Gross Versus Net-of-Cost Performance

Gross performance measures what a strategy's signal would have earned trading at the mid-price with zero friction, it isolates whether the underlying idea has predictive power at all. Net performance subtracts everything it actually costs to act on that signal: commissions, the bid-ask spread paid on every entry and exit, market impact from moving the price, and any financing or borrow fees. The gap between the two isn't a rounding adjustment, for a high-turnover strategy it can be the entire difference between a strategy worth trading and one that loses money on every single trade despite having a genuinely predictive signal.

Why the gap can be large

Cost scales with how often a strategy trades, not with how good its signal is. A signal that correctly predicts a 0.05% expected move but requires trading in and out of a position to capture it will lose money if round-trip costs (spread plus commission plus impact) exceed 0.05%, regardless of how statistically significant the underlying prediction is. This is why gross performance alone tells you almost nothing about whether a strategy is investable: a signal can be genuinely real, well-validated, and statistically robust, and still be economically useless once realistic costs are applied, simply because it trades too often relative to the size of the edge it's capturing.

What a proper net calculation subtracts

A defensible net-of-cost number accounts for: the bid-ask spread crossed on every trade (roughly half-spread per side for a market order), commissions per share or per trade, an estimated market-impact cost that scales with order size relative to available liquidity (not a flat number, larger trades cost proportionally more), and any holding costs like margin interest or borrow fees for short positions. Skipping any one of these, most commonly market impact, since it's the hardest to estimate, produces a net number that's still optimistic, just less so than gross.

Worked example: a signal that dies at realistic costs

A mean-reversion signal trades 200 times a year, capturing a gross average of 8 basis points per round trip, for a gross annual return before compounding of roughly $200 \times 0.0008 = 16\%$. Estimated costs per round trip: half-spread 3bp each way (6bp round trip) plus commission 1bp plus market impact 4bp at the strategy's typical size, 11bp total round-trip cost. Net return per round trip: $8 - 11 = -3$bp. Net annual return: $200 \times (-0.0003) = -6\%$. A strategy showing +16% gross is actually losing 6% a year once realistic costs are applied, not because the signal is fake, but because its 8bp edge doesn't clear an 11bp cost hurdle.

What this means in practice

Never evaluate a strategy, or compare two strategies, on gross returns alone. The right question is always net-of-realistic-cost performance, and for high-turnover strategies especially, cost estimation deserves as much rigor as the signal research itself, since it's just as capable of determining whether the strategy is viable. A strategy report that shows only gross numbers, or that uses a flat, low, unjustified cost assumption, should be treated with the same skepticism as one with no out-of-sample testing at all.