Fees – More Complex than First Imagined?

By Travis Morgan, CFA, CIPM

All too often during our verifications we run into issues regarding the treatment of fees. The typical question is whether a specific fee should reduce performance or be excluded. The Global Investment Performance Standards (GIPS®) specifically state that gross performance must be reduced by the actual transaction costs incurred and net performance must be further reduced by the management fees. The problem with today’s industry is that these fees can come in different forms. If a firm is not diligent in their review of their accounts and do not have a good understanding of the fees being paid, performance can often times be incorrectly calculated.

Let’s take transaction costs as an example. Historically these were easily identified and were inherent in the proceeds or cost of a transaction. For a standard equity trade, a broker would typically either take a flat dollar amount per trade or assess it on a per share level. In today’s market we are seeing more complex fee structures. Transaction costs are being bundled with other fees or in some instances are being charged as an asset based fee every month or quarter. It is very easy for a firm to overlook these fees and produce performance that is overstated. A regular review of your portfolios’ expenses should be conducted and any new or unknown expense should be investigated to ensure the treatment is correct.

The complexity of management fees these days are even more drastic and can cause some real head scratching to figure out how to contribute it to performance. Performance based fees are becoming more and more popular and reducing performance by these fees can be tricky. The biggest issue that we see is when firms try to accrue a performance based fee. These fees are typically only assessed once a year and trying to accrue it more often can cause performance to be very volatile. The real tricky area is when you are trying to apply a model performance based fee to the composite return. The problem is a performance based fee is typically based on a high watermark and this watermark can differ from one portfolio to another based on when the portfolio came under management. When you apply this type of fee to the composite, what you’re really doing is presenting performance based on what you would achieve if you were an investor from day one. The hedge fund world has been dealing with this issue for a long time but now the problem is getting escalated now that more traditional portfolios are demanding these types of fees. Our recommendation in this situation would be to reduce the underlying portfolio’s performance by the actual fee paid rather than attempt to apply some model fee to the composite return.

If you’re not sure how certain fees should be treated, please contact your verification team. They would be happy to help you determine whether the particular fee should reduce performance or not.

CFA®, CIPM®, and GIPS® are registered trademarks owned by CFA Institute.

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