Hypothetical Performance Risk Alerts

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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

A Summer Must-Read: the Latest SEC Risk Alert on the Marketing Rule

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The June 8 SEC Risk Alert isn’t a window into findings-to-date, nor a much-anticipated list of best practices offering clarification.  It is a solid overview of areas at your firm likely impacted by the new Marketing Rule (NMR).  Accept it as a “summer gift”: a quick read to inspire CCOs across the country to double-check key elements of the NMR and allocate some Annual Review testing time to map out your compliance in each of the areas included in the alert.

  • Policies & Procedures – Dates matter. Current SEC examination periods typically cover two years, which includes materials before and after the NMR.  Most firm’s P&P should have been edited to address new requirements, and the SEC’s initial request lists are looking for dates and descriptions of changes.

Recommendation: save redline versions and/or include effective dates in the P&P document.

  • Performance advertising/substantiation/books and records – The SEC reiterated its focus on these areas, so be sure to document, train, and collaborate with professionals at your firm directly responsible for compiling advertising inputs.

Recommendation: reverse training – have performance analysts train compliance on their own desktop policies and procedures and look for ways to continually improve documentation and disclosures; for GIPS compliant firms, reference additional GIPS P&P in your compliance manual.

  • General prohibitions – SEC registrants must be honest, fair, and balanced in your advertisements. As much as we love reading actual examples of violations (there were none included in the risk alert), we wouldn’t want anyone reading this to be made an example. Compliance needs to review not only what’s on the face of the firm’s advertisements, but also reviewing for what isn’t there.  And, where’s the backup?

Recommendation: review your firm’s advertisements with each of the seven prohibitions as a viewing lens. Is it unclear if a statement is a fact or opinion?  Could small edits make it more clear?  Does your firm advertise performance for strategies with no benchmark presented?  If so, what additional material market events need to disclosed to ensure the presentation is fair and balanced?

  • Three new areas of emphasis: Testimonials and Endorsements, 3P Ratings and ADV filings.

Again, no new guidance provided.  The focused summary provided in the risk alert, however, makes revisiting these areas in your firm’s policies, procedures, and everyday practices an excellent idea.

What we are hearing from SEC Consultants right now is: document and defend.  Firms need to know what is in their marketing materials and be able to defend anything that may be different from what is considered standard in the industry.  As your firm goes through this process, please let us know if you have any questions.  We are happy to help!

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.

From Team Performance to Investment Returns: Ted Lasso and GIPS Standards

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What do the GIPS Standards and Ted Lasso have in common?

The third season of Ted Lasso began in March 2023. For those that have not seen the show, it is about a small-time college football coach from Kansas named Ted Lasso, who is unexpectedly hired to coach a struggling English Premier League soccer team, AFC Richmond, despite knowing very little about soccer. While it may seem that Ted Lasso and the Global Investment Performance Standards (GIPS®) have nothing in common, we invite anyone working with GIPS compliance to explore the important similarities below and feel as good about what they bring to work as what Ted brings to his coaching.

At its core, Ted Lasso is about ethics, transparency, teamwork, and continuous improvement, and we are using the GIPS Standards framework to help clients tackle similar challenges every day.

Ethics: Ted and the GIPS Standards focus on ethics. Ted Lasso is known for his strong moral compass and commitment to doing what is right. Similarly, the GIPS Standards require investment managers to adhere to a strict code of ethics when reporting performance data, ensuring that they are not misrepresenting their results or misleading their clients. Choosing to be ethical is more than just following the rules; it’s the foundation for all of the decisions that come after.

Transparency: In the show, Ted is known for his open and honest communication style, an understated superpower that helps to build trust and rapport with his team. The GIPS Standards provide a powerful framework for investment managers to provide transparent and accurate performance data to their clients to build trust and confidence in their investment strategies.

Teamwork: Of course, a soccer show is about teamwork, but so is GIPS compliance. It applies to the whole firm, not just the back office or the front office, and the best GIPS compliance teams have representatives from executive leadership, compliance, operations, technology, marketing, and portfolio management.

Continuous Improvement: Ted is constantly looking for ways to improve himself and his team, even when things are going well, just as the GIPS Standards require investment managers to regularly review their performance reporting processes and make changes as needed to ensure they are meeting the highest standards of accuracy and transparency.

And the list goes on….

Attention to Detail: Both Ted Lasso and the GIPS Standards place a high value on attention to detail. Ted is known for his meticulous planning and attention to small details that can have a big impact on the success of his team. Anyone that’s worked with the GIPS standards knows compliance requires fiduciaries to pay close attention to the details, quarter after quarter, to ensure accuracy and consistency.

