Want to Show Performance and Not GIPS-Compliant?

The SEC Marketing Rule will require SEC-registered firms to have policies and procedures in place be able to show performance in marketing materials after November 4, 2022. For firms not claiming compliance with the GIPS Standards this could be challenging. This article will help you get a start on what is required and what is not.

Related Performance

The finalized rule requires the use of related net performance in advertisements, if performance is presented. This can be presented on a portfolio-by-portfolio basis or as a composite aggregation of all related portfolios. The rule does not specify which criteria should be used to determine related portfolios but requires advisors to document policies and procedures detailing the criteria used for including performance of all substantially similar portfolios. A portfolio may be excluded if the resulting performance results are not materially higher than if all related portfolios were included.

Where should a firm begin?  We’ve outlined some steps below:

1. Define the firm’s strategies and which accounts should be grouped together for the minimum 10-year history.
   • Determine how many strategies the firm has and wants to market
   • Look at investment policies and objectives across the accounts
   • Decide which accounts are similarly managed
2. Determine inclusion/exclusion policies
   • Inclusion: When an account opens the firm gets to decide a consistent policy for including accounts into the related performance. Some items to consider:
     • How long does it take to invest the account in the strategy?
     • Is there a percentage threshold for including accounts that have some assets not invested to the strategy?
   • Exclusion: When an account closes or changes strategies/guidelines, the firm gets to decide a consistent policy for excluding accounts from the related performance. Some items to consider:
     • Most firms choose to exclude accounts after the last full month under management of the strategy
     • Other options: quarterly exclusion, which is more common for illiquid strategies
3. Determine and document the calculation methodology used for calculating portfolio level performance. The SEC Marketing Rule specifically referenced the GIPS Standards as an acceptable framework. However, each firm needs to consider the resources available to them.  Methodologies listed below are commonly used in the industry, and the first two are used by GIPS compliant firms most frequently:
   • Daily performance using modified Dietz method
   • Monthly performance using modified Dietz method with large cash flows revalued on the date of the cash flow
   • Internal Rate of Return
4. Determine and document the calculation methodology used for the related performance and what the performance intervals (monthly, quarterly, annually) will be.
   • Most firms use a monthly asset weighted methodology
   • Firms with composite management systems can also use an aggregate method
   • While not allowed in the GIPS standards, firms might be able to use an equal weighted method
   • Present all individual portfolio returns for the required periods

For firms currently showing representative account performance, the new rule now requires policies and procedures as well as an analysis for determining that the single representative account returns shown are not material different than other accounts invested to the strategy.  The SEC wants to make sure firms are not cherry-picking accounts and showing their best performance.

Prescribed Time Periods

Once the firm has calculated related performance, the next item is required time periods of returns. If performance is shown, all advertisements must present 1-, 5- and 10-year net returns, with an end date no less recent than the most recent calendar year end. If the track record presented is shorter than 10 years, a since-inception return is required.

 

 

 

Firms will be expected to update returns through the most recent year end by 1/31 on all marketing materials. If gross of fee returns are shown, net returns must be presented with equal prominence and can be shown alongside returns for additional time periods if the firm chooses to present additional time periods.

The SEC does not specify whether cumulative or annualized returns must be used. Our recommendation is to use annualized returns to be more meaningful to prospective clients and align with the GIPS Standards advertising requirements. Either calculation is straightforward to do in Excel if you have monthly returns for the period.  See the formulas below if you want to try this at home.

5-year cumulative return =PRODUCT(1+MonthlyReturn1:MonthlyReturn60)-1
5-year annualized return =(PRODUCT(1+ MonthlyReturn1:MonthlyReturn60))^(1/5)-1

Extracted Performance

Extracted performance is defined as performance results of a subset of investments extracted from a portfolio. Under the final rule, extracted performance may be presented in an advertisement if certain conditions are met. The firm must disclose any differences between the total portfolio and the extracted performance and provide or offer to provide results of the total portfolio.

There is no prescribed methodology for the treatment of cash allocation within the extracted performance. Depending on the type of extracted performance, it may make sense to allocate cash synthetically. The firm must disclose whether cash was allocated to the extracted performance and the effect of the allocation, or if no cash was allocated. For example, “Extracted performance presented includes allocated cash.  Cash and cash returns are allocated to extracted performance based on each carve-out’s size relative to its total portfolio, using beginning-of-month values.”

Hypothetical Performance

Hypothetical performance is performance results that were not achieved by any portfolio managed by the investment advisor and includes model, back-tested, and projected performance returns. It is prohibited from being distributed in mass mailings or on general advertising such as the firm’s website. It may not be included in an advertisement unless certain steps are taken to ensure it is not misleading.

First, the firm must have policies and procedures established to ensure the information presented is relevant to the investment objectives of the intended audience and only distributed to investors who have the resources and expertise to analyze the information.

Second, sufficient information on the criteria and assumptions of the performance must be included. This will differ depending on the type of hypothetical performance presented and should enable the intended audience to understand the criteria and assumptions used in calculating the hypothetical performance.

Third, the firm must provide (or offer to provide if a private fund investor) sufficient details about the risks and limitations of hypothetical performance. This requirement will be met by tailoring the disclosures to the intended audience, so they can sufficiently understand the risks and limitations.

If presented, hypothetical performance does not need to comply with the required time periods, related performance or extracted performance requirements. Hypothetical performance presented in response to an unsolicited investor request may be provided in a one-on-one communication and would not be subject to any of the above requirements. Additionally, performance provided to a private fund investor in a one-on-one communication is excluded from the scope of these additional hypothetical performance documentation and disclosure requirements.

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.