As the investment industry has evolved over the years, advisers’ use of hypothetical performance has become more prevalent. In the release referenced below, the SEC defines “hypothetical performance” as “performance results that were not actually achieved by any portfolio of the investment adviser”. In some cases, hypothetical performance represents a contemporaneously maintained model that reflects the performance of a strategy and is provided to third-party platforms for implementation or directly to potential clients to represent the strategy free of client imposed restrictions, cash flows or other unrelated concerns. It may be backtested performance to show proof of concept. Still, in others cases, it could be proposed tweaks to an existing strategy that has actual assets or targeted/projected returns.
As more firms are fueling growth with the use of hypothetical performance, it is important to note the SEC’s updated guidance in their new press release, “SEC Adopts Modernized Marketing Rule for Investment Advisers,” issued on December 22, 2020. The press release can be found here (https://www.sec.gov/news/press-release/2020-334). The transition period for this new rule will be 18 months after it is published in the Federal Register and the impact the rule will have on the use of hypothetical information in advertisements is outlined below.
In short, the use of hypothetical performance in advertisements is prohibited unless three conditions are met:
• The advisor develops policies and procedures to ensure that hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience.
• The advisor provides disclosure of the appropriate criteria and assumptions underlying the hypothetical performance.
• The advisor provides sufficient information for the intended audience to understand the risks and limitations of hypothetical performance for investment decisions.
It is worth noting the expanded discussion on the use of hypothetical performance found in the final rule (https://www.sec.gov/rules/final/2020/ia-5653.pdf). The relevant pages are 200-227. As a lot of model providers fail to consider net-of-fees performance, it is also worth noting the changes to the requirements for net performance in advertisements starting on page 165. Specifically for hypothetical performance, the first paragraph of page 175 should be considered.
As always, if you have questions or would like to discuss how we can assist you in meeting the new SEC requirements related to hypothetical performance, don’t hesitate to let us know.