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 six 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 fifth 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
In addition to the general prohibitions, the new Marketing Rule contains multiple restrictions on the use of performance information in advertising. Requirements that must be followed include:
- The Net Performance Requirement: Presenting gross performance is prohibited in an advertisement unless net performance is also presented with at least equal prominence and calculated over the same time period using the same methodology as the gross performance. This requirement will mean a lot of work ahead of the compliance date for firms that use performance advertising. See our detailed description in the Gross and Net Performance section below.
- Prescribed Time Period Requirement: if performance results are presented, they must be presented in 1-, 5-, and 10-year periods and present each period with equal prominence.
- Applies to all performance information in any ads, with some exceptions for private funds.
- If a portfolio was not in existence for one or more of the prescribed time periods, the portfolio’s lifetime performance since inception must also be reported. For example, a portfolio that has existed for 7 years should be described via 1-, 5-, and 7-year periods.
- Time periods must end on a date that is no less recent than the most recent calendar year end. This recency requirement applies to all performance results, gross, net and any composite aggregation of related portfolios.
- Advisers are free to include other time periods so long as the prescribed time periods are presented.
- Commission Approval Requirement: RIAs are prohibited from stating or implying that any performance information has been approved or reviewed by the SEC. Including a statement like “performance results are prepared in compliance with the Commission’s requirements on performance presentations in advertisements” could lead audiences to mistakenly think that the SEC has approved the presented performance information.
- Related, Extracted and Hypothetical Performance Requirements: RIAs cannot use related, extracted, or hypothetical performance information, except under certain conditions. The specific requirements for each type of performance will be discussed in our next report.
Gross and Net Performance: The SEC believes the net performance requirement can prevent all types of prospective clients and private fund investors from being misled by the presentation of gross performance in an advertisement.
- Gross Performance is defined as a portfolio’s (or part of a portfolio’s) performance information without accounting for the fees and expenses that clients paid, or would pay, to the adviser for their services managing that portfolio. Gross performance should be calculated in a way that complies with the seven general prohibitions and appropriately illustrates their investment strategy.
- Note that Gross performance is any performance information that does not reflect deductions of all fees and expenses. For example, if an RIA shows performance information that reflects deducted transaction fees, but no other fees or expenses have been deducted, this performance information would still be considered “gross performance.”
- Net Performance is defined as a portfolio’s (or part of a portfolio’s) performance that incorporates the deduction of all fees and expenses that clients paid, or would pay, to the adviser for their services managing that portfolio.
- Fees and expenses deducted to produce net performance information include, but are not limited to, “advisory fees [including performance-based fees], advisory fees paid to underlying investment vehicles, and payments by the investment adviser for which the client or investor reimburses”.
- Custodian fees paid to third-party organizations (e.g., banks) do not need to be included in net performance.
- Any fees that were deducted when calculating gross performance must also be deducted when calculating net performance.
- Capital gains taxes paid by clients do not need to be deducted to calculate net performance.
- For hypothetical performance, net performance estimates should illustrate the fees and expenses that a client would pay if a portfolio performed as described.
- Model fees can be used to calculate net performance as long as deducting model fees is done in compliance with the rule.
Deducting Actual or Model Fees to Calculate Net Performance: Under the new Marketing Rule there are three ways to go about calculating net performance for presentation in an advertisement:
- Actual performance – display the actual net of fee return.
- The performance must still be fair and balanced. If actual performance includes a lot of significant fee breaks, affiliate fees or non-fee-paying accounts, consider a model to avoid a material difference. While current guidance does not give a range of what difference in returns would be material, firms must be able to stand by their returns as fair.
- Model Fee Performance – construct a model fee whose net of fee return is no higher than actual performance.
- If used, firms would need to test against actual performance every time. If accounts paying reduced fees are removed, the model fee should never be higher than actual performance.
- Consider the intended audience, if the ad is for SMA clients then institutional fees and returns may be inappropriate for the model.
- Highest Fee Model Performance – construct a model using the highest possible fee tier charged.
- This easily covers the fair and balanced issue, since the highest fee paying client saw these results.
- Firms should still consider the intended audience to make sure the model is appropriate.
What does this mean for me?
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.
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.