped into composites based on the strategy they follow. Performance is then reported at the composite level, based on the aggregation of the accounts within the composite. Composites only include actual discretionary accounts, not models, and it is required to present each composite’s performance statistics for each annual period.

These requirements, implemented in conjunction with the rest of the GIPS requirements, help prevent compliant firms from manipulating their results and improve comparability between firms that are GIPS compliant and manage similar strategies.

Why Become GIPS Compliant?

GIPS compliance offers investment managers both marketing and compliance benefits.

According to eVestment, two out of three searches made in their database by investors or consultants are set to exclude firms that are not GIPS compliant. Being able to “check the box” in RFPs and consultant databases indicating that your firm is GIPS compliant can be a valuable marketing benefit.

Being GIPS compliant requires firms to document policies and procedures, addressing how their firm complies with all of the GIPS requirements as well as the recommendations they choose to adopt. The practice of documenting and implementing these policies is an excellent way to ensure your firm is consistent in its practices across the firm, which can be immensely valuable to your compliance department.

Misconceptions About GIPS that Discourage Managers from Complying

Misconception 1: GIPS Compliance is Burdensome and Expensive

The initial process of becoming compliant can be time consuming; however, if sufficient time is put in at the start of the process to create detailed GIPS policies and procedures and construct composites that consistently follow these policies, the ongoing maintenance is very manageable.

For firms that do not have the resources available internally to bring their firm into compliance, GIPS consulting firms such as ours, Longs Peak Advisory Services (“Longs Peak”), are available to assist with the creation of policy documents, construction of composites, the creation of compliant presentations, etc.

Verification is often the largest direct expense associated with GIPS compliance; however, having your firm verified is not required. If you choose to be verified, the marketing benefit received will likely outweigh the cost. If the cost of a verification is more than your firm can currently afford, you can always become complaint now and add verification at a later date when it fits more comfortably in your budget.

If a firm can comply with all of the GIPS requirements without the help of a GIPS consultant and elects not to have their compliance verified, there is no direct cost for a firm to be GIPS compliant.

Misconception 2: GIPS is Not Relevant for My Firm

As mentioned earlier, GIPS offers both marketing and compliance benefits. Even if you are not marketing your strategies to institutional investors that require their managers to be GIPS compliant, your firm can still benefit from GIPS. More specifically, if your firm:

Only manages funds:

It may seem pointless to create a composite of one account; however, when marketing a composite rather than the fund itself, adjustments can be made to the fund’s fees to make the performance results more representative of what a separate account would have experienced following your strategy. This composite performance could be used to market your strategy to prospective separate account investors or to help prospective clients compare your performance to a competitor whose performance is based on a composite of separate accounts.

Manages customized portfolios:

Even if you are not managing a strategy strictly to a model, composites can be built based on the risk level of the client. For example, many wealth management firms have Conservative, Moderate, Growth, and Aggressive composites. There may be some dispersion between accounts within each composite, but these composites at least give you the opportunity to present an aggregation of your actual accounts with similar risk and objective profiles.

Questions?

If you have questions about the GIPS standards, we would be love to talk to you. Longs Peak’s professionals have extensive experience helping firms become GIPS compliant as well as helping firms maintain their compliance with GIPS on an ongoing basis. Please feel free to email Sean Gilligan directly at sean@longspeakadvisory.com.

‍Why “Net” Is Not a One-Size-Fits-All Answer

If you’ve worked in the investment industry, you’ve probably heard some version of this question:

“Should we show net or gross performance—or both?”

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On the surface, the answer seems straight forward. The rules tell us what’s required. Compliance boxes get checked. End of story.

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But in practice, presenting net and gross performance is rarely that simple.

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How you calculate it, how you present it, and how you disclose it can materially change how investors interpret your results. This article goes beyond the rulebook to explore thepractical considerations firms face when deciding how to present net and gross returns in a manner that is clear, helpful, and in compliance with requirements.

