SEC Marketing Rule – Hypothetical & Extracted Performance

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Hypothetical performance and extracted performance are a key point in the SEC Marketing Rule set to take effect on November 4, 2022.  Firms that have previously used model, targeted, projected, and back tested performance need to take special care when presenting such performance to prospective clients.  The new rule is a significant change from what a lot of firms have been previously allowed to do.

Hypothetical performance will only be allowed after November 4, 2022, if the advisor takes specific steps to address its potentially misleading nature. The SEC’s goal with this portion of the rule is to ensure that advertisements containing hypothetical performance are only distributed to investors who have the financial expertise and resources to interpret the data and understand the risks and limitations of these types of presentations.

There is no distinction between retail and non-retail investors in the new rule when considering the sophistication of the audience receiving the hypothetical performance). The only exception to the hypothetical performance rule is one-on-one communications provided in response to unsolicited investor requests or provided to a private fund investor.

What is considered hypothetical performance?

Hypothetical performance is defined as performance results that were not achieved by any portfolio of the investment advisor. Hypothetical performance includes, but is not limited to: model performance, backtested performance, and targeted or projected performance returns.

Model performance includes performance where the advisor applies an investment strategy that is similar to an actual investor account but makes slight changes to the model to accommodate different investor objectives. Computer generated models are included in the definition of model performance. This type of performance was originally described in the Clover Capital No Action Letter.

Backtested performance is performance that has had a strategy applied historically to market data from prior periods when the strategy was not actually used. This includes scenarios where an advisor could backtest performance based on current strategy data and apply it historically either because the manager doesn’t have actual portfolios during the period, or because the manager doesn’t have access to portfolio books and records for the past period.

Targeted and Projected performance reflects an advisor’s aspirational performance goals. These returns reflect an advisor’s performance estimates, often based on historical data and assumptions. Projections of general market performance or economic conditions are not subject to the provision on presentation of hypothetical performance.

What’s New

  1. The advisor must create and implement policies and procedures designed to ensure the performance information provided is relevant to the financial situation and investment objectives of the intended audience of the advertisement. These policies do not need to address each specific recipient’s circumstances but rather the likely investment objectives and financial situation of the advertisement’s intended audience. Being thoughtful in your establishment of policies and procedures that connect your firm’s hypothetical performance as a useful tool for your typical clients is a key step in being ready for November 2022.

What’s Familiar

  1. The performance being presented must be net performance—just like all actual performance beginning November 2022.
  2. An advisor must provide sufficient information to the intended audience to enable them to understand the criteria and assumptions used in calculating the performance. Sufficient information includes details about how the hypothetical performance is calculated and describes any assumptions used.
  3. An advisor must provide (or offer to provide if the audience is a private fund investor) sufficient information that enables the intended audience to understand the risk and limitations of using hypothetical performance in making investment decisions. Risk information should include reasons why the hypothetical performance might differ from actual performance of a portfolio. An example of this would be external cash flow timing. Simply disclosing the possibility of loss is not enough to satisfy this requirement.

Hypothetical Performance Example

Below is sample disclosure language pertaining to risk information for prospective clients and investors to understand the hypothetical performance shown.  Much of the sample language is straight from rescinded SEC no-action guidance, and we expect such guidance to live on in the implementation of the new Marketing Rule.  While there are familiar disclosures below, we encourage firms to be thoughtful in considering the variety of reasons that their hypothetical performance may differ from actual performance.

The presented performance represents hypothetical model results during the measurement time period. As such, these results have limitations, including, but not limited to, the following:

  • model performance may not reflect the impact that material economic conditions and market factors would have had on the adviser’s decision making or on individual clients, or the impact of the timing of actual client cash flows into or out of an actual portfolio;
  • results do not reflect actual trading by specific clients, but were achieved by [describe calculation methodology and material objectives or strategies used to obtain results];
  • model performance does not reflect brokerage commissions, custodian fees, taxes, or any other expenses a client would have paid, and as such, actual investment returns would be lower;
  • how (if) model performance reflects investments that differ from advisory services currently offered; and
  • hypothetical past performance [just like actual past performance] is no guarantee of future results.

