Performance Analysis, Management Fees, Management Expense Ratios (MERs), and Benchmark Expense Ratio

Proper performance analysis should preferably be both before and after management expenses. This will permit a portfolio’s owner to assess the after fees management value-added, relative to the benchmark.

The Problem

Portfolio fees and expenses take many forms depending on the portfolio’s assets; some are visible from portfolio reports; others are hidden. For example, a mutual fund asset has hidden fees that are subtracted before the fund’s payout to the owner’s portfolio. A portfolio manager may charge an annual fee (payable monthly) based on a % of assets under management (AUM). Portfolio fees may be paid directly from the portfolio or charged externally, the latter requiring an equal portfolio contribution. Benchmark ETFs have management and other expenses that are subtracted prior to its reported returns. Each of these requires a different procedure for properly comparing the performance of a managed portfolio to its benchmark.

Some Principles and Complicating Factors

If Management fees are paid infrequently to cover more or less than the analysis period, this requires a fees adjustment so that after fees performance analysis is correct. Over-payments may be offset by entering a prorated fees amount; under-payments require a prorated fees top up.

Fees paid prior to a portfolio receiving an asset’s distribution (e.g., dividends) or recording the asset’s value, do not require separate recognition because the fee results in a smaller distribution and portfolio value that is reflected in the portfolio’s performance analysis. Whereas, this fee is an expense for a stock it is not a portfolio’s expense because it results in a smaller dividend received.

Management fees subtracted directly from the portfolio are reflected in portfolio performance due to a decline in its cash component. However, before fees performance analysis requires that they are added back.

Taxes, such as withholding taxes for a foreign asset, are typically paid from the portfolio’s cash asset. Taxes do not require recognition if the desired performance is after (withholding) taxes, as is the case in RoboPPA™.

Brokers fees for asset sales and purchases reduce the portfolio value that is stated in the monthly statements. However, they are not a management fee and generally do not require a contribution or withdrawal. Portfolio owners should use discount brokers that charge reduced brokerage fees such as QuesTrade and E*Trade, for example.

RoboPPA™ uses benchmark ETFs rather than indexes because the former are purchasable and have published MERs. Therefore, the published benchmark returns are after fees and their before fees returns are calculated by adding back the MERs, on a monthly basis.

An Example

To illustrate the proper before and after fees calculation in RoboPPA™, an actively managed USD portfolio was purchased on Feb 28, 2009 and sold May 31, 2010. To protect privacy, RoboPPA™ provides analysis based on a purchased $100 unit of the portfolio that was subsequently sold for $235 market value. Over the 15-month analysis period, the total management fees was $14, total contributions was $170, and total withdrawals was $90, all based on $100 of stating portfolio value. The specified benchmark was 40% in S&P500 ETF and 60% Vanguard FTSE World Markets ETF (ex US) with total benchmark fees of $0.16.

The following table shows the ending values, two returns, two risks, and the reward to volatility (Sharpe ratio) of the portfolio and the benchmark, before and after management fees.

Allowing for the effects of transfers, the Table shows the total loss in portfolio value due to fees of $16.46 over the analysis period versus the benchmark loss of approximately $0. The before fees portfolio IRR substantially exceeded the benchmark return, 33.29%/year versus 26.21%/year. However, the portfolio’s large fees reversed that and its after fees IRR was slightly smaller 25.74%/year, compared to the benchmark’s 26.21%.

The after fee return risks (volatility and value at risk) were substantially better for the benchmark and that resulted in a substantially better reward to volatility (Sharpe ratio) for the benchmark. The value at risk for the benchmark says that there is a 5% chance that the benchmark return will be less than -10.1%/year compared with the portfolio’s riskier -15.5%/year.

The portfolio is a high return portfolio but clearly has fees and risk that are too large. The owner would have been far better off switching to the benchmark and probably better off in the future, particularly if market returns fall.

A significant advantage of RoboPPA™ is that the required inputs for its performance analysis can be saved in its template and updated monthly. This can be done entirely on the user’s computer and never stored on the software’s servers. RoboPPA™ maintains and updates the benchmark database thereby reducing the user’s work. Finally, the software allows analyses over any selected period contained in the data template’s horizon, providing it exceeds eight months.

Caveats

The analysis and the results in this document are not to be interpreted as representative of real markets and asset classes and are not warranted to be correct or complete. The example is based upon our opinion and interpretation of the data and results, which may be incomplete or incorrect. RoboPPA™ or the data suppliers are not responsible for any damages or losses arising from use of this blog. Details on the performance calculations are available on www.RoboPPA.com.