For investment advisory firms, marketing investment performance is hardly optional; for better or worse, investors want to know about firms’ track records. Historically, aside from highly regulated mutual funds, US investment advisers have been free to communicate about investment performance as long as the presentation was not misleading – – a general antifraud standard. But the SEC’s new investment adviser advertising rule, coming into effect in the second half of 2022, will impose many specific requirements, and will require a firmwide effort. Building a compliant performance track record takes time as well as an investment in data management – – it’s hardly a simple matter of putting the right caveats on customer communications. This raises business planning issues for firm executives: what performance figures they will want to use three, five and even ten years in the future?
Key Performance Investment Adviser Advertising Requirements
To assist, we have reframed key performance investment adviser advertising requirements as business questions that may help define and prioritize firms’ future performance advertising needs.
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Does the firm plan to advertise hypothetical performance, as the SEC has broadly defined it?
The SEC defines hypothetical performance to be any performance “not actually achieved by any portfolio of the investment adviser.” This sweeps in many statistics widely used by newer firms or firms launching new strategies, including any backtested performance, performance of model portfolios and projected returns. If the firm does plan to advertise hypothetical performance, there are two important considerations. First, any planned communication containing hypothetical performance, even to a single person, constitutes an advertisement under the rule, triggering the general advertising requirements. These include, among others, that statements be accurate, fair and balanced, and based on information the adviser can substantiate. Second, to tailor hypothetical performance communications to their “intended audience,” the rule requires firms to: (1) adopt policies and procedures designed to assure that the hypothetical performance is relevant to these investors’ financial situations and objectives; and (2) provide information enabling these investors to understand the criteria and assumptions on which the performance is based, and the risks and limitations of using the hypothetical performance.
Does the firm intend to use interactive analysis tools, such as Monte Carlo simulations, to illustrate the range of likely outcomes of investor choices?
If so, the good news is that these tools are classified separately from hypothetical performance; indeed, the SEC views these tools as generally helpful to investor understanding of potential risks and rewards.
The bad news is that they are subject to a separate set of disclosure requirements. Most firms do not develop these data-heavy tools in-house, and can often leverage disclosures provided by responsible service providers. That said, the SEC will hold the firm ultimately responsible for: (1) describing the tool’s criteria and methodology, including its limitations and key assumptions; (2) stating that results may vary with each use and over time; (3) describing the universe of investments considered and the selection criteria, with a statement that investments not considered may have superior characteristics; and (4) disclosing that the tool’s results are hypothetical.
When advertising actual (non-hypothetical) performance, does the firm intend to include predecessor performance - - that is, the performance of portfolios managed at a portfolio manager’s prior firm?
Predecessor performance is often incorporated in newer firms’ performance communications. The new SEC rule imposes very specific requirements on this practice: (1) that the portfolio managers “primarily responsible” for achieving the prior performance manage accounts at the new adviser; (2) that the prior firm accounts be “sufficiently similar” to accounts managed at the new firm that they provide “relevant information” to investors; (3) that all accounts managed in a substantially similar manner at the prior firm be included (unless the exclusion of some accounts would not result in materially higher performance); and (4) that the advertisement disclose that the performance was achieved at a different entity.
Although the SEC calls this “related performance,” this may be the most common form of performance advertising by investment advisers, and it comes with the most important constraints. Unless the adviser is advertising the performance of the same mutual fund, separately managed account or pooled investment vehicle that is being offered to the investor, any performance shown to a client is likely to be “related performance.” Put another way, the offer of individualized portfolio management, outside of an existing pooled account, to a client may imply that the client will receive something other than the portfolio whose performance is being shown. In fact, the SEC specifically includes the presentation of a composite aggregation of portfolios meeting specified criteria as “related performance.”
Here’s the important part: when showing related performance, the new rule requires that related performance include “all related portfolios.” Indeed, the SEC clarified in the adopting release that “an adviser may only have one composite aggregation for each stated set of criteria.” There is a narrow exception allowing the exclusion of portfolios if the exclusion does not materially increase the performance results shown and does not shorten the time frames required for standardized performance (discussed below). This means that firms are well-advised to make key decisions upfront about which investment strategies - - which sets of similar portfolios - - to support for performance recordkeeping and marketing purposes. For those strategies, the firm will need to develop consistent and workable written criteria for including or excluding each portfolio, and to invest in data maintenance. And, due to the time frames needed to establish a track record, the firm should consider what it may wish to advertise five or ten years into the future. Finally, any presentation of related performance should be labelled as a different product than the portfolio that the client or prospect will own.
