On December 22, 2020, the SEC amended the Investment Advisers Act of 1940, as amended, with respect to advertisements and payments to solicitors by investment advisers. The amendments create a single rule (the “Rule”) that supplants the existing advertising and cash solicitation rules, marking the first time in more than 40 years that the SEC has updated its rules governing adviser marketing. The Rule will become effective 60 days following its publication in the Federal Register, although the SEC is providing advisers with an 18-month transition period to comply with the Rule.
Among the many amendments, the Rule promulgates new requirements relating to adviser’s use of performance results in advertising materials. This post provides an overview of the Rule’s treatment of gross performance, net performance, and hypothetical performance —common features in advisers’ advertisements and offering materials—and future posts will examine other aspects of the Rule’s treatment of performance results in adviser advertising.
Gross and Net Performance Results. The Rule codifies prior guidance from the SEC by prohibiting any presentation of gross performance in adviser advertisements unless the advertisement equally presents net performance figures. This restriction is predicated on the SEC’s concern that displays of gross performance without any additional context could create the impression that investors received the full amount of the presented returns. By requiring the inclusion of net performance results, the Rule seeks to offset any potentially misleading effects inherent in gross performance results.
To navigate the Rule’s restrictions, it is important to understand the difference between gross and net performance. The Rule defines gross performance as the results of a portfolio (or portions of a portfolio included in extracted performance) before the deduction of all fees and expenses charged to an investor in connection with the investment adviser’s investment advisory services.
Net performance, in contrast, is defined as results of a portfolio (or portions of a portfolio included in extracted performance) after the deduction of all fees and expenses charged to an investor in connection with the investment adviser’s advisory services, such as advisory fees (including any performance-based fees), advisory fees paid to underlying investment vehicles, and expenses of the adviser reimbursed by the investors. As a general matter, if a fee or expense is ultimately borne by the investor, it should be deducted from net performance. Conversely, any fees or expenses borne by the adviser need not be included in the calculation of net performance.
To help ensure compliance with the Rule, advisers should clearly indicate when performance results are portrayed on a gross basis and include appropriate disclosures regarding what elements are included in the calculation of gross performance. In addition, in order to facilitate investors’ understanding of the advertised performance results, net performance must be presented with at least equal prominence to gross performance results, in a format designed to facilitate comparison between the two. Moreover, the discussion of the results should result from a calculation over the same time period using the same type of return and methodology, as the gross performance.
Hypothetical Performance. Advisers sometimes include hypothetical performance in their advertisements, such as model performance, back-tested performance, and targeted and projected performance returns. Although the Rule does not prohibit the use of hypothetical performance in advertising materials, it does prescribe significant conditions to its use based on the SEC’s belief that presentations of hypothetical performance “pose a high risk of misleading investors since, in many cases, they may be readily optimized through hindsight.”
Under the Rule, an adviser may not utilize hypothetical results in its advertisements unless it satisfies three conditions aimed to mitigate the risk that its inclusion will mislead investors:
1. Policies and Procedures: The adviser must adopt and implement policies and procedures reasonably designed to ensure the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience. This condition is meant to ensure that the adviser provides hypothetical performance information only to investors with sufficient resources and financial expertise to understand the information. In effect, it limits an adviser’s ability to use hypothetical performance in offering materials that are intended for general circulation to a mass audience, as the adviser could not know the audience’s financial situation or investment objectives. Advisers should work with their compliance consultants and legal counsel to determine whether their current policies and procedures require any conforming updates.
2. Criteria and Assumptions: The adviser must provide sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating the hypothetical performance. The SEC has not prescribed a particular methodology that advisers must use when calculating hypothetical performance; rather, it requires the adviser to provide (i) a general description of the methodology used in calculating and generating the hypothetical performance and (ii) a description of any assumptions underlying the hypothetical performance.
3. Risk Information: Finally, the adviser must provide sufficient information to enable the intended audience to understand the risks and limitations of using such hypothetical performance in making an investment decision. The SEC has indicated that this risk disclosure should provide information that applies to hypothetical performance generally, as well as specific hypothetical performance presented in the advertisement. In addition, the adviser should disclose any known reasons why the hypothetical performance might differ from actual performance results.
Implementation of the above performance requirements is likely to have significant impacts on advisers. Advisers should start evaluating required changes now though The SEC has given investment advisers 18 months after the effective date of the Marketing Rule to become compliant with its updated restrictions. https://www.sec.gov/rules/final/2020/ia-5653.pdf  Id.