30 September 2021
Main Contributor: Elizabeth Cope, CPA, CSCP, CIPM CEO & Lead Consultant
Did you know the old Advertising Rule NEVER addressed performance advertising and for years advisers relied primarily on the Clover no-action letter, which was drafted in 1986? The addition of requirements around performance advertising in the updated Marketing Rule is a necessary addition, and the focus of this series.
If you have not been following us, we highly suggest you start with the first article in our series, The Definition of an Advertisement, where we summarized the amended Marketing Rule’s definitions of an advertisement; specifically the elements covered under Prong 1 and Prong 2 of the definition. We follow this with part two of our series, which focuses on the General Prohibitions and what they mean in practice for our registered investment adviser audience. Every advertisement must fit within the realm of the General Prohibitions, and it is a necessary read in order to prepare for the impact they have on your marketing. Part 3 of our series addresses the use of Testimonials and Endorsements, which is the piece we find most advisers are excited about, and yet are most unaware of. To fully understand the requirements, please take the time to read that article.
In this article, the fourth in our series, we will breakdown the key requirements provided in the new Marketing Rule in three areas of discussion:
- Performance Reporting Requirements
- Hypothetical Performance
- Portability of Performance
As you are reading the requirements, we suggest you start making a list of the changes that need to be made in your current materials to prepare for these new requirements, which must be implemented no later than November 4, 2022. For those complying with GIPS, you will want to consider the similarities and differences to help further prepare for a discussion with your verifier when preparing your annual disclosure presentations.
1. Performance Reporting Requirements
The following requirements are necessary regardless of whether your audience is retail, institutional, or a private fund investor.
Every time you present performance, you will be required to provide net returns.
You are allowed to also present gross returns, but only if the net returns are presented with equal prominence. This means the same font, same page, same time-period and same type of return methodology so the reader can make an easy and quick comparison. Gross performance presented alone is considered misleading.
Net Performance is defined as the performance results of a portfolio after the deduction of all fees and expenses that a client or investor has paid or would have paid in connection with the investment adviser’s advisory services. Note the underlined “would have.” Keep this in mind as we discuss the use and requirements of hypothetical performance.
Gross Performance is defined to include the performance results of a portfolio before the deduction of all fees and expenses that a client or investor has paid or would have paid in connection with the investment adviser’s advisory services.
Fees Included in Net
The types of fees that could possibly be included in net performance include, but are not limited to:
- advisory fees
- advisory fees paid to underlying investment vehicles (e.g., mutual funds and ETFs held in the portfolio)
- payments by the adviser for which the client reimburses
- private fund fees and expenses
This is not an exhaustive list, and the SEC did not clarify what fees must specifically be included within the returns. Note the definitions above and take the time to understand all fees included and passed along to your clients to determine the appropriateness of the return calculations.
Custodian fees paid to a bank or broker-dealer safeguarding the client’s assets do not have to be included, unless the client is paying the adviser for those custodial services, in which case they should be included.
Use of a Model Fee
The presentation of net returns may be reduced by a model fee (versus actual fees paid by the clients), as long as the model fee is not lower than the highest fee a client would pay or the potential fee a client would expect to pay. You want to make sure the use of the model fee doesn’t make the net performance higher than if you had used actual fees. Take note, if you have changed your fee schedule over time, this could mean presenting net returns using the highest fee you no longer charge.
Type of Return
The new Marketing Rule does not specify the type of calculation to be used.
Advisers may use the type of returns appropriate for their strategies as long as they are in line with the General Prohibitions. Because the new Marketing Rule does define the types of expenses to include or exclude in gross returns, it is highly recommended that the advertisement discloses the components of the returns to make it transparent to the reader (i.e., “Gross Returns have been reduced by transaction costs. Net returns have been reduced by the management fees and one-time set up fee paid in the account.”)
Prescribed Time Periods
Advisers will be required to include a 1-, 5- and 10-year time period for the most recent calendar year-end, every time they are presenting performance (with an exception for Private Funds).