Standards of Excellence: Finally, both Ted Lasso and the GIPS Standards are focused on achieving high standards of excellence. In the show, Ted Lasso sets high expectations for himself and his team and is always striving to improve and achieve their goals. When the GIPS Standards were created, they were designed to provide the investment management industry a pathway to achieve the highest standards of accuracy, transparency, and ethical behavior for investment performance reporting, for firms (and now asset owners) to build credibility and trust with their clients and constituents.

While the connections between Ted Lasso and the GIPS Standards may seem tenuous at first, both share a commitment to excellence, ethics, transparency, teamwork, and continuous improvement. They also emphasize the importance of thinking long-term, paying attention to detail, and building trust through open and honest communication. Additionally, both have a strong focus on teamwork and collaboration, whether that’s between the characters in the show or between investment managers and their clients. Ultimately, these shared values and principles can help individuals and organizations achieve success in their respective domains, whether it’s on the soccer field or in the investment management industry.

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.

ESG Disclosure Standards

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In February 2023, CFA Institute released third-party assurance standards for firms claiming compliance with its Global ESG Disclosure Standards for Investment Products (the “Standards”).  As controversy over the proposed SEC ESG Rule grows, it’s important to understand the CFA Institute’s voluntary framework and assess the benefits of voluntary compliance and assurance on a firm’s investment products, as well as the similarities and differences in proposed regulations.

An Overview of the CFA Institute’s Global ESG Disclosure Standards

The CFA Institute’s Standards are designed to provide investors consistent, reliable ESG information that is complete and clear, to increase investor trust in the industry and avoid misleading greenwashing. The Standards allow firms to have specific ESG investment products claim compliance with these Standards and, as of February 2023, firms can have an independent third-party provide assurance for this claim. Unlike the proposed SEC ESG Rule, the Standards do not include any corporate or firm-level disclosures (other than stewardship activities discussed below).  The Standards include consideration of the intersection of a firm’s ESG policies, on a product-by-product basis, and that investment product’s objectives, investment strategy, and stewardship activities.  Firms that claim compliance with the Standards must document internal ESG policies and procedures that support the firm’s ESG-related marketing statements. Third-party assurance then adds an extra layer of accountability to further increase investor’s confidence that these products are actively and intentionally carrying out their ESG initiatives.

Sources and Types of ESG Information and Associated Disclosures

The ESG Disclosure Standards have different required disclosures for the various sources and types of ESG information. Below is a list of the sources and types of ESG information and a summary of the ESG Disclosure Statement requirements associated with each source/type.

  1. Financially Material ESG Information: Disclosures will need to describe how financially material ESG information is identified and incorporated into investment decisions, and any exceptions in which financially material ESG information is not considered in investment decisions.
  2. ESG Investment Universe (ESG index): if an ESG index is used as part of a product’s investment selection process, the disclosures will need to include either a description of how investors can obtain information about the index’s construction methodology, or, if the index is readily recognized, just the name of the index.
  3. Screening: If the investment product excludes certain investments or has criteria that must be met before an investment is considered, required disclosures include the characteristics and thresholds/conditions used to evaluate the investment, where the criteria are applied in the investment process, and whether there are any laws, regulations, or third-party frameworks used in the evaluation criteria.
  4. Portfolio-Level ESG Characteristics: products with portfolio-level targets for ESG characteristics will need to disclose:
    • the portfolio-level ESG characteristics, how they are measured, the target value or range, how the target is expected to be attained, any risks that could hinder an attainment of the target, and whether there are any laws, regulations, or third-party frameworks used to measure the characteristics or targets.
    • If the product’s targets are compared to an ESG index, additional disclosures include the characteristic that is compared to the index, information about the index (depending on recognizability, similar to ESG Investment Universe requirements), and how investors can obtain information about the index calculation methodologies.
    • How progress toward, or attainment of, the targets are reported to investors.
  1. Portfolio-Level Allocation Targets: products with portfolio-level allocation targets must disclose the specific ESG characteristics that are targeted, the value or range of the target, and how progress toward, or attainment of, those targets is reported to investors.
  2. Stewardship Activities: disclosures must include the types of Stewardship Activities undertaken by the product, how the Stewardship Activities are relevant to the product’s objectives, and the processes/systems that support the Stewardship Activities. Additionally, disclosures must be made on how investors can obtain all policies which govern the products’ Stewardship Activities and how the Stewardship Activities are reported to investors.
  3. Environmental and Social Impact Objectives: disclosures must include the impact objectives (in measurable or observable terms), stakeholders who will benefit from these objectives, the time horizon over which the objectives are expected to be attained, how these objectives relate to other objectives of the product, and how the pursuit of impact objectives could result in a trade-off with other objectives. Other required disclosures include:
    • The proportion of the portfolio focused on these impact objectives
    • How they’re expected to be attained
    • Any risks that may hinder attainment of these objectives
    • How progress toward, or attainment of, the impact objectives is measured/monitored/evaluated
    • How progress is reported to investors
    • The process for assessing/addressing/monitoring/managing potential negative social and environmental impacts that may occur while attaining these objectives
    • How the attainment of impact objectives will contribute to third-party sustainable development goals.

