In an investment management company such as a mutual fund, you will come across two types of returns being calculated, namely, returns on a gross, or net of fee basis. While there are some industry practices for calculating these returns, all fund managers don’t strictly follow one method.
In simple words, the gross returns refer to the returns calculated before deducting any fee, while the net returns refer to the returns calculated after deducting the fee. The fee may include managerial and administrative expenses such as management fees, custodial fees, taxes, and any other administrative expenses. The fee however does not include commissions, and any other expenses directly related to trading.
Since the gross returns are unaffected by the management and administrative expenses, they are a preferred measure for selecting and evaluating the relative performance of the portfolio managers. It is also preferred for attribution, risk, and other value-added reporting.
If we take two identical portfolios, they will have same gross returns; however, it’s not necessary that their net of fee returns will also be the same. This is because as the size of the assets grows, the magnitude of fee paid will reduce. So, on a risk-adjusted basis, a larger portfolio will seem superior compared to an identical smaller portfolio. This is the reason why gross returns are more suitable for evaluating performance of portfolio managers.
The net of fee returns are the returns the fund has actually earned for the investors. It’s calculated after deducting all the managerial, custodial and administrative expenses. These returns are what the investor is interested in knowing. The net returns can also be used for measuring the actual performance of the manager and the fund level.
Again if we take two identical funds, the fund having less assets will seem to have lower net returns compared to a fund with larger asset base because of the fee benefit for larger fund. For this reason, many mutual funds that don’t have large assets under management will waive off some fees to make their returns lucrative to investors.