Performance Presentations Under the Investment Adviser Marketing Rule

Section IV: Performance Presentations Under the Amended Adviser Marketing Rule

Overview

In this part of our summary, we explore the performance presentation requirements of the amended advertising rule.  Presentation of performance is an area that can lend itself to numerous compliance issues, such as sufficiency of disclosures, methods of calculation of performance, and presentation of performance information for starters.  The new rule sets forth specific requirements and restrictions for performance advertising, which we review in detail below.   This summary is one part of a series of updates regarding the amended marketing rule. You can read the entire article for our complete Summary of the Investment Adviser Marketing Rule or you may click on any of the links below to view a particular section.

• Summary: SEC Adopts Amendments to Investment Adviser Marketing Rule (Section I)
• Definition of an Advertisement Under the Investment Adviser Marketing Rule (Section II) 
• General Prohibitions Under the Investment Adviser Marketing Rule (Section III) 
• Third-Party Ratings Under the Investment Adviser Marketing Rule (Section V) 
• Compliance Reviews, Form ADV Amendments & Recordkeeping Requirements – Investment Adviser Advertisements (Section VI)

Performance Presentations 

1. My firm has stellar gross investment performance that we proactively share with our clients and prospects.  Can we keep doing that? Yes, BUT the final rule prohibits any presentation of gross performance unless the advertisement also includes net performance that (i) is, at a minimum, equally prominent to, and in a format designed to facilitate comparison with the gross performance, (ii) is calculated over the same time period, and (iii) uses the same type of return and methodology as the gross performance.   2. What does the SEC mean when using the term “gross performance”? Similar to the proposal, both “gross performance” and “net performance” are defined by reference to a “portfolio,” which is defined as “a group of investments managed by the investment adviser” and can be “an account or private fund.”   “Gross performance” is defined to mean the performance results of a portfolio (or portions of a portfolio that are included in extracted performance, which is discussed below, if applicable) before the deduction of all fees and expenses that a client or investor has paid or would have paid for the investment adviser’s services to the relevant portfolio.  The final rule does not prescribe any particular calculation of gross performance so long as the methodology does not violate the rule’s general prohibitions.   The release also notes that any calculation of performance that only deducts a portion of the portfolio’s expenses paid to the investment adviser would still be considered to be gross performance.  For example, any performance calculation that includes deduction only of transaction fees and expenses, or that reflects the deduction of advisory fees paid to an underlying investment vehicle before the deduction of all fees and  expenses paid in connection with the investment adviser’s investment advisory services, each of these presentations would represent gross performance.  However, if an adviser agrees to bear certain administrative fees or an investor agrees to directly bear administrative expenses, those expenses do not need to be deducted in order to calculate net performance. 3. What is considered to be “net performance”? “Net performance” is the performance results of a portfolio (or portions of a portfolio, which is discussed further below) 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 services to the relevant portfolio.   The final rule provides a non-exhaustive list of the types of fees and expenses that should at a minimum be considered when preparing net performance, such as advisory fees (including performance fees and performance fee allocations), advisory fees paid to underlying investment vehicles, and payments by the investment adviser that are reimbursed by a client or investor.   Expenses that are incurred outside of the portfolio, such as custodial fees (except where part of a bundled fee, such as in a wrap program) or taxes paid by the client or investor do not need to be included.  Notably in a welcome change from the proposal, the final rule does not require an adviser to include a schedule of fees and expenses deducted to calculate net performance. 4. What if the accounts within a portfolio have different fee structures? Do I have to aggregate the net performance of all accounts or is there an easier way to do it?  The final rule allows for net performance to be calculated using a model fee.  If an investment adviser opts to use a model fee, then it must be equal to the highest fee charged to the intended audience to whom the advertisement is provided.  Accordingly, you could have different performance displays for different performance displays depending on the type of customer receiving the performance presentation.  For example, the model fee could be different for an institutional client as opposed to a wrap client or a fund client. 5. My net returns are not as good as my gross returns.  Can I put the net returns in a footnote or in the back of the presentation? No.  Net performance must be presented in an advertisement with at least equal prominence to, and in a format designed to facilitate comparison with, the gross performance results.  An investment adviser cannot provide greater prominence to any aspect of its performance, such as highlighting or using bold text. 6. My firm has really great returns during certain periods as compared to others.  Can I show only the periods of performance where I had great returns? No.  With the exception of private funds, the final rule requires an investment adviser to show returns in advertisements for prescribed time periods, specifically one-, five- and ten-year periods.  If performance is not available for a prescribed period, then the advertisement must also include performance information from inception of the portfolio.  For example, if a portfolio has a seven-year track record, you would show one, five, and life of the portfolio (7 year) returns.  The prescribed time periods apply to both gross and net performance results, which must end on a date that is no less recent than the most recent calendar year-end.  If there is more recent performance information available that represents a significant change from the prior year-end performance information – this could be due to market events or other reasons – an adviser may be required to include that information so that the performance information is not misleading under the general prohibitions.  