The Standards vs. the Proposed SEC ESG Rule

Key Differences

  • The Standards are voluntary guidelines for asset managers and asset owners, while the proposed SEC ESG Rules would be mandatory for public companies that are subject to SEC reporting requirements.
  • The Standards include a new investment product-specific disclosure document—the ESG Disclosure Statement, while the proposed SEC ESG Rule disclosures would be added to already-existing documents such as fund prospectuses, annual reports, and regulatory reporting (Form ADV Parts 1 and 2), and the disclosure requirements vary based on the document in question.
  • The proposed SEC ESG Rule includes a significant emphasis on corporate Greenhouse Gas Emission (GHG) disclosures and a prescribed methodology for the calculation and presentation of GHG computations, while the Standards provide a framework that would include such considerations, if included in an investment product’s ESG approach, without addressing them specifically.
  • In contrast to the type of ESG investment-specific disclosures required by the Standards, the proposed SEC ESG Rule’s general requirements are broken down into two types of funds:
  1. Integration Funds: ESG factors are incorporated alongside non-ESG factors in the investment process, but the ESG factors are no more significant than the other factors.
  2. ESG-Focused Funds: Funds which focus on one or more ESG factors as a significant or main consideration in investment decisions (includes Impact Funds).

The required disclosures for Integration Funds are not as comprehensive as the required disclosures for Focused Funds (detailed in the graph below), and include ESG factors considered, a few sentence summary of how the Fund incorporates such ESG factors in the investment selection process, and a description of GHG selection process and calculation methodology, if any.

  • The Standards provide a set of recommended metrics and data points for reporting on ESG issues, while the SEC’s Proposed Rules do not prescribe specific metrics beyond GHG calculations, but instead require companies to disclose material climate-related risks and opportunities.
  • The Standards are a finalized, flexible global framework, while the proposed SEC ESG Rule is still a moving work-in-progress limited to U.S. companies.

Similarities

The Standards and the proposed SEC ESG Rule both prioritize the disclosure of material ESG information that is relevant to a company’s business and financial performance.  They also are designed to be compatible with existing reporting frameworks, such as the Global Reporting Initiative (GRI) and the Sustainability Accounting Standards Board (SASB)

Below is the tabular format in which the SEC has proposed ESG-Focused Funds present the required information in their Fund Prospectuses. We’ve added an additional column to show the comparison between the proposed SEC ESG Focused Fund disclosures and the Standards.


In summary, the Standards and the proposed SEC ESG Rule have different scopes, focus areas, and approaches to ESG reporting. However, both initiatives are aimed at improving transparency and accountability in ESG reporting, which can help investors make better-informed decisions and promote more sustainable business practices.

As firms consider if they will comply with the CFA Institute’s voluntary Standards, we are here to help.  If your firm is interested, please contact us to discuss Cascade Compliance’s ESG consulting  and assurance solutions.

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.

Year-End Marketing Material Updates

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And a new FAQ from the SEC

RIAs across the country are preparing year-end 2022 performance presentations, and for most GIPS compliant firms, it’s time to update annual performance on your GIPS Reports.  Or is it?  Below are four timely Q&As as we kick-off annual verifications and performance examinations.

1) Is it better to send updated GIPS Reports to your verifier at the beginning or end of the verification?

Most verifiers provide an initial request list asking for policies, performance data, and GIPS Reports right from the start. However, many firms prefer waiting right until the end of the verification to update their GIPS Reports, in case there are updates made to a composite that could change year-end statistics.  At Cascade, we’ll work with your preferences, while also making suggestions to make the process more efficient.  We encourage firms to draft GIPS Reports using their best data, generally the performance data being provided as part of the initial request at the beginning of the verification, and send the GIPS Reports along with the performance.  That way, your verifier can triangulate the most up-to-date policies, performance, and GIPS Reports from the beginning.  Firms may have to make an update to their GIPS Reports at the end of the verification, however more general updates can be communicated from the onset of the initial data review, rather than after multiple rounds of open items at the end of the verification.

2) With the new SEC Marketing Rule in effect, can we distribute GIPS Reports as stand-alone performance presentations with just the performance updated by January 31 (and the rest of the statistics provided through 2021)?

Yes.  Only the required time period performance (1-, 5-, and 10 year returns) is required to be updated within 30 days.  However, as stand-alone presentations, GIPS Reports must include 5- and 10-year returns (or since inception returns, if 5 or 10 year returns aren’t available) through December 2022, in addition to annual 2022 performance.  GIPS Reports must also include benchmark performance for the same time periods composite performance is presented.

