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
The change here is allowing broker-dealers to provide the information to intermediary financial advisers and putting the burden on the intermediaries to prevent use directly with their retail clients. Regardless, we recommend against using hypothetical backtested performance data because of SEC concerns as well as the significant regulatory and disclosure limitations.
The SEC fined a large asset manager $1.9 Million for failing to fully disclose that it used hypothetical back-tested performance data in advertisements. The SEC asserts that the respondent claimed that it could prove back to 1995 that its stock strategy combining fundamental and quantitative research outperformed either approach alone. Although the firm labeled such research as “hypothetical,” the SEC faults the firm for failing to disclose that its research was based on back-tested quantitative ratings for a time period before it generated its own quantitative models or research. Using the longer period helped boost the claimed outperformance. The outperformance data was used in marketing to institutional investors, RFP responses, and a white paper. The SEC also criticizes the compliance program because compliance personnel that reviewed the materials were not informed that the materials included back-tested data.
OUR TAKE: Do not market hypothetical, backtested performance. No amount of disclosure can ever insulate you from the SEC’s retrospective criticisms and analysis that you cherry-picked time periods or data. Also, compli-pros should note that marketing materials delivered solely to institutional investors are subject to the same rules as more widely-distributed marketing materials (with a few exceptions such as allowing presentation of gross performance together with net performance).
The SEC censured and fined an investment adviser and its principal for misleading advertisements that utilized hypothetical backtested performance. According to the SEC, the adviser continually updated its models but failed to fully disclose that the models’ out-performance resulted from these post hoc revisions. The SEC alleges that the respondents revised the models to specifically account for unforeseen events such as market movements. The SEC charges the firm and the principal, who also acted as the Chief Compliance Officer, with engaging in manipulative practices and for failing to implement a reasonable compliance program. As part of the settlement, the firm agreed to retain a dedicated Chief Compliance Officer and an outside compliance consultant.
OUR TAKE: As we have advised many times in the past: (i) do not advertise hypothetical backtested performance and (ii) retain a dedicated Chief Compliance Officer that has regulatory credentials. Also, rather than continue to bring these cases whereby a dual-hatted principal continues to fail as Chief Compliance Officer, the SEC should solve this pandemic by requiring all advisers to undergo periodic third party compliance reviews.
OUR TAKE: Investment advisers must adopt and implement procedures to test performance claims made by third parties, and firms can’t claim ignorance and innocence if the third party refuses to provide backup data. Also, we do not believe firms should ever use hypothetical backtested performance data, because the SEC usually alleges that such information is too misleading.