As we approach the one-year anniversary of when firms were required to adopt the SEC Marketing Rule, we have a better understanding of the rule and its impact on GIPS-compliant firms. One of the areas we’ve seen where firms have had to make changes to their policies and procedures relates to model fees and the calculation of net-of-fees performance.
When calculating net-of-fees performance, the GIPS standards permit firms to use actual investment management fees charged to individual client portfolios or a model investment management fee that is usually applied at the composite level. When electing to use a model fee, the GIPS standards require that certain criteria be met. First, the net-of-fees return calculated must be equal to or lower than the returns that would have been calculated had actual fees been used. The second criterion requires that the model fee be appropriate to the prospective client or prospective investor.
The SEC Marketing Rule also provides firms with the option to use a model fee when calculating net-of-fees performance. Under the SEC Marketing Rule, there are two options firms can choose from as it pertains to model fees.
SEC Marketing Rule Model Fee Option #1
Firms may calculate net-of-fees performance using a model fee so long as the resulting returns are not higher than the returns that would have been calculated if actual investment management fees had been deducted. This option is, for all intents and purposes, the same approach taken by the GIPS standards, as described above.
One important item to note in connection with this option can be found in footnote 590 of the Adopting Release which states, “If the fee to be charged to the intended audience is anticipated to be higher than the actual fees charged, the adviser must use a model fee that reflects the anticipated fee to be charged in order not to violate the rule’s general prohibitions.” As such, it would be inappropriate for a firm to rely on actual net-of-fee returns when it is anticipated that the intended audience will be charged a higher fee.
SEC Marketing Rule Model Fee Option #2
A second option allows firms to calculate net-of-fees returns that reflect the deduction of a model fee that is equal to the highest fee charged to the intended audience to whom the advertisement is disseminated. Unlike the first option, this option focuses on the intended audience and is not influenced by the actual investment management fees charged to the underlying portfolios. As such, the net-of-fees returns calculated may be greater than or less than returns that would have been calculated had actual fees been used.
However, the Adopting Release makes it clear that firms are prohibited from using a fee that is not available to the intended audience. Furthermore, the Adopting Release clarifies that firms are not permitted to deduct the highest model fee that was charged historically if that fee is less than the current fee that would be available to investors or clients receiving the advertisement.
SEC Marketing Rule Cautions
At first glance, a GIPS compliant firm might conclude that it is compliant with the new SEC Marketing Rule’s requirements pertaining to model fees given the similarities between the GIPS requirements and option one of the SEC Marketing Rule. While this may be true in most cases, there are some situations in which firms should be cautious.
One instance of potential conflict is when model fees change over time. Take, for example, a firm that has increased the model fee used to calculate net-of-fees performance over time in tandem with increases in the firm’s current fee schedule. When initially calculating net-of-fees returns for historical periods, the GIPS standards permit firms to either use the current fee schedule or the fee schedule that was in effect for the respective historical period as the basis for determining the model fee to apply. Once the decision is made, very rarely do the GIPS standards promote retroactive changes to performance. The GIPS standards embrace the principles of fair representation and full disclosure, which is based on accurate and consistent data.
However, under the new SEC Marketing Rule, using a model fee based upon historical fee schedules for respective historical period calculations could be construed as misleading, which would violate the rule’s general prohibitions. The primary reason for this is that the model fees being used for the historical periods would no longer be available or applicable to the prospective client or investor receiving the advertisement. As a result, firms would need to restate net-of-fee performance using a model fee based upon the current, or applicable, fee schedule. Fortunately, these restatements would likely not be considered an error under the GIPS standards that would need to be evaluated in accordance with the firm’s error correction policy. Instead, these changes would be viewed as a change in policy as it relates to the calculation of net-of-fee performance.
Firms should also be cautious when calculating net-of-fees performance using actual fees that are no longer available or applicable to the intended audience. The most common example of this is when firms have older composites, which include portfolios that are grandfathered into older fee schedules. As a result, returns calculated using actual fees would result in net-of-fees performance that is no longer available to the prospective clients or investors receiving the advertisement. In these situations, firms would be required to use a model fee based on the current fee schedule when calculating net-of-fees performance in order to comply with the SEC Marketing Rule.
In some situations, firms have considered the approach of presenting multiple net-of-fees return streams within the same composite report for the purpose of accommodating different users of advertisements. For example, a firm may present one net-of-fees return stream applicable to institutional investors and a second return stream applicable to retail clients. Even if accompanied by appropriate disclosure, the presentation of net-of-fee performance that is not available to the intended audience may be viewed by the SEC as a violation of the general prohibitions. As such, firms should consider maintaining two separate reports for each type of investor as opposed to including multiple net-of-fees return streams within the same presentation.
It is important that firms evaluate the facts and circumstances surrounding each of these situations to properly assess the risks when making decisions regarding model fees. For instance, there is likely to be less risk associated with model fees that have decreased over time compared to those that have increased over time, as the former would result in an understatement of performance, which could be considered less risky. We encourage firms to discuss these situations with their verifiers and compliance counsel so that informed decisions can be made that align with the firm’s risk appetite.
If you have any questions about this information or would like more guidance about the SEC marketing rule and its impact on GIPS-compliant firms, please contact Kreischer Miller’s Investment Industry Group.