Performance Results in Fund Brochures

Section 206 of the Investment Advisers Act prohibits fraud, deception or manipulation, regardless of whether the fund manager is registered. Once registered, Rule 206(4)-1 imposes additional restrictions on advertising that the SEC has determined would be fraudulent, deceptive or manipulative.

The first item on the list of fraudulent, deceptive or manipulative practices is testimonials, which I wrote about earlier.

The second item in the advertising rule is prohibition on using past performance in an advertisement, subject to some qualification:

206(4)-1(a)(2): Which refers, directly or indirectly, to past specific recommendations of such investment adviser which were or would have been profitable to any person:

Provided, however, That this shall not prohibit an advertisement which sets out or offers to furnish a list of all recommendations made by such investment adviser within the immediately preceding period of not less than one year if such advertisement, and such list if it is furnished separately:

(i) State the name of each such security recommended, the date and nature of each such recommendation (e.g., whether to buy, sell or hold), the market price at that time, the price at which the recommendation was to be acted upon, and the market price of each such security as of the most recent practicable date, and

(ii) contain the following cautionary legend on the first page thereof in print or type as large as the largest print or type used in the body or text thereof: “it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list”

Of course, all advertising is still subject to the prohibition on advertising that is otherwise false or misleading in Rule 206(4)-1(a)(5).The SEC has adopted a facts-and-circumstances test to determine whether the use of performance results is false or misleading.

[W]e believe the use of model or actual results in an advertisement would be false or misleading under Rule 206(4)-1(a)(5) if it implies, or a reader would infer from it, something about the adviser’s competence or about future investment results that would not be true had the advertisement included all material facts. Any adviser using such an advertisement must ensure that the advertisement discloses all material facts concerning the model or actual results so as to avoid these unwarranted implications or inferences. Because of the factual nature of the determination, the staff, as a matter of policy, does not review any specific advertisements. Clover Capital Management, Inc. 1986 No Action Letter

A facts-and-circumstances test is not one that helps a compliance officer sleep at night. That means judgment calls and disagreements with management on what can be included and how it can be included.

There are many SEC no action letters out setting some lines in the sand. A 1986 No Action Letter to Clover Management lays out a series practices that are bad for disclosing model and actual results:

(1) Fails to disclose the effect of material market or economic conditions on the results portrayed (e.g., an advertisement stating that the accounts of the adviser’s clients appreciated in the value 25% without disclosing that the market generally appreciated 40% during the same period);

(2) Includes model or actual results that do not reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid;

(3) Fails to disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings;

(4) Suggests or makes claims about the potential for profit without also disclosing the possibility of loss;

(5) Compares model or actual results to an index without disclosing all material facts relevant to the comparison (e.g. an advertisement that compares model results to an index without disclosing that the volatility of the index is materially different from that of the model portfolio);

(6) Fails to disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed (e.g., the model portfolio contains equity stocks that are managed with a view towards capital appreciation);

(7) Fails to disclose prominently the limitations inherent in model results, particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser’s decision-making if the adviser were actually managing clients’ money;

(8) Fails to disclose, if applicable, that the conditions, objectives, or investment strategies of the model portfolio changed materially during the time period portrayed in the advertisement and, if so, the effect of any such change on the results portrayed;

(9) Fails to disclose, if applicable, that any of the securities contained in, or the investment strategies followed with respect to, the model portfolio do not relate, or only partially relate, to the type of advisory services currently offered by the adviser (e.g., the model includes some types of securities that the adviser no longer recommends for its clients);

(10) Fails to disclose, if applicable, that the adviser’s clients had investment results materially different from the results portrayed in the model;

(11) [for actual results] Fails to disclose prominently, if applicable, that the results portrayed relate only to a select group of the adviser’s clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material.

The other important thing to keep in mind when deciding to use performance results is that you must keep all of the accounts, books, internal working papers and other records necessary to demonstrate the calculation of the performance results. SEC Rule 204-2(a)(16)