Best Practices for Presenting Model and Hypothetical Performance

These are my notes from an ACA Compliance Webcast on this subject. I’m sure you can find a replay on the ACA website.

There were three great presenters:

• Alicia Hyde, Partner, ACA Performance Services
• Mike Sonnenburg, CIPM, Managing Director, ACA Performance Services
• Kim Daly, Managing Director, ACA Compliance Group

Definitions

The first topic was what these terms mean:

Model–A list of investments and transactions for an investment strategy that are not actually held by the portfolio but can be backtested over historical periods and/or run contemporaneously. Model portfolios are typically constructed using individual securities (stocks and bonds), ETFs, pooled funds, or other investment products. Also known as a paper portfolio, a policy portfolio, or a target portfolio.

Hypothetical–Performance of a model or synthetic portfolio (i.e., non-actual performance). Hypothetical performance can be ex-post and/or ex-ante.

Backtested–Ex-post testing of an investment model to see how it would have performed historically. Backtesting attempts to demonstrate how an investment strategy, constructed with the benefit of hindsight, would have performed as if it had been implemented historically.

Simulated –Same as backtested; non-actual performance and can be ex-post or ex-ante.

Theoretical–Same as backtested; non-actual performance and can be ex-post or ex-ante.

Ex-ante–Projected future performance. Ex-ante performance is non-actual and, as such, is hypothetical.

Ex-post –Performance over historic (after the fact)periods. Ex-post may be non-actual or actual performance.

Contemporaneous (Live) Model–Performance derived from a live, or contemporaneous model, where investment decisions occur in real time. Live model performance is still considered non-actual.

Synthetic Portfolio–The ex-post combination of actual portfolio returns. For example, taking an actual equity portfolio and combining it with an actual fixed income portfolio to create a synthetic balanced portfolio. The underlying performance is that of actual portfolios, but they are synthetically combined according to a prescribed asset allocation. Synthetic performance is considered to be hypothetical performance.

The Law

The main limitation is section 206 that prohibits you from being fraudulent, deceptive or manipulative. That has been further extrapolated by the SEC in Rule 206(4)-1, the advertising rule. That rule has been further elaborated in the Clover No Action Letter.

All of this has been heightened by the F-Squared cases that failed to properly disclose that the adviser and the firms that used its services were not based on actual performance.

Presenting Model Performance

1. Model portfolio performance must not be presented in a false or misleading manner.
2. Model performance should not be linked to actual performance.
3. ‘White-labeling’ third party model performance requires sufficient due diligence.
4. Model portfolio performance must include specific, accurate, and robust disclosures.

Model Performance Disclosures

Disclosures should address these items:

• 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
• Any material changes to the conditions, objectives, or investment strategies of the model portfolio during the time period portrayed and, if so, the effect of any such change on the results portrayed
• As applicable, that the adviser’s clients had investment results materially different from the results portrayed in the model

Include the following disclosures:

1. The results do not represent the results of actual trading using client assets but were achieved by means of the retroactive application of a model that was designed with the benefit of hindsight.
2. The returns should not be considered indicative of the skill of the adviser
3. The client may experience a loss.
4. The results may not reflect the impact that any material market or economic factors might have had on the adviser’s use of the back-tested model if the model had been used during the period to actually manage client assets.
5. The adviser, during the period in question, was not managing money at all, or according to the strategy depicted.
6. The back-testing is for a strategy that the client accounts will follow or, if not, what difference there will be.

You can show projected returns

Sources:

• Rule 206(4)-1, the advertising rule
• Clover Capital Management, Inc. 1986 No Action Letter
• Backtesting Performance Failure