One final note on hypothetical that bridges both policies and disclosures pertaining to hypothetical performance: with the new requirement to show related account performance for actual accounts, now more than ever, it is important to have policies and procedures for reviewing actual portfolio performance to results portrayed in a model.  Results that are materially similar will lend credibility to the usefulness and relevance of the hypothetical/model performance.  Alternatively, we recommend firms reconsider using model performance where model results materially differ from the actual results of related accounts, nor can firms use model results as a replacement for doing the difficult work of aggregating related account performance histories.

Extracted Performance

Extracted performance is defined as performance results of a subset of investments extracted from a single portfolio. This type of performance is commonly known as a “carve-out” to firms that comply with the Global Investment Performance Standards (GIPS®). Additional requirements will apply to advisors who present this type of performance.

The advisor must provide, or offer to provide promptly, the results of the total portfolio from which the extracted performance was derived. This is intended to prevent advisors from cherry-picking certain performance results.

Performance that is extracted from a composite of multiple portfolios is not considered extracted performance because it is not a subset of investments extracted from a single portfolio. This type of performance (including carve-out composite performance that complies with the GIPS Standards) is considered hypothetical and will be subject to the hypothetical requirements discussed above.

The final rule does not require a specific treatment for cash allocation in extracted performance. However, it would be considered misleading to not disclose the allocation of cash and the effects of the cash allocation, or the absence of a cash allocation. When crafting disclosures to meet the SEC rule, it’s important to consider the intended audience. For firms claiming compliance with the GIPS Standards,  cash allocations and additional disclosures are required.

With the SEC Marketing Rule, please remember that when performance is shown, firms must show performance as net of fees.  Firms can also show gross of fee performance however, net must be shown in equal prominence.

Read our blog on SEC portability and predecessor performance here.

If you have any other questions regarding the marketing rule, contact us here.

Cascade Compliance has over 34 years of combined experience working with SEC Regulations, the GIPS standards, and performance.  Our employees have worked with hundreds of firms in the U.S. and abroad.  One of the best parts of working with clients is getting to share expertise and knowledge of best practices across the industry.  Whether you are a client of ours or not, we are here to help you get better at what you do and answer any questions you may have.  Contact us at connect@cascadecompliance.com.

 

SEC Marketing Rule – Prescribed Time Periods

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The modernization of the SEC Marketing Rule has firms hard at work to comply with new requirements related to the presentation of performance. One of these requirements is referred to as Prescribed Time Periods, where a firm must present a 1-, 5-, and 10-year net returns in any of its marketing materials that show performance. This level of prescription is a significant departure from the SEC’s past performance disclosure requirements.  Similar to the GIPS Standards®, this requirement is particularly valuable in that it prevents firms from presenting only the best time periods and also provides prospective clients comparable short-term and long-term performance figures across RIAs. Below, Cascade outlines the requirements for presenting the prescribed time periods, and what this will mean for GIPS Compliant firms.

Presentation Requirements

Beginning November 4, 2022, all performance presented in an SEC-registrant’s marketing materials must include the additional time period requirements. Private funds are currently exempt from the prescribed time periods; however, there is a proposed rule that would require the same time periods for liquid private funds for their current investors.

One-, five- and ten-year net performance must be included in marketing materials when presenting performance. For strategies without ten (or five) years of performance, a since inception return is required. The SEC Marketing Rule does not specify whether cumulative or annualized returns are to be used when calculating these returns. Cascade recommends annualized returns for easier comparison to annual performance and for consistency with industry best practices.

All returns must be updated through an end date no less recent than calendar year-end. The one caveat is if there has been an event which has had a significant negative effect on performance. In that case, performance through the most recent quarter-end is required (if available). If the most recent quarter-end performance is not available, the adviser should include appropriate disclosure on the performance that is presented.

