In our last post, Craig laid out the process of advertising a performance track record. That’s great, if you have a track record. What about a newly operational robo-adviser with no performance history? Your firm likely has spent considerable resources building and developing an investment strategy and corresponding algorithm. But without a client base, you can’t build a performance track record, and without a performance track record, it’s difficult to build a client base. Luckily, an option is available to advertise the hypothetical or “back-tested” performance of your strategy.
As a reminder, Rule 206(4)-1 (the “Advertising Rule”) generally prohibits misleading disclosure in advertising materials. The scope of this rule is broad and includes any disclosures made on your firm’s website. While the use of back-tested performance is not an automatic violation of the general prohibition, it certainly raises significant complications and the potential for scrutiny from regulators.
The SEC strongly disfavors the use of hypothetical performance. In fact, the SEC has sanctioned numerous advisers over the years for advertising misleading back-tested performance. In those cases, the agency primarily focused on the lack of disclosure provided alongside the hypothetical performance. Before including any hypothetical performance in an advertisement, your firm must address a number of issues, including the fact that:
- Hypothetical performance does not involve actual market conditions, especially real-world market risk;
- Hypothetical performance inherently has the benefit of hindsight, thus making it difficult to determine what factors would have affected a manager’s decision-making process; and
- The data shown in a particular set of hypothetical performance results may involve assumptions not indicative of the investment strategy displayed.
The SEC has not provided any guidance that specifically endorses the use of hypothetical performance. However, the SEC staff has repeatedly emphasized that the inclusion of abundant disclosure is the key to adverting hypothetical performance without misleading potential clients. Some of the best practices for advertising hypothetical performance include:
- Clearly labeling all applicable performance as hypothetical and indicating that such performance was not subject to actual market conditions (note that disclaimers in small type are not sufficient to dispel otherwise misleading advertising);
- Do not mix hypothetical and actual results in the same display;
- Disclose all assumptions relied upon in creating the hypothetical performance;
- Do not refer to hypothetical results as “past performance” as doing so may imply to the reader that such performance is actual in nature;
- Maintain all records related to the production of the hypothetical performance displayed in the advertising; and
- Develop written procedures related to the production and review of any hypothetical performance.
While all of these best practices are important, perhaps the most important is the development of a strong set of policies and procedures related to advertising of hypothetical performance. Thorough review of advertising is fundamental, for whether a particular advertisement, performance based or not, is considered misleading is a factual determination. Moreover, the inclusion of hypothetical performance in an advertisement always carries the potential to attract regulator scrutiny. Developing a robust compliance program to review all hypothetical performance advertising can alleviate these concerns and allow your firm to focus on growing its client base.
We hope that you’ve found our series on advertising useful. Check back next time, when we’ll shift our focus and Craig will discuss the new Form ADV Part 3. Thanks for reading!