Does the firm intend to advertise extracted performance - - performance of a portion of a portfolio - - either separately or as part of a composite?
Like related performance, extracted performance is a fancy name for something that almost all advisers will need to use. It is essentially the only way to show the performance of a given segment or strategy - - such as equity or fixed income segments, or growth or value strategies - - when it is used as part of an investor’s overall portfolio. The new rule permits the use or incorporation of extracted performance if, like all performance under the new rule, it uses performance net of fees, which may be a trickier calculation when applied to a segment of a portfolio. In addition, the rule mandates that the advertisement needs provide, or offer to provide, the performance of the entire portfolio from which the performance was extracted. The SEC’s rationale for this second requirement is to avoid the temptation for cherry picking performance. (Editorially, it is hard to see the relevance of a blended portfolio containing, say, 40% fixed income, to an equity strategy advertisement, especially when the extracted performance would likely trigger require showing all portfolios managed with a similar strategy under the related performance rule.)
That is not all. Advisers may include an extracted portfolio in a composite of similar portfolios, but may NOT advertise performance extracted from a composite (where the SEC sees a risk of cherry-picking).
The SEC rule adds important requirements regarding net performance, mandatory time frames, fair and balanced disclosures, compliance review and recordkeeping. While addressing SEC mandates, should the firm consider the extra step of complying with GIPS?
Besides regulating what performance may be advertised, as noted above, the SEC will require performance advertisements to:
- Display performance net of fees with at least equal prominence to every other measure of performance (by default, “gross performance”). Net performance requires 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 to the relevant portfolio.” Such fees and expenses are expressly defined to include, without limitation, the adviser’s fees, any fees of underlying funds in the portfolio, and any expenses reimbursed by the client. “Model” fees may be used, based for example on a current fee schedule, if the highest applicable fee chargeable to the intended audience is chosen. Third party custodial fees may be excluded.
- Similar to mutual fund rules, show performance over the 1, 5 and 10 year periods (or life of portfolio if less) with at least equal prominence to other time periods, as of a date no earlier than the last calendar year-end.
- Comply with general prohibitions against: including or excluding performance results or time periods in a manner that is not fair and balanced; discussing the benefits of the adviser’s services without a fair and balanced disclosure of associated risks or limitations; or implying that a performance presentation is endorsed by the SEC.
Given all that must be done under the new SEC rule, we highlight a strategic question. The CFA Institute established Global Investment Performance Standards (GIPS) to provide investors, especially institutional investors, a way to compare investment adviser returns on an apples-to-apples basis. As long as a US firm has to take on the new SEC standards, should it take the extra step of complying with GIPS?
While there are some differences, GIPS overlaps with SEC requirements and is generally stricter. For example, GIPS requires a firm to establish a firmwide composite, while permitting presentation of sub-composites, while the SEC does not require a firmwide composite. With some exceptions, GIPS requires the use of time-weighted returns and the adoption of benchmarks for composites, while the SEC permits either time or money weighted returns and does not require benchmarks (except for registered mutual funds). GIPS also contains standards for data maintenance and reporting. Despite these demands, firms with plans to become GIPS-compliant, to enhance their appeal to certain investors, may find efficiencies in addressing GIPS and SEC requirements at the same time. And it is worth observing that the stricter standards applicable to registered mutual funds have not greatly impeded the growth of that sector.
Does the firm use performance information in marketing private funds ?
Ads for private funds, within the private offering exemptions of 3(c)(1) or 3(c)(7) of the Investment Company Act, are subject to the rule but benefit from a few exceptions. First, hypothetical performance of a private fund managed by the adviser may be provided in one-on-one communication with, or in response to an unsolicited request for the data from, a current or prospective private fund investor or firm client. Second, the mandatory time periods do not apply to private fund performance. Commenters had noted that private venture capital funds often have long formation periods that are not relevant to future performance, and the SEC went further by allowing the time period exception for all private funds.