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Let’s Start with the Basics (Briefly)

At a high level, for separate account strategies:

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• Gross performance reflects returns before investment management fees

• Net performance reflects returns after investment management fees have been deducted

Both gross and net performance are typically net of transaction costs, but gross of administrative fees and expenses. When dealing with pooled funds, net performance is also reduced by administrative fees and expenses, but here we are focused on separate account strategies, typically marketed as composite performance.

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Simple enough. But that definition alone doesn’t tell the full story—and it’s where many misunderstandings begin.

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Why Net Performance Is the Investor’s Reality

From an investor’s perspective, net performance is what actually matters. It represents the return they keep after paying the manager for active management.

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That’s why modern regulations and best practices increasingly emphasize net returns. Investors don’t experience gross returns. They experience net outcomes.

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And let’s be honest: if an investor chooses an active manager instead of a low-cost index fund or ETF tracking the same benchmark, the expectation is that the active approach should deliver something extra—after fees. Otherwise, it becomes difficult to justify paying for that active management.

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Why Gross Performance Still Has a Role

If net returns are what investors actually receive, why do firms still talk about gross performance at all?

Because gross performance tells a different, but complementary, story: what the strategy is capable of before fees, and what investors are paying for that capability.

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The gap between gross and net returns represents the cost of active management. Put differently, it answers a question investors are implicitly asking:

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How much return am I giving up in exchange for this manager’s expertise?

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Viewed this way, gross returns help investors assess:

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• Whether the strategy is adding value before fees
• How much of the performance is driven by skill: security selection, asset allocation or portfolio construction
• Whether fees are the primary drag—or whether the strategy itself is struggling

When gross and net returns are shown together, they create transparency around both skill and cost. When shown without context, they can easily obscure the economic tradeoff.

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Gross-of-fee returns are also most important when marketing to institutional investors that have the power to negotiate the fee they will pay and know that they will likely pay a fee lower than most of your clients have paid in the past. Their detailed analysis can more accurately be done starting with your gross-of-fee returns and adjusting for the fee they expect to negotiate rather than using net-of-fee returns that have been charged historically.

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The Real-World Gray Areas Firms Struggle With

How to Present Gross Returns

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Gross returns are pretty straightforward. They are typically calculated before investment management or advisory fees and usually include transaction costs such as commissions and spreads.

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For firms that comply with the GIPS® Standards, things can get more nuanced—particularly for bundled fee arrangements. In those cases, firms must make reasonable allocations to separate transaction costs from the bundled fee. But, if that separation cannot be done reliably, gross returns must be shown after removing the entire bundled fee. [1]

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Once you move from gross to net returns, however, the conversation becomes less straightforward. We’ve had managers question, “why show net performance at all?” This is especially the case when fees vary across clients or historical fees no longer reflect what an investor would pay today. Others complain that the “benchmark isn’t net-of-fees,” making net-of-fee comparisons inherently imperfect. These concerns highlight why presenting net returns isn’t just a mechanical exercise. In the sections that follow, we’ll unpack these challenges and walk through how to present net-of-fee performance in a way that remains meaningful, transparent, and fit for its intended audience.

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How to Present Net Returns

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This is where judgment and documentation matters most.

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Not all “net” returns are created equal. Even under the SEC Marketing Rule, there is no single mandated definition of net performance—only a requirement that net performance be presented. Under the GIPS Standards, net-of-fee returns must be reduced by investment management fees.

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In practice, firms may deduct:

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• Advisory fees (asset-based investment management fees)
• Performance-based fees
• Custody fees
• Transaction costs

Two net-return series can look comparable on the surface while reflecting very different assumptions underneath. This lack of transparency is one of the main reasons institutional investors often require managers to be GIPS compliant—it simplifies comparison by requiring consistency in the assumptions used and how they are presented or additional disclosure when more fees are included in the calculation than what is required.

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And context matters. A higher fee may be perfectly reasonable if it reflects broader services such as tax or financial planning, holistic portfolio construction, or access to specialized strategies. The problem isn’t the fee itself, it’s failing to use a fee scenario that is relevant to the user of the report.

