Performance advertising is a tool that is used by investment firm to articulate their investment strategy and performance to current clients as well as attract capital from prospective investors. The information provided in the marketing material with respect to performance is of great interest to all stakeholders in the investment management process due to the value provided in evaluating the quality of the process. The stakeholders interested in the integrity of the performance return can be divided into two categories:
- Internal stakeholders:
- portfolio managers
- marketing personnel
- performance managers
- risk and compliance managers
- External stakeholders:
- investment consultant
For a current and prospective investor, performance is significant as it communicates the investment manager’s results and ability, enabling the investors to make better decisions. The Securities and Exchange Commission (“SEC”) focuses considerable attention on performance advertising and conducts vigorous enforcement actions when it perceives misleading or inappropriate advertising practices. The table below presents certain enforcement actions by the SEC related to performance:
|Mackensen and Company Inc.||September 2015||Misleading advertisements sent to trustees of trust funds where they presented what was purported to be actual historical performance for MCI’s model portfolios.|
|F-Squared Investment Inc.||December 2014||Materially inflated and hypothetical, and back-tested performance track record. Advertised the hypothetical historical performance as not backtested and based on an actual strategy that had been used to manage live assets.|
|Strategic Capital Group LLC||September 2014||Provided prospective client advertisements that contained false and misleading claims, and disclosures about the performance of the investment model. In the advertisements, SCG claimed that the performance returns portrayed were historical for the investment model when in fact the majority of the results were hypothetical because they were based in part on the use of indices rather the firm’s actual investment recommendations.|
|ZPR Investment Management Inc.||
|Misleading performance return advertising by failing to comply with GIPS while they were falsely claiming GIPS compliance in certain publications.|
|Modern Portfolio Management Inc.||October 2013||Making misleading statements on their website, omitting disclosures in their performance information that were required, and making misleading statements in its performance information by providing model results that did not deduct advisory fees.|
*Source: U.S Securities and Exchange Commission
The SEC has also imposed limitations on the use of actual or model performance results that impact all investment manager’s including hedge funds:
- Effect of material market or economic conditions on the results shown must be disclosed.
- Results must take into account the fees incurred such as: advisory fees, brokerage/commissions and other expenses that a client paid. In the case of a model portfolio, expenses that would have paid.
- Advertising must state whether and to what extent the results presented include reinvestment of dividends and other income.
- Advertising that makes claims of potential for profit must also disclose the possibility of loss.
- Any comparison of a model or actual results to an index must be to a closely comparable index and must disclose all material facts relevant to the comparison.
- Any material conditions, objectives or investment strategies used to obtain the performance advertising must be disclosed.
Inputs Drive the Output
Performance advertising is viewed as the output or deliverable to clients. The output however is derived by the inputs that produce the performance returns. A firm should have proper oversight over the inputs, and the management of those inputs, to ensure that the information produced does not contain mistakes or misleading information.
To achieve the appropriate oversight, it is critical for firms to have a strong control environment in place regarding the management of the inputs used to measure performance that include:
- Account and Composite Structure
- Security Transactions and Classification
- Corporate Action Management
- Treatment of Income and Expenses
- Treatment of Significant Cash Flows
- Quality of Benchmarks
- Controls over performance system
- Qualified performance personnel
Once controls have been determined, a firm should document their policies and procedures to reflect the actual controls implemented. Further a review of the controls should be performed on a periodic basis to ensure that the policies and procedures are updated and reflect any changes.
In cases that the firm’s performance results are outsourced (i.e. hedge funds), a firm should perform their own independent review to ensure that the results provided by the service provider (i.e. administrator) are reliable and accurate. In the case that the firm is calculating their performance internally, steps should be taken to ensure that the performance is independently calculated by experienced performance specialists. Once the results are derived, the performance specialists should be implicated in the advertising and client reporting process.
All performance advertising should be pre-approved by a designated person (i.e. Compliance or Legal department) to ensure that the presentation, information, disclaimers are all current and not misleading. The investment manager should maintain appropriate records necessary to demonstrate the performance calculation results of its fund(s) and all its managed accounts. Records may include: account statements and appropriate backup that demonstrates the calculation of the performance.
Performance advertising should not be treated as a canvas where whatever helps sell is painted on it but rather as a communications tool that conveys the quality of the portfolio management. Moreover, demonstrating integrity in performance advertising helps elevate investments managers own stature and positively impact the capital allocation process. Lastly, great care should be taken to the independence, quality of performance measurement and analysis, and always taking into consideration the most important stakeholder in the investment process, the investor.PDF version