As of now, it’s expected of firms to have updated performance numbers on marketing materials within one month of year-end (or quarter-end when there’s been significant negative performance as mentioned above). While this is not explicitly stated in the SEC’s marketing rule document, it was addressed in an April Q&A which can be found here. If your firm has illiquid products, stay tuned. Future SEC guidance for illiquid investment performance is expected, and we will update this article when/if additional guidance is released for updating performance.

Implications for GIPS Compliant Firms

If your firm claims compliance with the GIPS standards and is SEC registered, additional requirements will apply. Showing a GIPS Report with 10 years of performance is not a substitute for the prescribed time period requirements. Each firm will need to consider how they present their GIPS Report to prospective clients to better understand their options for presenting the SEC required prescribed time periods.

  • If the GIPS Report is used as a standalone advertisement, 1-, 5- and 10-year net returns must be added to meet the SEC requirement.
  • If the GIPS Report is included as part of a pitchbook, the 1-, 5- and 10-year returns can be presented on a separate page.

Another important consideration is that the GIPS Standards require the presentation of benchmark returns for the same periods that composite returns are presented. If your firm claims compliance with the GIPS standards and adds 5- and 10-year composite gross and net returns to the GIPS Report, benchmark returns must also be shown for those same periods. Further, if your firm follows the GIPS Advertising Guidelines, a 3-year annualized return for the composite and benchmark is required in addition to the 1- 5- 10-year SEC prescribed time periods. Remember that everything on the GIPS Report is subject to your firm’s GIPS error correction policies, including the 5-, and 10-year returns, if added. We recommend firms add error correction policies and procedures for the prescribed time periods, should a firm include them in the GIPS Report.

Example 1-, 5-, and 10-year returns:

If you would like to receive a copy of our template for calculating annualized and cumulative performance, or have any other questions regarding the marketing rule, contact us here.

Cascade Compliance has over 34 years of combined experience working with SEC Regulations, the GIPS standards, and performance.  Our employees have worked with hundreds of firms in the U.S. and abroad.  One of the best parts of working with clients is getting to share expertise and knowledge of best practices across the industry.  Whether you are a client of ours or not, we are here to help you get better at what you do and answer any questions you may have.  Contact us at connect@cascadecompliance.com.

SEC Portability Predecessor Performance

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Money Can’t Buy You Love – Or Your Manager’s Predecessor Performance

A portfolio manager’s track record is an important asset and key pillar of evaluation by institutional investors/asset owners.  Ensuring that a portfolio manager’s performance can—or whether it should—go with her/him/the team to a new firm is of critical concern for planning or evaluating any transition.

At a high level, the new or acquiring firm must:

  • Make sure the strategy stays intact, with no break in performance – ✓
  • Bring the entire team primarily responsible for investment decisions – ✓
  • Secure books and records to support substantially similar management and “not materially higher” performance – ✓
  • And now, with the SEC’s new marketing rule – make sure no one responsible for the predecessor performance ever retires, dies, or decides to do something different.

With portfolio managers leaving firms, and mergers and acquisitions happening frequently, the latest regulatory update on what predecessor performance can and can’t be advertised will impact the current published performance of any firms with acquired track records where key decision makers have since moved on.

Let’s say you are evaluating Firm B, which acquired a Team from Firm A with a great ten-year track record in 2018.  The Team was with Firm B for three years and advertises a 13-year track record through 2021, with a disclosure that the performance results prior to 2018 were achieved by the Team at another firm.  Then, the key portfolio manager moves on to Firm C (or buys a yacht and sets off to sail around the world).  A strict interpretation of the SEC’s new rule leaves Firm B with a three-year track record, and disclosure of the departure of a key portfolio manager in 2022.