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Deciding Between Actual vs Model Fees

The next hurdle is deciding whether to use actual fees or a model fee when calculating net returns. Historically, firms most often relied on actual fees, viewing them as the best representation of what clients actually experienced. But that approach raises an important question: are those historical fees still relevant to what an investor would pay today? If the answer is no, a model fee may provide a more representative picture of current expected outcomes. Under the SEC marketing rule, there are cases where firms are required to use a model fee when the anticipated fee is higher than actual fees charged.

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This consideration becomes even more important for strategies or composites that include accounts paying little or no fee at all. While the GIPS Standards and the SEC Marketing Rule are not perfectly aligned on this topic, they agree in principle—net performance should be meaningful, not misleading, and should reflect what an actual fee-paying investor should reasonably expect to pay. Thus, many firms opt to present model fee performance to avoid violating the marketing rule’s general prohibitions. [2]

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Additional SEC guidance published on Jan 15, 2026 on the Use of Model Fees reinforced that the decision to use model vs actual fees is context-dependent. While the marketing rule allows net performance to be calculated using either actual or model fees, there are cases where the use of actual fees may be misleading. The SEC emphasized flexibility and that while both fee types are allowed, what’s appropriate depends on the facts and circumstances of the situation, including the clarity of disclosures and how fee assumptions are explained.

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Which Model Fee Should Be Used?

Most firms offer multiple fee structures, typically based on account size, but sometimes also on investor type (institutional versus retail clients). That variability makes fee selection a key decision when presenting net performance.

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If you plan to use a single performance document for broad or mass marketing, best practice—and what the SEC Marketing Rule effectively requires—is to calculate net returns using the highest anticipated fee that could reasonably apply to the intended audience. This helps ensure the presentation is not misleading by overstating what an investor might take home.

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A common pushback is: “But the highest fee isn’t relevant to this type of investor.” And that may be true. In those cases, firms have a few defensible options:

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• Create separate versions of the presentation tailored to different investor types, or
• Present multiple fee tiers within the same document, clearly explaining what each tier represents

Either approach can work—but only if disclosures are explicit and easy to understand. When multiple fee structures are shown, clarity isn’t optional; it’s essential.

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In practice, many firms maintain separate retail and institutional versions of factsheets or pitchbooks. That approach is perfectly reasonable, but it comes with operational risk. If this becomes standard practice, firms need strong internal controls to ensure the right presentation reaches the right audience. That means:

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• Clear internal policies
• Consistent naming and version control
• Training marketing and sales teams on when each version may be used

This often involves an overlap of both marketing and compliance to get it right because getting the fee right is only part of the equation. Making sure the presentation is used appropriately is just as important to ensuring net performance remains meaningful, compliant, and credible.

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Which Statistics Can Be Shown Gross-of-Fees?

Since the introduction of the SEC Marketing Rule, there has been significant debate about whether all statistics must be presented net-of-fees—or whether certain metrics can still be shown gross-of-fees. Helpful clarity arrived in an SEC FAQ released on March 19, 2025, which confirmed that not all portfolio characteristics need to be presented net-of-fees. The examples cited included risk statistics such as the Sharpe and Sortino ratios, attribution results, and similar metrics that are often calculated gross-of-fees to avoid the “noise” introduced by fee deductions.

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The staff acknowledged that presenting some of these characteristics net-of-fees may be impractical or even misleading. As long as firms prominently present the portfolio’s total gross and net performance incompliance with the rule (i.e., prescribed time periods 1, 5, 10 years),clearly label these characteristics as gross, and explain how they are calculated, the SEC indicated it would generally not recommend enforcement action.

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Bringing it all Together

On paper, presenting net and gross performance should be a straight forward exercise.

In reality, layers of regulation, evolving expectations, and heightened scrutiny have made it feel far more complicated than it needs to be. But complexity doesn’t have to lead to confusion.