An adviser can include other time periods of performance in an advertisement in addition to the prescribed time periods so long as the presentation complies with the other aspects of the rule. Private funds (all types) are excluded from the prescribed performance time period requirements.  Performance presentations for private funds will be subject to the federal securities laws and the general prohibitions, such as including or excluding performance results, or presenting performance time periods in a manner that is not fair and balanced.  7. What about related performance?  Can I show that to clients and investors in advertisements? Yes, with some caveats.  The final rule defines “related performance” as “the performance results of one or more related portfolios, either on a portfolio-by-portfolio basis or as a composite aggregation of all portfolios falling within stated criteria [(each, a “Composite”)].”  The final rule does not identify or prescribe any particular requirements for determining whether portfolios are related except that they must have “substantially similar” investment policies, objectives, and strategies as those of the services being offered in the advertisement.  The release helpfully notes that an adviser may use the same criteria used to construct GIPS composites to satisfy the substantially similar requirement of a related portfolio.  The criteria used to create the Composite should also be provided in the advertisement. While the final rule conditions the use of “related performance” on the inclusion of all “related portfolios,” an adviser may exclude related portfolios if the advertised performance results are not “materially higher,” (which was changed from the proposed “no higher than” standard), than if all related portfolios had been included, and the exclusion does not alter the presentation of any applicable prescribed time period requirement for performance presentations.  The release acknowledges that an adviser would likely have to calculate the performance of all related portfolios to determine that the exclusion of any particular portfolio would not otherwise mislead investors – this practice is sometimes referred to as “cherry picking”.  Moreover, a portfolio cannot be excluded if doing so would alter the presentation of the prescribed time periods.   While some commenters on the proposal sought to be able to show “representative account” performance, such as a flagship fund, or other subsets of related portfolios, in lieu of using Composite performance, the SEC declined to permit this practice on its own, however such information can be provided in addition to the required related performance presentations.  These presentations will be subject to the general prohibitions under the rule.  8. Can I show clients and investors a subset of performance for a particular portfolio? Yes, subject to certain conditions.  In the final rule, the SEC called this “extracted performance,” which means the performance results of a subset of investments extracted from a single portfolio.  The final rule permits the use of extracted performance so long as the adviser provides, or offers to provide promptly, the results of the total portfolio.  In addition, there is not a requirement to include a cash allocation with respect to extracted performance.  The final rule provides advisers with flexibility to evaluate whether the inclusion of a cash allocation is appropriate under the particular facts and circumstances. 9. Do I have to include pages and pages of disclosure in my marketing materials under the final rule? Not necessarily.  The final rule does not prescribe any specific disclosure requirements for net and gross performance presentations and allows investment advisers to evaluate the particular facts and circumstances to develop disclosures that are relevant to investors.  Depending on the facts and circumstances, the release states that disclosures may include: (1) the material conditions, objectives, and investment strategies used to obtain the results portrayed; (2) whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings; (3) the effect of material market or economic conditions on the results portrayed; (4) the possibility of loss; and (5) the material facts relevant to any comparison made to the results of an index or other benchmark. In addition, the final rule prohibits any statement that suggests, either express or implied, that the calculation or presentation of performance results in the advertisement has been approved or reviewed by the SEC.  While this seems straightforward, the release notes that this could include even innocuous statements such as “performance results are prepared in compliance with the SEC’s requirements on performance presentations in advertisements” as they could mislead an investor into thinking that the SEC has approved the performance results included in an advertisement. 10. I have developed a new methodology to pick winning investments that I have been testing over time.  I don’t have any client money invested in the strategy but I want to show prospective clients and investors the hypothetical performance that would have been generated.  Can I do that? An investment adviser may use hypothetical performance in advertisements but subject to certain caveats.  Be¹fore discussing the limitations, we need to review the vocabulary.  The final rule defines “hypothetical performance” 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, backtested performance, and targeted or projected performance returns,² each of which is described in more detail below.

• Model Performance – includes, but is not limited to, performance generated by the following types of models: (i) where the investment adviser applies the same investment strategy to actual investor accounts, but where the adviser makes slight adjustments to the model (e.g., allocation and weighting) to accommodate different investor investment objectives; (ii) computer generated models; and (iii) those the adviser creates or purchases from model providers that are not used for actual investors.
• Backtested Performance – performance that is derived by applying a strategy to data from prior time periods when the strategy was not actually used during those time periods. 
• Targets and Projections – targeted returns reflect an investment adviser’s aspirational performance goals.  Projected returns reflect an investment adviser’s performance estimate, which is often based on historical data and assumptions.  The final rule only applies to targeted or projected performance returns for advisory services offered in the advertisement and does not apply to projections of general market performance or economic conditions.