– Whatever Firm B paid to acquire that great ten-year track record goes out the door with any key person responsible for achieving it –

What about Firm A?   Firm A can continue to show the performance of the Team from 2009 through 2018, linked to its ongoing performance, with disclosure of the departure of key personnel in 2018.

What about Firm C?  If only one member of a two-person team goes to Firm C, Firm C gets the portfolio manager, but not the predecessor performance.  If Firm C is acquiring a strategy managed by a single portfolio manager with the books and records to support the entire history, Firm C can advertise the previous performance for the full 13 years, but only as long as the portfolio manager stays at Firm C.

This strict interpretation of the SEC’s Marketing Rule, which goes into effect this November, dwarfs the nuanced differences between the SEC’s requirements and the Global Investment Performance Standards (GIPS®) portability requirements. But should the new rule be interpreted so narrowly?

Two next-level considerations that will impact predecessor performance decisions going forward:

  • Manager knowledge transfer
  • The transitive property (of equality) on books and records

Manager Knowledge Transfer:

The GIPS Standards take the position that performance belongs to the firm.  Once the Team left Firm A to join Firm B in 2018, if all the requirements were met to link the ten-year predecessor performance from Firm A, Firm B can advertise that performance. Period.

During the three years that the Team is part of Firm B, investment professionals may come and go, research analysts are trained and promoted to portfolio management, and after three years, the Team has left an imprint on Firm B, even if a key portfolio manager moves on in 2022.  According to the GIPS Standards, Firm B can continue to advertise the 13-year performance record.  CFA Institute staff has communicated in every presentation on this topic that they hope the SEC will consider manager knowledge transfer in its interpretation and enforcement of the latest predecessor performance requirements.

How long does knowledge transfer take?  Many solo portfolio managers move from one financial institution to another, without training a team, and in those cases, Firm B shouldn’t continue showing the performance of a manager no longer managing accounts there, no matter how much time has passed.  What if Firm B acquires the Team from Firm A, and after just a few weeks/months, the key portfolio manager leaves?  Can the rest of the Team remaining at Firm B carry the knowledge transfer forward?  Stay tuned – the industry is eagerly anticipating the SEC’s answers to these questions.

The Transitive Property (of Equality) on Books and Records:

We all learned in grade school that if a = b, and b = c, then it follows that a = c.

This is good news for new or acquiring firms that don’t claim compliance with the GIPS Standards: essentially, if all accounts are managed similarly, then a subset of composite performance should be substantially similar to the composite.  This is the heart of an ongoing nuanced difference between SEC requirements and the GIPS Standards: the SEC only requires books and records to support that the historical performance is for “substantially similar” managed accounts and that results are “not materially higher” than the performance of all accounts managed in that strategy.

If the Team’s strategy at Firm A was block traded, with substantially similar performance for 100 accounts, Firm B doesn’t need custodial statements or portfolio accounting records for all 100 accounts to advertise the Team’s performance from Firm A.  If 25 of the accounts follow the Team to Firm B, it’s likely Firm B could obtain statements for just those 25 accounts and support advertised predecessor results that are “not materially higher.”

If Firm B does claim GIPS compliance, the Team will need to bring books and records for all accounts to advertise and link performance from Firm A. If Firm A claimed compliance with the GIPS Standards, policies for input and calculation methodologies and composite maintenance are also important for the Team to bring to Firm B.

More predecessor performance questions before we get to the other side of November 2022?

Cascade Compliance has over 34 years of combined experience working with SEC Regulations, the GIPS standards, and performance.  Our employees have worked with hundreds of firms in the U.S. and abroad.  One of the best parts of working with clients is getting to share expertise and knowledge of best practices across the industry.  Whether you are a client of ours or not, we are here to help you get better at what you do and answer any questions you may have.  Contact us at team.cascade@cascadecompliance.com.

Money-Weighted Returns in Excel

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Beyond “Don’t Use” – How (Not) to Calculate Money-Weighted Returns in Excel

If cost was of no matter, then asset managers would all own (fill in the blank with your favorite accounting system). Read more