FAS 157 Fair Value for Active vs Passive fees

[Amy7]

Under fair value accounting, we must assume that all funds earn the same risk-free return regardless of their expected real-world performance.

The question is, do we assume they earn the same return prior to fees, or on a net basis after fees?

Suppose I invest 1000 in an actively managed fund with an 80bp fee. I decide to move it to a passively managed fund with a 50bp fee. If they earn the same return prior to fees, then I will make a fair value gain from this transaction. This seems counter to the theory that I should not make a fair value gain at the point of a trade. This would support them earning the same return on a net basis after fees - so a fund with higher fees should get a higher (gross) return.

However, I have not heard of people assuming this, and ultimately FAS 157 requires market consistency.

If you know what is commonly done, or even better, can refer me to a paper, book, or any source in which this issue is discussed, I would appreciate it.

Thank you!

[Amy7]

Originally Posted by Car'a'carn

I believe it should be gross return. Fund fees are your payment for the service, and do not depend on the fund performance.

Besides if you use net return, then you will have a risk free rate for every fund, this seems very unrealistic and confusing.

I agree it would be confusing - though one could model it by settling on a risk free rate net of fees, and applying this same growth rate to all funds (and then not modeling fees).

What do you say to this argument:

Originally Posted by Amy7

...Suppose I invest 1000 in an actively managed fund with an 80bp fee. I decide to move it to a passively managed fund with a 50bp fee. If they earn the same return prior to fees, then I will make a fair value gain from this transaction. This seems counter to the theory that I should not make a fair value gain at the point of a trade....

I'm still really looking for references if anyone has any to suggest.

(Note Car'a'carn's response was in the Life subsection, I responded here to avoid having multiple threads about the same topic.)

[Car'a'carn]

Originally Posted by Amy7

I agree it would be confusing - though one could model it by settling on a risk free rate net of fees, and applying this same growth rate to all funds (and then not modeling fees).

Net of fees will be different for different companies, because of different invested amounts in different funds, so you switch from risk free rates based on the fund to risk free rates based on the company. I think fees should be modeled as an expense.

[Amy7]

Originally Posted by Car'a'carn

Net of fees will be different for different companies, because of different invested amounts in different funds, so you switch from risk free rates based on the fund to risk free rates based on the company. I think fees should be modeled as an expense.

I didn't mean that each company would settle on a risk free rate net of fees. I mean the market would settle on what the proper risk free rate net of fees would be, just as the market has currently settled on LIBOR being proper risk free rates. Each company would then use the identical market consistent net-of-fees yield curve, and ignore fees in their modeling.

I am not arguing for this view, merely saying that it would be a simple way to model the view that net return should be the same for all investments.

Possibly some people are already doing this, and viewing the LIBOR rate as this net-of-fees rate (i.e. not subtracting fees in their projections). If so (or if not) at your company, that would be helpful information. Also if you know of written guidance which dictates what to do, or any other resources, that would be helpful.

[Flavia Flav]

Originally Posted by Amy7

Under fair value accounting, we must assume that all funds earn the same risk-free return regardless of their expected real-world performance.

The question is, do we assume they earn the same return prior to fees, or on a net basis after fees?

Suppose I invest 1000 in an actively managed fund with an 80bp fee. I decide to move it to a passively managed fund with a 50bp fee. If they earn the same return prior to fees, then I will make a fair value gain from this transaction. This seems counter to the theory that I should not make a fair value gain at the point of a trade. This would support them earning the same return on a net basis after fees - so a fund with higher fees should get a higher (gross) return.

However, I have not heard of people assuming this, and ultimately FAS 157 requires market consistency.

If you know what is commonly done, or even better, can refer me to a paper, book, or any source in which this issue is discussed, I would appreciate it.

Thank you!

For the "pure" fair-value point of view, think of it in terms of a dividend-paying asset vs. a non-dividend-paying asset. Dividends affect the net risk-free return for risk-neutral valuation. In the case of a management fee, the asset just happens to be funding a dividend received by someone other than the asset's owner.

On the argument about the fair value gain upon trading: the fund managers certainly experience a fair value loss, why shouldn't it be a gain for the asset owner? As in the post above, the management fees are an expense.

Couldn't say that's necessarily the "most common" approach though. It certainly isn't universal.

[Amy7]

Originally Posted by Flavia Flav

For the "pure" fair-value point of view, think of it in terms of a dividend-paying asset vs. a non-dividend-paying asset. Dividends affect the net risk-free return for risk-neutral valuation. In the case of a management fee, the asset just happens to be funding a dividend received by someone other than the asset's owner.

On the argument about the fair value gain upon trading: the fund managers certainly experience a fair value loss, why shouldn't it be a gain for the asset owner? As in the post above, the management fees are an expense.

Couldn't say that's necessarily the "most common" approach though. It certainly isn't universal.

Hi Flavia,

Thanks... Those are helpful arguments, I understand your reasoning.

What do you mean when you say you can't say it's the "most common" approach and is not universal. Are you saying you know of some companies which do not subtract fund fees while doing a FAS 157 valuation?

Also, once again I repeat my request for papers on the subject, if you or anyone knows of any.

Thank you!

Amy7