Tag Archive for: Hypothetical Performance

SEC Marketing Rule – Hypothetical & Extracted Performance

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.

 

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.