Introduction
Hypothetical performance is a key component of the SEC’s Marketing Rule, which imposes specific criteria that firms must follow, including detailed disclosures and ensuring the qualifications of prospects who receive this information. Since the rule's implementation, the SEC has taken enforcement actions related to hypothetical performance. Exam teams will likely review all aspects of a firm's marketing, including potential uses of hypothetical performance. The article will also explore the different types of hypothetical performance and discuss compliance with these regulatory standards.
Types of Hypothetical Performance
Model Performance involves results derived from a theoretical portfolio managed similarly to actual client portfolios but is not an actual portfolio. This type of performance helps advisers illustrate potential outcomes based on a consistent strategy, often reflecting the investment philosophy used for real clients.
Backtested Performance is generated by applying a specific strategy to historical data, simulating how the strategy would have performed if it had been employed during that period. It provides insights into how a strategy might behave under various market conditions.
Targets and Projections qre forward-looking estimates, offering hypothetical future performance based on specific assumptions about market conditions or investment strategies. These projections help clients understand potential future outcomes under various scenarios.
Other Hypothetical Performance
This category includes any performance data not actually achieved by a portfolio but presented as a hypothetical scenario. It can encompass a wide range of scenarios designed to illustrate potential outcomes under different conditions or strategies.
Compliance Requirements for Hypothetical Performance Under the SEC Marketing Rule
The SEC’s Marketing Rule imposes specific requirements on the use of hypothetical performance in advertisements. These requirements are designed to ensure that the information presented is accurate, relevant, and not misleading.
Key Rule Requirements:
Relevance to the Audience:
Firms must develop and implement policies and procedures to ensure that hypothetical performance information is relevant to the financial situation and investment objectives of the intended audience. This includes tailoring the presentation to the specific needs and circumstances of the prospective client.
Firms need to have a way to determine that the prospect understands what hypothetical performance means based on the information provided. The SEC’s Marketing Rule emphasizes that hypothetical performance must be relevant and understandable to the intended audience. Initially, the SEC considered banning hypothetical performance for retail clients due to its complexity, but ultimately allowed it, recognizing its potential value when appropriately presented and understood.
Avoidance of Mass Distribution:
Hypothetical performance should not be used in advertisements distributed to a mass audience or for general circulation. The rationale is that it's challenging to assess the financial situation and investment objectives of a broad, undefined audience.
Transparency in Assumptions and Criteria:
Firms are required to provide all relevant information that allows the intended audience to understand the criteria and assumptions used in calculating hypothetical performance. This includes any assumptions regarding future events or market conditions that the performance data relies on.
Disclosure of Risks and Limitations:
It's essential to disclose the risks and limitations associated with using hypothetical performance in making investment decisions. These disclosures help prospects understand that hypothetical results may not reflect actual trading conditions or outcomes.
Ways to Comply:
Client Qualification Worksheets: Use questionnaires or a worksheet to verify that prospects are qualified to receive hypothetical performance data, ensuring relevance to their financial situation and objectives.
Provide the Definition of Hypothetical Performance: A clear explanation that hypothetical performance is based on models, assumptions, or historical data and does not represent actual past results.
Ensure an Understanding of Assumptions: Questions to verify that the prospect understands the assumptions underlying the hypothetical performance, such as market conditions, strategy consistency, and lack of real trading.
Ensure an Awareness of Risks and Limitations: Items that confirm the prospect's understanding of the risks and limitations, including the fact that hypothetical performance may not predict future results.
Assessment of Financial Expertise: Questions to gauge the prospect’s financial background and experience, ensuring they have the capacity to comprehend the speculative nature of hypothetical performance. It’s important to note that being an ultra-high-net-worth individual or accredited investor alone is not sufficient; someone might have inherited wealth and lack a deep understanding of financial matters. The questionnaire should, therefore, assess not just financial standing but also the prospect's experience and knowledge of investment concepts.
