Reality Check: Hypothetical Performance and the New SEC Marketing Rule
As we continue to unpack the new SEC marketing rule in our blog post series, we now turn to hypothetical performance. Under the new rule, advisers may advertise hypothetical performance, including in retail ads. Before we dig deeper into new rule requirements and restrictions, let’s start with a brief history of hypothetical performance.
The former advertising rule did not reference hypothetical performance, nor has the SEC addressed it in formal guidance, such as no-action letters. Instead, the SEC has addressed the subject through enforcement actions, which essentially state what not to do. The industry has used these enforcement actions as “guidance” on how to use hypothetical performance in advertising.
Clearly, hypothetical performance has been a bit of a controversial subject when it comes to marketing and has the potential for misleading investors. We open with this caveat to remind investment advisers that, although the new rule officially allows marketing of hypothetical performance, important details—and, of course, disclosures—need to be considered.
What’s Hypothetical Performance?
The new marketing rule defines hypothetical performance as performance results that none of an investment adviser’s portfolios have actually achieved. Ads are prohibited from presenting hypothetical performance unless advisers
- 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 ad’s intended audience,
- provide sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating the hypothetical performance, and
- provide sufficient information to enable the intended audience to understand the risks and limitations of using hypothetical performance in making investment decisions.
It’s critical for advisers to evaluate the last two points very carefully, as they indicate where you’ll need to add the proper disclosure to each ad. Advisers who currently advertise hypothetical performance already know that the disclosures can be longer than the actual performance presentation! We believe this will continue to be the case. What's more, new rule requirements may make the disclosures even longer.
In addition, the SEC stated in the new rule release that hypothetical performance should be distributed only to investors who have access to resources to analyze the information and who have the expertise to understand the risks and limitations. What’s the bottom line? In most cases, advisers will not be able to include hypothetical performance in ads directed at a mass audience or intended for general circulation.
Consider these inclusions and exclusions of hypothetical performance as you interpret and apply the new rule.
Now let’s dig a little deeper into the three types of hypothetical performance.
Performance derived from model portfolios is the first type of hypothetical performance that the new rule allows. Here’s what model performance includes.
Backtested performance is the second type of hypothetical performance permitted by the new rule. This category includes performance that is assessed via the application of a strategy to data from prior time periods when the strategy was not actually used. The SEC notes in the new rule release that backtested performance—like other types of hypothetical performance—has the potential to mislead investors.
Still, the SEC acknowledges that backtested performance could help investors understand how an investment strategy may have performed in the past if the strategy had existed or had been applied at that time. This type of performance information may also demonstrate how advisers adjusted their models (as mentioned above) to reflect new or changed data sources.
Targeted and Projected Performance
Targeted and projected performance is the third type of hypothetical performance that the new rule allows. This includes any type of performance presented in ads as results that investment advisers could achieve, are likely to achieve, or may achieve in the future on behalf of investors.
Keep these distinctions in mind as you decide whether to advertise targeted and projected performance.
We remind advisers to proceed with caution when thinking about how to implement these new guidelines and requirements for marketing hypothetical performance. Here’s a recap of the three main challenges advisers now face:
- determining whether hypothetical performance is__ appropriate__ for the intended audience,
- adopting reasonably designed written policies and procedures, and
- creating disclosures that sufficiently address the various requirements of the new rule.
Figuring out what the new marketing rule does and doesn’t allow—and what is and isn’t new guidance—is a huge hurdle. Our blog post series on the new rule has your back. In our next post, we’ll examine third-party ratings.