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 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.