Confirmation of No Guarantees: Explicit questions to ensure the prospect understands that hypothetical performance does not guarantee actual future performance.
Detailed Disclosure Statements: Provide comprehensive disclosures outlining how hypothetical performance is calculated, including all assumptions and potential risks.
Interactive Tools: When using interactive tools to generate hypothetical performance, ensure compliance with the rule’s general prohibitions and provide clear disclosures on the methodology and limitations.
Documentation and Record-Keeping: Maintain thorough records of all hypothetical performance presentations, including client qualifications and the disclosures provided.
Projections: Unlike backtested or model performance, projections are forward-looking and speculative. The rule requires that these projections be accompanied by detailed disclosures about the assumptions and the potential variability in outcomes, emphasizing that they are not guarantees of future performance.
Compliance Review: All hypothetical performance materials should undergo review and approval by the Chief Compliance Officer (CCO) to ensure they meet SEC requirements.
Using Hypothetical Performance in Client Meetings
Many firms may not realize that hypothetical performance shown during a conversation with a prospect—whether displayed on a computer screen or another electronic device—still falls under the SEC’s Marketing Rule. For example, telling a prospect, "If you had invested $500,000 in our strategy five years ago, here’s what you would have now based on our analysis tool," qualifies as presenting hypothetical performance. Even if the materials are not given to the prospect to take home, this still counts as an advertisement under the rule.
In-Office Presentations: Any display of backdated or hypothetical performance during a meeting is considered an advertisement, regardless of whether it is provided in physical form. Compliance standards must be followed as if the information were distributed in print.
Client Requests: Hypothetical performance data provided at a client’s request must be unsolicited and not pre-prepared in a way that encourages the request. The data must still comply with all relevant guidelines, including ensuring relevance to the client’s financial situation and providing full disclosure of risks and assumptions.
Recent SEC Enforcement Actions
Recent SEC enforcement actions have highlighted the importance of adherence to the Marketing Rule:
Best Practices for Compliance
To avoid enforcement actions and maintain compliance:
Implement Robust Policies and Procedures: Ensure all hypothetical performance data is reviewed and approved by compliance professionals before being presented to prospects.
Avoid Pre-preparing Data: Do not prepare hypothetical performance data in advance with the intention of having prospects request it.
Provide Full Disclosures: Whether data is shown in a meeting or provided afterward, make sure all necessary disclosures regarding assumptions, risks, and limitations are clear.
Potential Benefits of using Hypothetical Performance for Prospective clients:
Insight into Potential Outcomes: Hypothetical performance can illustrate how a strategy might perform under specific conditions, helping prospects understand potential returns and risks.
Strategic Evaluation: Prospects can evaluate different investment strategies and their potential impact on their portfolios before committing to an actual investment.
Informed Decision-Making: By visualizing possible future performance, prospects can make more informed decisions tailored to their financial goals and risk tolerance.
Transparency: Provides transparency about how investment strategies could play out, allowing for better alignment with expectations.
Conclusion
Exam teams are likely to scrutinize all aspects of a firm’s marketing, including hypothetical performance. Firms should carefully analyze what is being provided or discussed in these contexts. Conducting mock meetings, where a compliance team member acts as if they were a prospect, is an effective way to ensure everyone is aligned on proper practices. Compliance is about educating and strengthening your program, not punishing or demeaning staff. By adhering to these guidelines, advisers can use hypothetical performance effectively while staying compliant and protecting their interests.
If you would like specific compliance education, training, and services to help with your compliance program or project, please contact Coulter Strategic Services.
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All information provided is for educational purposes and shall not be construed as specific advice. The information does not reflect the view of any regulatory body, State or Federal Agency or Association. All efforts have been made to report true and accurate information. However, the information could become materially inaccurate without warning. Not all information from third-party sources can be thoroughly vetted. Coulter Strategic Services and its staff do NOT provide legal opinions or legal recommendations. Nothing in this material should be considered as legal advice or opinion.
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