Hypothetical Performance Risk Alerts

As long as you haven’t been living under a rock for the past year, you may have heard that a modernized Securities and Exchange Commission (SEC) Marketing Rule went into effect this past November 2022. These past few weeks, the SEC has charged 10 firms with violating the New Marketing Rule (NMR), and each of the firms charged share a common error: advertising hypothetical performance without establishing and implementing the required internal “policies and procedures reasonably designed to ensure that the performance is relevant to the likely financial situation and investment objectives of the intended audience.”

In this article, we explore the importance of internal policies and procedures—especially as it pertains to hypothetical performance under the NMR.  The adopting release for the NMR notes that hypothetical performance can be useful, and it isn’t banned.  However, firms not only need to document how they are managing the risk of showing returns with “attention-grabbing power”[1] and ensuring those returns are relevant, they also need to be following those internal procedures.

Policies and procedures—and the compliance officers charged with drafting them—may finally be getting the attention they deserve.  All firms claiming compliance with the GIPS standards have comprehensive written policies covering distribution of performance and disclosures, and the vast majority of those firms also have an outside verifier to test that the policies are actually implemented.  One of the key benefits of claiming compliance with these voluntary standards, that goes way beyond marketing objectives, is attributed to those policies and procedures: getting input into the policies across the firm; having relevant training and continuous feedback from independent verifiers; and providing accessibility and consistent application to newcomers across the firm and over time.

Whether firms are claiming compliance with the GIPS standards or not, well-written performance calculation and distribution policies tailored to your firm with input from all departments to ensure relevance and increase firmwide adoption/implementation is an opportunity to raise operational efficiencies, not a cost center.  The inclusion of detailed actual and hypothetical performance requirements in the NMR has created an opportunity for firmwide dialogue in order for your firm to adopt updated regulatory compliance policies that reflect the NMR requirements that aim to ensure performance is relevant.

The NMR emphasized that hypothetical performance is not suitable for broad marketing to a mass audience, and the nine firms charged in September 2023 all included hypothetical performance on their public websites.  At first read, it doesn’t appear these firms took the time for that firmwide dialogue or careful consideration.  If hypothetical performance is an important tool for your firm and relevant to many of your prospective clients, then the appropriate response to these charges isn’t to quit showing hypothetical performance altogether, but to carefully consider the context in which you present such performance figures. With mass audiences, firms can’t make assumptions about individual financial situations or investment objectives or know if the recipients of the performance are sophisticated enough to interpret the information and understand the risks.  Even in one-on-one presentations, it’s important to make sure your firm is documenting and tracking who is receiving hypothetical performance and relevance criteria.  Our recommendation is to not show hypothetical performance on your website to reduce your regulatory risk.

Compliance with these new requirements is paramount, not only to avoid the very real censure, penalties, and other regulatory consequences faced by these firms, but also to uphold transparency and trust within the industry. Investment firms that successfully navigate these changes will be better positioned to provide investors with meaningful and relevant performance information for their financial decisions.

As firms continue to evaluate value-add performance consulting and verification providers, we hope you’ll consider Cascade Compliance.  We can tailor our high-touch personalized professional service, experienced staff, and competitive fees for a best-fit solution for your firm.  For firms already working with another verifier, we will make the transition seamless, so you only notice the extra responsiveness and attention to detail. Cascade Compliance has over 45 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.

[1] SEC.gov | SEC Sweep into Marketing Rule Violations Results in Charges Against Nine Investment Advisers