Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues. Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.
Every year, the SEC publishes a handful of enforcement cases alleging that an investment adviser violated the advertising and marketing rules by misusing hypothetical backtested performance (HBP). In our experience with exams, the SEC nearly always cites deficiencies when firms use HBP in marketing. Although there is no rule specifically prohibiting the use of HBP, our position is that firms should never use HBP. To support our view, we have highlighted below 10 of the most common HBP failings and cite to specific SEC actions (click on links). As a side note, most institutional investors with whom we work look very critically at HBP because they also understand the limitations.
10 Common Problems with Hypothetical Backtested Performance
- Failure to disclose limitations. One common allegation is that firms fail to fully disclose the limitations on HBP.
- Insufficient backup data. The SEC will seek to verify that you have maintained adequate backup data to support your HBP claims.
- Cherry-picking time periods. Many firms have violated the SEC marketing rules when they cherry-pick a specific time period that makes their HBP look better.
- Misleading disclosures. Hidden or confusing HBP disclosure will draw the SEC’s enforcement interest.
- Retrospective model changes. Firms can’t keep tinkering with their models to improve the HBP results.
- Using incorrect historical market inputs. The SEC can verify actual market data from past time periods, so make sure you use the correct numbers.
- Applying different models. The SEC has raised red flags when HBP differs significantly from audited or live performance information applying the same models.
- Using the wrong model rules. Firms have gone astray by applying different model rules to the backtested data than they use to manage real accounts.
- Investments didn’t exist. The SEC will call out HBP that includes investments that were not available at the time.
- Faulty algorithm. Check the algorithm used, because faulty programming can result in inflated performance numbers.