The Securities and Exchange Commission (SEC) is intensifying its scrutiny of registered investment advisors (RIAs) for violations of the Marketing Rule 206(4)-1 under the Investment Advisers Act, hammering home the need for registrants to carefully review all advertised performance statements.

In April, the SEC announced charges against five RIAs for marketing misleading hypothetical performance to the general public. This follows the SEC’s announced charges in September against nine advisors for hypothetical performance reporting violations, as well as breaches of the Marketing Rule’s recordkeeping requirements to archive advertised performance statements.

When announcing the recent settlements, the SEC stated “[b]ecause of their attention-grabbing power, hypothetical performance advertisements may present an elevated risk for prospective investors whose likely financial situation and investment objectives don’t match the advertised investment strategy.”

Overhauled two years ago, the Marketing Rule requires investment firms to adopt and implement policies and procedures reasonably designed to ensure that when hypothetical performance is presented in marketing materials, it accurately represents investment performance, and is relevant to the likely financial situation and investment objectives of the advertisement’s intended audience.

The Marketing Rule also prohibits advisors from presenting extracted performance (i.e., the performance of a subset of investments extracted from a portfolio), unless the advertisement provides or offers to provide results of the total portfolio from which the performance was extracted (Source: SEC Release, Investment Advisor Marketing, Release No. IA-5653; File No. S7-21-19, Pg. 195). This is intended to prevent advisors from cherry-picking certain results.

One often overlooked best practice is to ensure that the net investment performance is relevant—meaning the performance presented must be representative of what the prospective client could reasonably expect. Firms are permitted to show performance gross of fees; however, net results must also be shown with equal prominence.

For hypothetical performance, funds and advisors must also provide sufficient information so the intended audience can understand the criteria and assumptions used in calculating performance, as well as the risk and limitations of using hypothetical performance in making investment decisions.

Risk information should include reasons why hypothetical performance might differ from actual performance. An example of this would be external cash flow timing. However, simply disclosing the possibility of loss is insufficient to satisfy this amended marketing requirement.

The final Marketing Rule does not require a specific treatment for cash allocation in extracted performance. However, it would be considered misleading to not disclose the allocation of cash and the effects of the cash allocation, or the absence of a cash allocation.

Given regulators’ intent to align reported performance with reality, it is vital to have policies and procedures in place to review actual performance along with results portrayed in models. Results that are materially similar will lend credibility to the usefulness and relevance of model performance. Conversely, firms should never use models that materially differ from actual results, or use models as a replacement for doing the difficult work of aggregating related account performance histories.

Investment advisors would be well-advised themselves to ensure their websites and all disseminated materials include accurate performance representations, and that they archive performance statements in compliance with the recordkeeping rules. This will enable them to easily produce previously stated results should auditors, regulators or any other authorized entities request it.

The rules governing the presentation of investment performance must meet the following requirements:

• One-, five-, and 10-year performance must be presented net of advisory fees and any performance-related fees;

• Materials that compare performance to an index or benchmark must use a fair and meaningful index or benchmark and significant facts relevant to the index or benchmark must be disclosed;

• The presentation or advertisement must disclose whether and to what extent the performance results portrayed reflect the reinvestment of dividends and other earnings;

• The advertisement must disclose any material market conditions, economic externalities, or any other meaningful inputs used to calculate the reported results;

• A presentation or advertisement that includes any claims about the potential for profit must also include disclosures about the possibility of loss;

• Materials must prominently disclose that past performance does not guarantee future results.

Investment professionals must heed requirements regarding performance marketing as regulators continue to sweep the industry for misrepresentations in promotional materials.

Recently, failing to do so landed a New York-based registered investment advisor with more than $500M assets under management (AUM) in the SEC’s crosshairs for using misleading performance metrics in advertisements on its website. Without admitting or denying the SEC findings, the firm agreed to a cease-and-desist order, a censure, a nearly $200,000 disgorgement as well as an $850,000 civil penalty to be paid to affected clients.

To avoid a similar fate, many firms are engaging compliance professionals to show they are making a proactive effort to accurately calculate and report investment performance. Retaining specialized experts to ensure compliance with the new rules entails minimal up-front cost relative to the long-term reputational and financial impact of a potential breach.

Kim Cash is the founder of Cascade Compliance. Janice Kitzman is a partner at Cascade Compliance.