Importantly, advertisements that include hypothetical performance do not need to comply with the performance presentation requirements of the rule, such as the prescribed time periods and the other conditions applicable to presenting related or extracted performance. The release also clarifies that for purposes of hypothetical performance, the actual performance of the adviser’s proprietary portfolios and seed capital portfolios is not a type of hypothetical performance.³  11. Can I distribute hypothetical performance to all my clients and prospective clients? It depends on the sophistication of your client base.  The release notes that hypothetical performance information should only be distributed to investors who have access to the resources to independently analyze the information and who have the financial expertise to understand the risks and limitations of these types of presentations.  An investment adviser also must provide additional information about the hypothetical performance that is tailored to the audience receiving the advertisement, such that the intended audience has sufficient information to understand the criteria, assumptions, risks and limitations.   12. Do I need to change or enhance any of my processes as it pertains to the presentation of hypothetical performance? Yes.  The rule actually prohibits the use of hypothetical performance unless the following conditions are satisfied:

• Policies and Procedures – The adviser must adopt and implement policies and procedures reasonably designed to ensure that the hypothetical performance information is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement.  While the final rule does not prescribe the content of such policies and procedures, the release suggests that certain key aspects of such policies and procedures may include distinctions between investor types based on certain criteria, net worth, certain defined regulatory categories (e.g., qualified purchaser or qualified clients), or whether the intended audience includes only natural persons or only institutions.
• Criteria and Assumptions – The adviser must provide sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating any hypothetical performance.   The release notes that a general description of the methodology used to calculate the performance should suffice and does not otherwise require an adviser to disclose any information that is confidential or proprietary.  Similar to actual performance calculations, the final rule does not prescribe any specific methodology for calculating hypothetical performance.  
• Risk Information – An investment adviser must provide (or, if the intended audience is a private fund investor, provide, or offer to provide promptly upon request) sufficient information to enable the intended audience to understand the risks and limitations of using hypothetical performance in making investment decisions.  In this regard, investment advisers should disclose information that would apply to both hypothetical performance generally and to the specific hypothetical performance presented.  Risk information should also include any known reasons why the hypothetical performance might differ from actual performance of a portfolio.  All of this information should be tailored to the investment adviser’s intended audience.

Importantly, certain types of hypothetical performance are excluded from the conditions described above.  Hypothetical performance provided in response to an unsolicited request from a current, or prospective, client or private fund investor is excluded from the conditions.  Also excluded is hypothetical performance given to a prospective or current private fund investor.  Notably, there isn’t an exception for one-on-one presentations of hypothetical performance outside of the private fund investor context. 13. My firm has developed some awesome interactive tools that can be used by current and prospective clients.  Can I still provide these tools? Generally yes.  The final rule leverages the definition of “investment analysis tool” from FINRA Rule 2214.  The final rule defines “investment analysis tool” as an interactive technological tool that produces simulations and statistical analyses 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 the potential risks and returns of investment choices.  However, the final rule requires that a current or prospective client or investor must use the tool by inputting information into the tool or giving the information to the adviser to input into the tool. The good news is that under the final rule, an adviser is permitted to use these tools so long as the adviser: (1) provides a description of the criteria and methodology used, including the investment analysis tool’s limitations and key assumptions; (2) explains that the results may vary with each use and over time; (3) if applicable, describes the universe of investments considered in the analysis, explains how the tool determines which investments to select, discloses if the tool favors certain investments and, if so, explains the reason for the selectivity, and states that other investments not considered may have characteristics similar or superior to those being analyzed; and (4) discloses that the tool generates outcomes that are hypothetical in nature.  Importantly, the SEC clarified that the output of the tool is not an advertisement because it is tailored to a particular investor’s circumstances.   14. My firm just hired a team of investment professionals from another firm and we would like to use their awesome performance track record that was achieved while they were at their former firm.  Can we do that? Yes, but your firm will have to meet certain conditions, as follows:

• Primarily Responsible.  The person(s) who were primarily responsible for achieving the prior performance results manage accounts at the advertising adviser.  If there was more than one person making investment decisions at the prior firm, such as co-portfolio managers, you should consider the authority or influence of each person in making those decisions and a substantial number of those individuals must manage the portfolios at the advertising adviser;
• Sufficiently Similar Accounts.  The accounts managed at the predecessor investment adviser are sufficiently similar to the accounts managed at the advertising adviser such that the performance results would provide relevant information to investors.  
• Managed in a Substantially Similar Fashion.  All accounts 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 the exclusion of any account does not alter the presentation of any prescribed time periods.  Accounts that are substantially similar are those with substantially similar investment policies, objectives and strategies.  Notably, if an adviser shows predecessor performance but also has accounts that are managed in a similar fashion, the advertising adviser must include these related portfolios in its performance presentation.
• Relevant Disclosures.  The advertisement clearly and prominently includes all relevant disclosures, including that the performance results were from accounts managed at another entity.

In addition to these conditions, the general prohibitions continue to apply to any such advertisements.

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