The New Marketing Rule Part 6: Categories of Performance and Their Requirements

On December 22, 2020, the U.S. Securities and Exchange Commission (SEC) passed amendments to the advertising and cash solicitation rules, along with updates to other requirements for registered investment advisers. The formerly separated rules are now combined under the new Marketing Rule, Rule 206(4)-1 of the Advisers Act, made effective May 4, 2021, with a compliance date of November 4, 2022.

With less than five months until the compliance date for the new Marketing Rule, our Flash Reports will cover areas RIAs will need to consider as they update their compliance program for the new regulation. This Flash Report is the sixth in that series. See the rest of our series here:

• The New Marketing Rule: Part 1 – What is an Ad?
• The New Marketing Rule Part 2 – What are Testimonials and Endorsements?
• The New Marketing Rule Part 3 – General Prohibitions
• The New Marketing Rule Part 4 – Implications for Social Media
• The New Marketing Rule Part 5 – Challenges for Performance Advertising

In addition to the general prohibitions, the new Marketing Rule contains requirements for the use of several categories of performance advertising, namely hypothetical performance, related performance, extracted performance and predecessor performance.

Hypothetical Performance includes performance derived from model portfolios; performance that is back-tested by the application of a strategy to data from prior time periods when the strategy was not actually used during those time periods; and targeted or projected future performance returns with respect to any portfolio or to the investment advisory services with regard to securities offered in the advertisement. Interactive investment tools are excluded from this definition of hypothetical performance as long as the elements of 206(4)-1(e)(8) for the use of such tools are present. Otherwise, all backward looking or future looking performance presentations where no actual dollars were invested would be hypothetical performance.

Recall that including hypothetical performance in a one-on-one communication to a current or prospective advisory client makes that communication an advertisement. The SEC stated distribution of hypothetical performance should only be to “investors who have access to the resources to independently analyze this information and who have the financial expertise to understand the risks and limitations of these types of presentations.” Many RIAs have developed limitations for the audience that will see hypothetical performance. Only presenting to institutional investors or qualified investors or another selective group that would have sufficient financial expertise to understand the risks of relying on hypothetical performance reduces the compliance risk to the RIA. To present hypothetical performance the new Marketing Rule’s requires that an RIA:

• Adopts and implements written policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience;
• Provides sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating such hypothetical performance; and
• Provides (or, if the intended audience is an investor in a private fund, provides, or offers to provide promptly) sufficient information to enable the intended audience to understand the risks and limitations of using such hypothetical performance in making investment decisions

Maintaining records of the intended audience and documenting the information provided with the advertisement (or offered to be provided to investors in a private fund) are necessary to meet these requirements.

Related Performance (also known as Representative Performance) is the performance of one or more related portfolios, either on a portfolio-by-portfolio basis or as a composite aggregation of all portfolios within a stated criteria. A related portfolio is a portfolio with substantially similar investment policies, objectives, and strategies as those of the services being offered in the advertisement, and a representative account would be a single account with those substantially similar attributes.

• Related performance is prohibited unless it includes all related portfolios
• However, related portfolios may be excluded if:
• The advertised performance results are not materially higher than if all related portfolios were included, and
• Exclusion of a related portfolio does not alter the required presentation of any applicable 1-, 5- and 10-year prescribed time periods

This means that the use of a representative account would be prohibited unless all other related portfolios could be properly excluded. If an RIA excludes some related portfolios rather than including all of them, the results must be tested to make sure they are not materially higher after excluding those portfolios.  RIAs using representative accounts may need to start constructing composites to make use of related performance presentations.

Extracted Performance (also known as “carve-out” or “segmented” performance) is the performance of a subset of investments extracted from a portfolio.  To use extracted performance in an advertisement, the RIA must provide or offer to provide the performance results of the total portfolio from which the performance was extracted.  Several things to consider with extracted performance:

• Carve-out from multiple portfolios – Extracting or carving out performance from multiple portfolios would be hypothetical performance subject to the additional requirements for hypothetical information.
• Net performance – All performance presentations must clearly and prominently include net performance.  When extracting information to show attribution from a sector to the overall performance, that means calculating net performance for that sector or at a minimum presenting the net performance for the total portfolio clearly and prominently.
• Case Studies and Specific Investment Advice – The general prohibitions do not allow references to specific investment advice unless it is presented in a “fair and balanced” manner.  Like with attribution, this will mean presenting more information on the overall portfolio to add balance to the presentation in a fair manner

Predecessor Performance is performance achieved by a group of investments consisting of an account or a private fund that was not advised at all times during the period shown by the investment adviser advertising the performance. Performance is portable as long as all of the following are met:

• The person or persons who were primarily responsible for achieving the prior performance results manage accounts at the advertising adviser;
• The accounts managed at the predecessor investment adviser are sufficiently similar to the accounts managed at the advertising investment adviser that the performance results would provide relevant information to clients or investors;
• All accounts that were managed in a substantially similar manner are advertised unless the exclusion of any such account would not result in materially higher performance and the exclusion of any account does not alter the presentation of any applicable 1-, 5- and 10-year prescribed time periods; and
• The advertisement clearly and prominently includes all relevant disclosures, including that the performance results were from accounts managed at another entity.

In addition, RIAs should consider the extent to which other provisions of the advertising rule, such as the general prohibitions (including those pertaining to the fair and balanced presentation of information), apply to any display of predecessor performance.

Although the new rule offers relief from certain restrictions, significant compliance and operational oversight will be needed to ensure all the new requirements are fulfilled. Now is the time to audit your marketing materials for compliance with the new rule, and Fairview is here to help.

Fairview provides full-service, ongoing compliance services and can help maintain your compliance program. Our performance division has more than 40 years of experience in GIPS compliance and composite maintenance, and can assist in constructing and calculating composite performance, reporting net performance in your advertising, and more.

Contact us today with any questions about composite creation and calculations, performance advertising requirements, and any other questions or assistance you may need to maintain your compliance program.