Hypothetical Performance
Understanding Hypothetical Performance in Fund Marketing
Hypothetical performance can be a powerful tool in fund marketing, offering investors a glimpse into how a strategy might perform under specific scenarios. However, the use of hypothetical performance data is heavily scrutinized by regulators, particularly the SEC, to prevent misleading claims and ensure investor protection. In this post, we’ll explore what constitutes hypothetical performance, the rules governing its use, and best practices for compliance.
What is Hypothetical Performance?
Hypothetical performance refers to performance results that do not reflect the actual results of a managed portfolio but are instead based on simulations or assumptions. Common types of hypothetical performance include:
Model Portfolio Returns: Performance of a portfolio created as an example but not actually managed.
Backtested Performance: Results of applying a strategy to historical market data.
Projected or Target Returns: Forecasts of potential future performance based on assumptions.
While these metrics can provide valuable insights into a strategy’s potential, they are not without significant limitations, including their reliance on assumptions and historical data that may not reflect future market conditions.
SEC Rules on Hypothetical Performance
Under the SEC’s Marketing Rule (Rule 206(4)-1 of the Investment Advisers Act of 1940), hypothetical performance can be used in advertisements, but strict conditions apply to ensure transparency and prevent misuse.
Key Requirements:
Clear and Prominent Disclosures
The criteria and assumptions underlying the hypothetical performance must be disclosed, including:
The methodology used to calculate performance.
Any fees or expenses deducted.
The market conditions considered in the analysis.
Limitations of the data must be clearly communicated, including risks that actual performance may differ.
Tailored to the Audience
Hypothetical performance can only be shown to an audience with the resources and expertise to understand its inherent limitations. This generally includes institutional or sophisticated investors rather than retail clients.
Substantiation of Claims
Advisers must be able to substantiate the accuracy and validity of the hypothetical performance data, demonstrating that the calculations are based on reasonable assumptions and sound methodology.
Fair and Balanced Presentation
The data must not cherry-pick favorable results or omit material facts that could give a misleading impression.
Advisers should present a full picture, including periods of underperformance and relevant risks.
Risks of Non-Compliance
Improper use of hypothetical performance can result in severe consequences, including enforcement actions, fines, and reputational damage. Common pitfalls include:
Failing to disclose material risks or assumptions.
Presenting hypothetical performance as guaranteed or likely.
Targeting unsophisticated investors with complex data they may not fully understand.
The SEC’s recent enforcement actions reflect its focus on ensuring that hypothetical performance is used responsibly and in line with regulatory standards.
Best Practices for Using Hypothetical Performance
To comply with SEC guidelines and build trust with investors, fund managers should follow these best practices:
Develop Robust Disclosures
Provide detailed explanations of the assumptions, methodologies, and limitations behind the hypothetical data.
Use clear, concise language to ensure disclosures are understandable.
Target the Right Audience
Restrict the use of hypothetical performance data to institutional or other sophisticated investors.
Avoid presenting hypothetical data in marketing materials directed at retail investors unless accompanied by thorough explanations.
Ensure Methodological Integrity
Use consistent and reasonable methodologies when calculating hypothetical returns.
Regularly review and update models to reflect current market conditions and data.
Maintain Comprehensive Records
Keep detailed records of all data, assumptions, and methodologies used in hypothetical performance calculations.
Be prepared to substantiate claims during audits or regulatory reviews.
Engage Legal and Compliance Teams
Collaborate with legal and compliance professionals to ensure all marketing materials meet SEC requirements.
Conduct periodic reviews of advertising practices to identify and mitigate potential risks.
Conclusion
Hypothetical performance can be a valuable marketing tool when used responsibly and transparently. By adhering to SEC guidelines and implementing best practices, fund managers can leverage this data to provide investors with meaningful insights while maintaining compliance. As regulatory scrutiny of fund advertising remains high, understanding and applying these principles is essential for long-term success.