The periods must be presented with equal prominence to avoid highlighting the time period with the best performance. As long as the advertisement includes the prescribed time periods, you can include other time periods as well, such as quarter to date, year to date, or each annual period. If the portfolio wasn’t in existence for the particular periods required, then you may present information for the life of the portfolio. For example, if the portfolio has only been in existence for 7 years, your advertisement would include periods for the 1-, 5- and 7-year time periods.
Just to add some complexity, let’s look at the requirement in light of the general prohibitions., Depending upon the facts and circumstances it might be more meaningful to present the required performance for a period more recent than the calendar year. A possible example could be to use the period ending Q1 2020 to reflect the impact of the COVID pandemic on the markets.
SEC FAQ on Prescribed Time Periods
The SEC has provided two FAQs at this time on the new Marketing Rule. One of the FAQs shed light on performance, stating that it is expected when updating performance numbers following the quarter-end to present the previous period performance and update the current period’s no later than one month following the quarter-end.
Exception for Private Funds
The only exception to the required time periods of 1, 5 and 10 years is for private funds of any type. In fact, the new Marketing Rule does not mandate performance for any specific period for private funds. As a reminder, the General Prohibitions still apply, so the time periods used must not be misleading and must be fair and balanced.
When presenting performance, you will be required to include the performance of all your related portfolios. You are allowed to exclude related portfolios as long as the results would not be materially higher if they had been included. You may also present the performance of a representative account as long as it’s not higher than the performance of all related accounts and does not violate the general prohibitions. Warning here, because showing only one account could easily be construed as cherry picking – you will therefore need strong evidence and disclosures to ensure it is not misleading. This would require you to calculate the returns of all related portfolios in order to substantiate that the exclusion of related accounts or the presentation of a representative account does not result in higher performance.
The exclusion of a related portfolio may not impact the prescribed time periods discussed above. If the exclusion of a related portfolio only allows the adviser to present 1- and 5-year returns, when the inclusion of one could have resulted in the addition of the 10 year return, then that account must be included.
The SEC is not defining materiality. We suggest you set policies and procedures and include definitions to set up a clear process for presenting performance. It’s important to understand, the SEC could also disagree with your policies and processes when you get examined.
Related Portfolio is defined as a portfolio with substantially similar investment policies, objectives, and strategies as those of the services being offered in the advertisement.
You will be allowed to present extracted performance as long as you either include the total performance or offer to provide promptly when requested.
This may be useful when you are offering new or modified strategies. The new Marketing Rule does not indicate whether there needs to be an allocation of cash, which would be based on the facts and circumstances, particularly whether the cash would have an impact on performance.
Extracted Performance is defined to include the performance results of a subset of investments extracted from a portfolio. Take note, this does not include the extracted performance of composites but only that of a single portfolio.
The new Marketing Rule does not prescribe disclosure requirements for gross and net returns, instead advisers will have to comply with the General Prohibitions when determining what disclosures are necessary. However, similar to the Clover no-action letter, the SEC provided disclosures that advisers may include, such as:
- The material conditions, objectives, and investment strategies used to obtain the results portrayed.
- Whether and to what extent the results reflect the reinvestment of dividends and other earnings.
- The effect of material market or economic conditions on the results portrayed.
- The possibility of loss.
- The material facts relevant to any comparison made to the results of an index or other benchmark.
In addition to the examples noted above, advisers should take into consideration additional disclosures around how the performance is calculated, the types of fees included and possibly excluded, if cash was or wasn’t allocated in the extracted performance, the use of a representative account, and any other information that would be relevant for the reader to make a sound decision regarding the performance provided.
2. Hypothetical Performance
Buyer Beware! If you plan on presenting hypothetical performance, be sure to understand that it will face greater scrutiny from the regulators. I would argue for good reason, as it’s NOT real! However, there are good reasons to present hypothetical performance, such as to provide deals made from previous funds when launching a new fund or providing potential performance of a new investment strategy and/or methodology. When using hypothetical performance, you MUST implement and consistently apply the requirements discussed herein.
