These FAQs are part of a series of frequently asked questions that address four primary areas of interest to investment advisers:
- Compliance Program Components;
- Daily Operations;
- Client Protection; and
- Registration and Disclosure
Q1: What are the general guidelines for presenting performance?
A1: The general guidelines for presenting performance were set forth in the Clover Capital Management, Inc. No-Action Letter (available Oct. 28, 1986). Pursuant to Clover, all advertisements presenting performance (both model and actual) must:
- Disclose the effect of material market or economic conditions;
- Reflect the deduction of investment advisory fees, brokerage or other commission and any other expenses that a client would have paid or actually paid;
- Disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings;
- Disclose the possibility of loss if it suggests or make claims about the potential for profit;
- Disclose all material facts relevant to any comparison to an index; and
- Disclose any material conditions, objectives or investment strategies used to obtain the performance advertised.
Q2: Are there any additional guidelines for the presentation of model performance?
A2: Yes. In addition to the above general guidelines, any advertisement that presents model performance results must also:
- Disclose prominently the limitations inherent in model results;
- Disclose, if true, material changes in the conditions, objectives or investment strategies of the model portfolio during the period portrayed and the effect of those changes;
- Disclose, if true, that any of the securities contained in, or the investment strategies followed with respect to, the model portfolio do not relate, or only partially relate, to the type of advisory services currently offered by the adviser; and
- Disclose, if true, that the adviser’s clients had investment results materially different from the results portrayed in the model.
Q3: What types of practices would be considered misleading when presenting actual performance results?
A3: It would be considered misleading if the advertisement failed to disclose (i) that the results relate only to a select group of the adviser’s client; (ii) the basis on which the selection was made; and (iii) the effect of this practice on the results portrayed (if material).
Specific Performance Advertising Issues
Q4: Are there any exceptions to the general rule that performance must be shown net of advisory fees?
A4: Yes. There are three exceptions to the “net of fees” requirement:
- You may distribute advertisements containing performance figures both gross and net of fees so long as both sets of fees are presented in an equally prominent manner (e.g., the “Side-by-Side Gross and Net of Fees Exception”);
- You may present performance without reflecting custodial fees paid to a bank or other custodian for safekeeping client funds and securities (e.g., the “Custodial Fees Exception”); and
- You may use gross performance results in one-on-one presentations to both wealthy prospective clients and consultants (e.g., the “One-on-One Presentation Exception”).
Q5: Are there any additional disclosures required when relying on these exceptions?
A5: When relying on the One-on-One Presentation Exception, you must include a representative example showing the effect advisory fees, compounded over years and the presentation must have the following disclosures:
- That performance does not reflect the deduction of advisory fees;
- That the client’s return will be reduced by the advisory fees and other expenses; and
- That advisory fees are described in Form ADV Part 2A.
Q6: When presenting model performance can you use “model” fees?
A6: The SEC Staff said that it would not object if an adviser advertises the composite performance of accounts for which it employs a particular investment strategy by deducting model fees equal to the highest fee charged to any such account during the performance period.
Q7: What is backtesting?
A7: Backtesting is hypothetical performance that is developed by applying a particular methodology to historical data. Unlike traditional forward-looking models, backtesting does not involve market risk. The SEC staff regards backtesting as highly suspect because the adviser can run the backtested model again and again until it gets the results it wants.
Q8: What is the difference between backtesting and model performance?
A8: With model performance, the adviser tests a hypothetical portfolio on a real time basis, producing simultaneous records of transactions and limiting the adviser’s discretion as to the time periods that can be used to test the strategy. With backtesting, the adviser chooses the testing period and simultaneous records cannot be produced.
Q9: Are there certain disclosures that must be used when presenting backtested performance?
A9: In addition to any other disclosures required under Clover, backtesting requires the following additional disclosures:
- Performance does not represent the results of actual trading, but was achieved by means of retroactive application of a model designed with the benefit of hindsight;
- Results may not reflect the impact that material economic and market factors might have had on the adviser’s decision-making if adviser were actually managing client assets;
- Adviser began offering the service after the performance period referenced in the advertisements;
- Model changed materially during the time period; and
- Actual trading results were materially lower.
Q10: What records is an adviser required to keep to support their performance calculations?
A10: Advisers are required to keep all working papers and other records necessary to form the basis for or demonstrate the calculation of the performance or the rate of return of any or all managed accounts or securities recommendations in any ad. These record keeping requirements may be satisfied if the adviser retains account statements that show all debits, credits and other client transactions for the applicable period and all worksheets necessary to demonstrate the performance calculations. The SEC requires that these account statements be prepared contemporaneously with the period reported.
Q11: Can an adviser just keep the account statements for those accounts included in the performance?
A11: No. All account statements for the periods for which performance is calculated must be kept, not just for accounts included in the composition of the performance figures advertised. SEC staff has recommended that advisers maintain 3rd-party records such as custodial or brokerage statements and reports prepared by independent auditors that confirm the accuracy of the internally generated records.
Q12: What records does the SEC usually request prior to a regulatory examination?
A12: The SEC’s core initial request may include all or some of the following records:
- A copy of any promotional brochures, pamphlets or other materials routinely furnished to prospective clients.
- A copy of any advertisements (e.g., newspaper or magazine ads, radio scripts, etc.) used to inform or solicit clients during the past 2 years.
- A copy of any newspaper or magazine article reprints disseminated to clients or prospective clients during the examination period.
- A copy of performance figures or charts used in general advertising or in one-on-one presentations.
- A description of any benchmark index, including any internally constructed benchmark, to which performance has been compared; the name of the entity that sponsors, produces, and/or distributes such index and/or any component of an internally constructed benchmark; and whether or not the index is price weighted.
- A list and description of all composites, which details each composites inception date, account minimum and investment objective.
- A statement of the account inclusion criteria your firm employs in the construction of any composite performance results.
- A spreadsheet detailing the accounts included in each composite, including, internal calculations indicating beginning and ending asset values for each quarterly, all capital addition as and withdrawals including the dates) and the quarterly performance return.
- All custodial statements, including a statement that indicates the beginning asset value for the performance period.
- A list of all composites that were terminated during the examination period.
- A list of any composites that have been shown to clients whose composite construction criteria were changed on a retroactive basis; and, include the dates and reasons for the change.
- All accounts not included in a composite.
- Documentation that your firm is complying with GIPS, if applicable.