When firms are clear about:

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• Who they are communicating with,
• What that audience expects,
• What the performance is intended to represent, and
• Why certain assumptions were chosen

…the decisions around what gets presented become far more manageable.

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Net returns aren’t about finding a single “correct” number. They’re about telling an honest, well-documented story. And when that story is clear, investors don’t just understand the performance—they trust it.

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[1] 2020 GIPS® Standards for Firms, Section 2: Input Data and Calculation Methodology(gross-of-fees returns and treatment of transaction costs, including bundled fees).

[2] See SEC Marketing Rule 2 026(4)-1(a) footnote 590 as well as the SEC updated FAQ from January 15, 2026. Available at: https://www.sec.gov/rules-regulations/staff-guidance/division-investment-management-frequently-asked-questions/marketing-compliance-frequently-asked-questions

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Understanding Tracking Error & R-Squared

When evaluating the performance of an investment portfolio, it's essential to consider metrics that help measure the portfolio's consistency and alignment with its benchmark. Two critical metrics in this context are Tracking Error and R-Squared. These metrics provide insights into the portfolio's performance and risk characteristics. Let's explore what these metrics mean, how they are calculated, and their significance.

What is Tracking Error?

Tracking Error measures the deviation of a portfolio's returns from its benchmark returns. It indicates how closely a portfolio follows the benchmark to which it is compared. A lower tracking error suggests that the portfolio's returns are closely aligned with the benchmark, while a higher tracking error indicates greater deviation.

Tracking Error Formula

Tracking Error= standard deviation of (P-B)

where:

• P = Portfolio return
• B​ = Benchmark return

Annualized Tracking Error

When using monthly data, tracking error is annualized by multiplying the result by the square root of 12.

What is a Good Tracking Error?

A "good" tracking error depends on the investment strategy. For passive funds that aim to replicate a benchmark, a lower tracking error is desirable. For active funds that seek to outperform the benchmark, a higher tracking error might be acceptable, reflecting the manager's active bets.

What is R-Squared?

R-Squared (R²) measures the proportion of the portfolio's movements that can be explained by movements in its benchmark. It ranges from 0 to 100%, where a higher R-Squared indicates a greater correlation between the portfolio and its benchmark.

R-Squared Formula

R² = (Correlation of portfolio and benchmark returns)²

What is a Good R-Squared?

A higher R-Squared (closer to 100%) indicates that the portfolio's returns are highly correlated with the benchmark. For passive funds, a high R-Squared is preferred. For active funds, a lower R-Squared might indicate that the manager is taking independent positions relative to the benchmark.

How to Interpret Tracking Error and R-Squared

• Tracking Error: Indicates the consistency of the portfolio's returns relative to the benchmark. A lower tracking error is desirable for passive strategies, while active strategies might tolerate higher tracking errors.
• R-Squared: Shows the degree of correlation between the portfolio and benchmark returns. A high R-Squared suggests strong alignment, suitable for passive strategies, while a lower R-Squared might indicate active management.

While both Tracking Error and R-Squared are good measures to understand how closely a track record is managed to a benchmark, they should be analyzed with other available performance metrics. A high or low Tracking Error and R-Squared does not indicate if the performance was good or not. Therefore, using Tracking Error in combination with other metrics like Alpha or the Sharpe Ratio can help provide additional information on whether the strategy performed well while analyzing how closely it was managed to a benchmark. Any selected performance metric should also cover the same time periods as the calculated Tracking Error and R-Squared for the most relevant comparison.

Why are Tracking Error and R-Squared Important?

Both metrics are crucial for assessing portfolio performance and understanding the risk-return profile. They help investors gauge how well a portfolio is managed relative to its benchmark and assess the effectiveness of active versus passive management strategies.

Conclusion

Tracking Error and R-Squared are essential tools for evaluating portfolio performance. Understanding these metrics can help investors make informed decisions about their investment strategies and better manage their portfolios.

For more information on performance metrics and investment strategies, feel free to contact us or explore our other resources on investment performance.