CFA Level IEthical and Professional StandardsEasy
A GIPS-compliant firm's composite produced a gross-of-fees return of 12.50% for the year. The composite's weighted-average annual investment management fee is 1.00%, deducted from client assets at year-end. Using the standard method of converting a gross-of-fees return to a net-of-fees return (deducting the actual fee from the ending value), which of the following is closest to the net-of-fees return the firm should present?
- A12.50%, because GIPS only requires disclosure of gross returns
- B11.50%, found by simply subtracting the fee from the gross return
- C13.50%, found by adding the fee to the gross return
- D11.39%, found by dividing (1 + gross return) by (1 + fee) and subtracting 1
Show answer & explanationAnswer & explanation
Correct answer: D. 11.39%, found by dividing (1 + gross return) by (1 + fee) and subtracting 1
Net-of-fees return must reflect the compounding effect of the fee on the ending asset base, not a simple linear subtraction. Net return = (1.125 / 1.01) − 1 = 0.1139, or 11.39%. Simple subtraction (12.5% − 1% = 11.5%) understates the fee drag because it ignores that the fee is charged on a growing asset base.
Why the other options are wrong
- A. GIPS requires firms to present net-of-fees returns as well; gross-only presentation is insufficient.
- B. Ignores compounding; simple subtraction is not the technically correct conversion method.
- C. Adding the fee is the opposite of the required adjustment and produces an impossible result.
Net-of-Fees Return Calculation
Under GIPS, net-of-fees returns must reflect the actual deduction of investment management fees from portfolio value, typically calculated by dividing (1 + gross return) by (1 + fee) and subtracting 1, rather than simple subtraction.
- Net return = (1+gross)/(1+fee) − 1 for a lump-sum year-end fee
- Simple subtraction understates true fee impact due to compounding
- GIPS firms must present at least one of gross- or net-of-fees returns per firm policy
Memory trick: Fees compound, don't just subtract — divide and conquer the return.