RIA Hypothetical Performance In The Context Of The SEC Marketing Rule
The SEC Marketing Rule governs a variety of marketing-type activities that registered investment advisers (RIAs) may undertake. Performance marketing, in addition to other types of marketing, such as affiliate marketing, including via endorsements and testimonials as well as third party ratings, are some of the key components that comprise the Marketing Rule. RIA hypothetical performance is a subset of the broader classification of “performance marketing” and includes a variety of additional compliance obligations.
Primary Resource
Advertisement Generally Under The Marketing Rule
“Advertisement” under the Marketing Rule (in relevant part) includes:
“any direct or indirect communication an investment adviser makes that: (i) offers the investment adviser’s investment advisory services with regard to securities to prospective clients or private fund investors, or (ii) offers new investment advisory services with regard to securities to current clients or private fund investors.”
SEC Final Rule of the Marketing Rule
While the relevant (1st part of the) definition of “advertisement” does not include one-on-one communications, hypothetical performance does not qualify for the “one-on-one exclusion unless provided in response to an unsolicited investor request or to a private fund investor.”1
Hypothetical Performance Defined
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
Compliance Steps
General Prohibitions
Advertisements, including hypothetical performance, are subject to the “general prohibitions” ranging from untrue statements of a material fact, omitting to state a material fact, substantiation of claims, the requirement to be fair and balanced, as well as the prohibition against advertisements that are otherwise materially misleading.
Recordkeeping
The Marketing Rule requires a variety of recordkeeping, including but not limited to records of all advertisements, such as those concerning performance, as well as “books and records” used to form the basis for the calculation of the performance, as well as records of the “intended audience” for any hypothetical performance.
In addition to the general prohibitions and recordkeeping, hypothetical performance requires the following:
- Policies and Procedures: Document the “intended audience” (retail, institutional, high net worth, etc.).3 Implement “policies and procedures” to ensure the hypothetical performance “is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement.”
- Criteria and Assumptions: Provide sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating such hypothetical performance (for example, trading dynamics, income, cash flow, fees, and calculation methodology). While hypothetical performance is not required to include the prescribed time periods (1,5,10 years), the period of disclosure required will differ based on the sophistication of the investor and the likelihood of misleading the intended audience. 4
- Risk Information: Provide sufficient information to enable the intended audience to understand the risks and limitations of using such hypothetical performance in making investment decisions (for example, noting hypothetical performance does not account for any impact of material economic and market factors on investing, changes to the strategy over time, and the benefit of hindsight).
Enforcement Actions
So far, enforcement of the Marketing Rule concerning performance marketing has focused on firms that advertised hypothetical performance to the general public on their websites “without adopting and implementing policies and procedures reasonably designed to ensure that the hypothetical performance was relevant to the likely financial situation and investment objectives of each advertisement’s intended audience.” 5
Other enforcement aspects in the context of the Marketing Rule include alleged violations of the recordkeeping requirement and the obligations concerning endorsements and testimonials.
- In re: “unsolicited,” the Final Rule states: “…where an investor affirmatively seeks hypothetical performance information from an investment adviser and the investment adviser has not directly or indirectly solicited the request, hypothetical performance information provided in response to the request will be excluded from the definition of advertisement under the final rule. In the case of an unsolicited request, an investor seeks hypothetical performance information for the investor’s own purposes, rather than responding to a communication disseminated by an adviser offering its investment advisory services with regard to securities.” See at page 31 of the Final Rule.
↩︎ - Model performance is defined as a contemporaneous model used with actual accounts, computer-generated models, and those created or purchased from model providers not used for actual investors. Back-tested performance is the application of a strategy to a period where no strategy existed. It takes market data to create a track record for those periods prior to the strategy’s existence. Targets and projections reflect aspirational performance goals and estimates, most often based on historical data and assumptions. See at page 204 of the Final Rule.
↩︎ - The SEC states that “advisers generally would not be able to include hypothetical performance in advertisements directed to a mass audience or intended for general circulation. In that case, because the advertisement would be available to mass audiences, an adviser generally could not form any expectations about their financial situation or investment objectives.” See at page 220 of the Final Rule.
↩︎ - The SEC states: “The rule does not prescribe any particular methodology or calculation for the different categories of hypothetical performance, just as it does not prescribe methodologies or calculations for actual performance. Instead, advisers must provide the information about criteria and assumptions so that the intended audience can understand how the hypothetical performance was calculated.” See at page 223 of the Final Rule.
↩︎ - See “SEC Charges Five Investment Advisers for Marketing Rule Violations” available at https://www.sec.gov/news/press-release/2024-46 and an earlier enforemnet action of the Marketing Rule available at https://www.sec.gov/news/press-release/2023-173.
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