January 2023 is the first time firms are required to make annual updates to GIPS Reports while also taking the new Marketing Rule into consideration. For firms that distribute GIPS Reports annually to databases, it’s a great time to consider adding a separate table for SEC required performance time periods, if you haven’t already.

3) With the new SEC Marketing Rule in effect, can we leave 2021 performance in GIPS Reports unchanged until our firm’s AUM is finalized and the GIPS Reports are verified, which is usually during February or March, as long as the GIPS Reports are part of a fair and balanced presentation that includes 2022 performance?

Maybe.  Firms may satisfy SEC general prohibitions by documenting procedures for fair and balanced presentations that prominently present SEC required performance time periods, updated through December 2022 by the end of January. It depends on each firm’s appetite for risk, because what a fair and balanced presentation is under the Marketing Rule is still untested.  At a minimum, we would recommend including references from GIPS Reports to performance pages that have been updated through 2022 and to include required performance time periods.

Because of the significant differences between strong 2021 performance and bearish 2022 performance, we also recommend firms not updating their GIPS Reports to be prepared with an answer if an SEC examiner asks why they weren’t updated, since the performance numbers were available.  Even firms that elect not to include the SEC’s required time period performance on their GIPS Reports this year, may want to update just the annual performance (net and benchmark, and optional gross) through 2022 by the end of January.

The fourth and final Q&A below isn’t our own – it’s an FAQ published by the SEC in January, specifically for firms that manage private funds and want to show investment level returns.  Presenting deal level returns to prospective clients net of fees requires firms to make assumptions that aren’t necessarily helpful/meaningful when applied to unrealized gains and losses of individual investments. The SEC knows this and included a statement to that effect in the proposed PF guidance for reporting to existing clients.  The new marketing rule FAQ below emphasizes subjective selection of best performers as a concern when reporting to prospective clients, and it addresses case studies and groups of investments, rather than addressing a complete side-by-side presentation of all gross deal level returns.  A law firm might argue that such a breakdown of every investment return could still be shown gross of fees in support of fund level returns presented both net and gross of fees.  With only three published FAQs, however, we believe the SEC’s decision to not explicitly permit such a presentation speaks volumes.

What do you think?  We’re not lawyers, but we’d be happy to help you with straightforward assumptions and methodologies for allocating management fees to deal level returns and documenting calculations in performance disclosures.

From: SEC.gov | Marketing Compliance Frequently Asked Questions

 Q. When an adviser displays the gross performance of one investment (e.g., a case study) or a group of investments from a private fund, must the adviser show the net performance of the single investment and the group of investments?

A. Yes. The staff believes that displaying the performance of one investment or a group of investments in a private fund is an example of extracted performance under the new marketing rule.[1]Because the extracted performance provision was intended, in part, to address the risk that advisers would present misleadingly selective profitable performance with the benefit of hindsight, the staff believes the provision should be read to apply to a subset of investments (i.e., one or more). Accordingly, an adviser may not show gross performance of one investment or a group of investments without also showing the net performance of that single investment or group of investments, respectively.[2]In addition, the adviser must satisfy the other tailored disclosure requirements as well as the general prohibitions, including the general prohibition against specific investment advice not presented in a fair and balanced manner, when showing extracted performance.[3]

At Cascade Compliance, we believe that every firm deserves personalized, timely service provided by experienced professionals.  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.

[1] Extracted performance means “the performance results of a subset of investments extracted from a portfolio.” Rule 206(4)-1(e)(6). See section II.E.5 of the adopting release.

[2] The rule prohibits any presentation of gross performance in an advertisement unless the advertisement also presents net performance. See section II.E.1 of the adopting release. The gross and net performance requirement applies to not only an entire portfolio but also to any portion of a portfolio that is included in extracted performance. See sections II.E.1(a) and (b) and the definitions of gross and net performance in rule 206(4)-1(e)(7) and (10) (“Net performance means the performance results of a portfolio (or portions of a portfolio that are included in extracted performance…”)). The adopting release also states that the rule requires that advisers that show extracted performance must show net and gross performance for the applicable subset of investments extracted from a portfolio. See section II.E.1.a. of the adopting release (discussing gross performance).

[3] The adopting release states that “advisers should evaluate the particular facts and circumstances that may be relevant to investors, including the assumptions, factors, and conditions that contributed to the performance, and include appropriate disclosures or other information such that the advertisement does not violate the general prohibitions…or other applicable law.” See section II.E.1 of the adopting release (discussing the net performance requirement). In addition, it would be considered “misleading under the final rule to present extracted performance in an advertisement without disclosing whether it reflects an allocation of the cash held by the entire portfolio and the effect of such cash allocation, or of the absence of such an allocation, on the results portrayed.” See section II.E.5 of the adopting release (discussing extracted performance).