Hypothetical Performance is defined as performance results that were not actually achieved by any portfolio of the investment adviser and explicitly includes, but is not limited to, model performance, back tested performance and target or projected performance returns.
Under the new Marketing Rule, the following conditions MUST be met before hypothetical performance can be presented:
- Policies and Procedures. You must adopt written policies designed to ensure hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience.
- Disclosures. You must provide sufficient information to enable the audience to understand the criteria used, assumptions made, and the risks and limitations.
- The Advertisement meets the requirements of the General Prohibitions.
To meet the first condition, you must only present hypothetical performance to an investor that has the resources and financial expertise to understand and interrupt the results. The policies should address how this will be ascertained and supported. For example, having an existing relationship with the investor to conclude their financial sophistication could qualify.
Investment Analysis Tools
Investment Analysis Tools will be exempt from the definition of hypothetical performance. It is defined as an interactive technology tool that produces simulations and statistical analysis that present the likelihood of various investment outcomes if certain investments are made or certain investment strategies or styles are undertaken, thereby serving as an additional resource to investors in the evaluation of potential risks and returns of the investment choices. However, the following disclosures must be included:
- Description of criteria and methodology used, including the investment analysis tool’s limitations and key assumptions.
- Explain that the results may vary with each use over time.
- Describe the universe of investments considered in the analysis.
- Explain how the tool determines which investments to select.
- Disclose if the tool favors certain investments, and if so, explain the reasons for the selection.
- State that other investments not considered may have characteristics similar or superior to those selected.
- Disclose that the tool generates outcomes that are hypothetical in nature.
3. Portability of Performance
We are in a world of constant mergers, acquisitions, and transitions which can often result in the desire to present performance achieved while at prior firms. If a portfolio management investment team decides to leave a firm and join another, there are certain conditions that MUST be met if they want to be able to present their performance track record while at the prior firm. Much of this information is not new, as we have been relying on several no-action letters for years to determine what is and not allowed. With the new Marketing Rule, it will now be codified into the Advisers Act and the specific no-action letters we previously relied upon will be rescinded (which are still waiting on the SEC to communicate with us about).
Under the new Marketing Rule, the following conditions MUST be met before portability of performance can be presented:
- The person(s) who were primarily responsible for achieving the prior performance results will continue to manage the accounts at the new firm.
- The account(s) managed at the prior firm are sufficiently similar to the accounts managed at the new firm, so much so that the performance results being presented are relevant.
- All account(s) that were managed in a substantially similar manner are advertised unless the exclusion of any such account would not result in materially higher performance and/or alter the presentation of the prescribed time periods.
- The Advertisement clearly and prominently discloses all relevant disclosures, including that the performance was achieved at a prior firm.
- The Advertisement meets the requirements of the General Prohibitions.
Before presenting the portability of prior performance, a fact pattern analysis must be conducted. Make sure you have a full understanding of the team in place both pre and post move., Ensure you have the records to support and substantiate not only the current performance but also that primarily all of the accounts are included with the exclusion of any not increasing performance or changing the time periods, and that its representative of what a current investor could achieve.
Performance reporting requirements, hypothetical returns, and portability of performance are huge components of an adviser’s marketing repertoire. It’s important to take time to understand how the Marketing Rule’s requirements around performance advertising will impact the marketing pieces you use today and then decipher changes that must be made to comply with the new rule. You may need to add certain time periods to your presentations or amend disclosures to better explain your performance reporting. If you use hypothetical performance, you will need to review the rule and ensure your disclosures and presentations are compliant. We suggest you start now and use an organized process to understand how your materials will need to change, who will need to change them, and set intermittent internal deadlines so compliance can review for accuracy and adherence to the new rule.