Net-of-fee returns

Net-of-fee returns show the actual investment performance that investors receive after all fees and expenses have been subtracted from gross returns. This calculation gives investors the most accurate picture of their real experience. The hedge fund industry uses this as the standard measure for reporting and comparing performance.

To understand this concept, consider the difference between gross and net returns. Gross-of-fee returns Gross-of-fee returns Gross-of-fee returns represent investment performance calculated before deducting management fees and performance-based compensation, providing a measure of a hedge fund's investment performance before considering the impact of the fee structure. represent the fund's investment performance before any deductions. Net-of-fee returns show what investors actually receive after paying for fund management and operations. This distinction matters because fees compound over time and can significantly reduce overall returns.

The Securities and Exchange Commission (SEC) has created clear rules for how investment managers must present performance results. The SEC considers it misleading and prohibited to show performance results before deducting advisory, brokerage, and other fees. Such presentations fail to show the true cost of compensation paid to advisers and others, which reduces the actual returns that investors receive.

The regulator emphasizes that simply disclosing applicable fees when showing gross performance is not enough. Investors cannot easily calculate the cumulative negative impact that compounding fees have on performance results over time. Therefore, net-of-fee presentations protect investors by providing transparency about their true returns.

Net-of-fee returns account for all fund-level expenses that reduce what investors receive. These expenses include management fees Management fee Management fee refers to a recurring fee, typically calculated as a percentage of assets under management, that hedge funds charge investors to cover operational and administrative expenses regardless of fund performance. , performance fees Performance fee A performance fee is compensation paid to a hedge fund manager based on the fund's investment profits, typically calculated as a percentage (commonly 20%) of returns above a specified threshold, subject to high-water marks and potentially hurdle rates. or allocations, administration fees, audit fees, legal fees, and other operating expenses. This comprehensive approach to deductions ensures that performance figures reflect the actual economic benefit received by investors rather than theoretical returns that ignore the cost of investment management.

The range of deducted expenses is broad because hedge funds have complex operational requirements. Management fees typically range from 1-2% of assets annually, while performance fees often take 15-20% of profits above certain thresholds. Administrative costs, while smaller individually, can add up significantly over time when combined with other operational expenses.

Although net-of-fee returns remain the regulatory standard, the SEC does allow investment advisers to show gross-of-fees performance Gross-of-fee returns Gross-of-fee returns represent investment performance calculated before deducting management fees and performance-based compensation, providing a measure of a hedge fund's investment performance before considering the impact of the fee structure. in certain limited situations. Advisers may present gross performance only if they also show net-of-fees performance with equal prominence. They must also include proper disclosure that explains how the calculations were made and clarifies that gross performance does not reflect the payment of advisory and other fees and expenses.

Recent guidance from March 2025 provides additional flexibility for presenting certain portfolio characteristics and performance metrics on a gross basis without corresponding net performance. This applies when specific conditions are met, including situations where the gross characteristic is clearly identified as calculated without fee deductions, accompanied by total portfolio gross and net performance, and presented with equal prominence to help with comparison.

When different clients pay different advisory and other fees, the SEC does not require advisers to present performance that reflects the actual fees charged to each specific client. Instead, the SEC allows advisers to present performance results calculated using the highest fees charged to any client. This approach must include appropriate disclosures that explain how such performance results were calculated.

This practice ensures that performance presentations are conservative and do not overstate returns for any investor group. Investors can understand that their actual returns may be higher if they pay lower fees than the maximum fee structure used in the calculations.

The regulatory framework surrounding performance advertising stems primarily from the 1986 Clover Capital no-action letterA significant SEC no-action letter that provided new guidance allowing investment managers to use hypothetical performance in their marketing materials under specific conditions., which identifies several practices considered false or misleading when presenting performance results. Among these prohibited practices is the failure to adjust performance results for advisory fees, brokerage commissions, or other expenses.

This guidance reinforces the importance of net-of-fee presentations for maintaining regulatory compliance. However, advisers should note that current Marketing RuleThe SEC's current regulation governing investment adviser advertising and marketing practices, which permits hypothetical performance with proper disclosures and became fully effective in November 2022. requirements have evolved beyond the original Clover Capital framework and now include additional considerations for performance presentation and advertising practices.

Investment advisers must maintain comprehensive records that support their performance presentations. Current recordkeeping rules require registered advisers Registered investment adviser (RIA) A registered investment adviser (RIA) is a hedge fund manager or other investment adviser that has registered with the SEC or state securities regulators. These advisers must follow comprehensive rules including fiduciary duties, compliance requirements, and regular examinations. to preserve information and documents used to form the basis for performance results, including net-of-fee calculations. These records must be kept for five years from the end of the fiscal year in which the advertisement with performance results was last published or communicated.

These records must be maintained in an easily accessible format. The first two years must be kept in an appropriate office of the adviser for immediate access during examinationsRegulatory inspections and reviews conducted by SEC staff to assess investment adviser compliance with federal securities laws and regulations. or regulatory inquiries. This requirement ensures that advisers can demonstrate the accuracy and methodology behind their performance calculations when regulators conduct reviews.