We often discuss calculating and presenting investment performance with clients, prospects, and colleagues.

These conversations normally lead to a discussion about the Global Investment Performance Standards and what is allowed or is not allowed.

We are also occasionally asked about calculating and presenting hypothetical, back-tested performance.

Using hypothetical, back-tested performance can be risky because it does not involve actual market risk or client money.

A recent settlement between the SEC and an investment advisor offers a reminder of the difficulty in presenting and disclosing hypothetical, back-tested performance.

This advisor is now struggling to overcome the SEC’s charges and plans to cut its staff by 25 percent – 40 people – as a result of the outflow of assets under management.

The information below summarizes the issues raised by the SEC in its examination of the investment advisor, as noted in the Administrative Proceeding.

Background on the Investment Advisor

The advisor marketed various sector rotation strategies, some of which were based on an algorithm that provided a signal to buy or sell certain industry ETFs.

In 2008, the advisor contracted with a third party to provide the trend signals to the firm.

A positive trend was a signal to be in, or to buy the ETF, while a negative trend was a signal to be out, or to sell the ETF.

The advisor was provided with three sets of trend signals, including those based on a 41-week moving average, a 61-week moving average, and an algorithm developed by the signal provider.

The firm then created a hypothetical, back-tested, historical performance record for 2001 to late 2008.

The advisor began marketing the strategy in 2008 and its marketing presentations included a description of the strategy as well as past performance, including periods prior to 2008.

The firm advertised the past performance as index performance, even though the strategy was not created until 2008.

The main problems with these presentations were that the use of hypothetical, back-tested returns was not disclosed, and that the back-tested performance contained a material error in the calculation.

Disclosures

Disclosures surrounding hypothetical, back-tested returns are inherently tricky.

While SEC rules do not prohibit model-type performance, Rule 206(4)-1 prohibits any advertisement that contains any untrue statement of a material fact, or which is otherwise false or misleading.

Hypothetical, back-tested performance is derived from retroactive application, developed with the benefit of hindsight and without actual money at risk.

Naturally, there will be heightened skepticism surrounding these disclosures.

In this case, the advisor’s advertisements indicated that the performance was based on an active strategy since 2001, and explicitly claimed that the track record for the period 2001 to late 2008 was not back-tested.

The firm also used a combination of the three back-tested returns (41-week moving average, 61-week moving average, and the algorithm) to calculate the return history.

The disclosures did not indicate that different methods were used for different time periods, but rather just referred to the use of the algorithm.

Material Error in the Back-Tested Performance

The back-tested performance used in the advertisements included material errors in the timing at which the trades were implemented, based on the buy or sell signals produced from the averages or the algorithm.

The historical track record reflected that all purchases and sales transactions dictated by the trend signals were implemented one week prior to when they should have been implemented.

This resulted in the historical track record reflecting buy transactions before the prices actually increased and sales transactions before the prices actually declined.

The error resulted in a material misstatement of the firm’s hypothetical, back-tested performance record.

It inflated performance by nearly 350 percent over what it would have been had the signals been implemented with the timing for normal implementation.

Settlement

The advisor consented to a settlement with the SEC for this and several other matters.

The settlement required the firm to hire an independent consultant to perform a full review of its advertising policies and procedures and to issue a report on the results of that review to the SEC.

The SEC settlement also included censure: $30 million in disgorgement and $5 million in civil penalties.

This case clearly demonstrates the need to be very careful when calculating and presenting back-tested or hypothetical performance results, as it includes both errors in the disclosures and in the calculation methodology.

One way to reduce your risk is to eliminate these types of returns from marketing materials.

This approach is consistent with the GIPS standards, which prohibit the use of hypothetical, back-tested performance.

Firms that choose to use hypothetical, back-tested performance should prepare themselves for additional scrutiny, review disclosures and calculation methodologies for potential bias, and consider whether the risks associated with this type of performance presentation are worth the rewards.

We will be happy to provide further information relating to SEC and GIPS compliance. For more information, contact Todd E. Crouthamel at tcrouthamel@kmco.com or 215.441.4600.

You may also like:

• Decoding GIPS
• Key drivers of value in asset managers
• Beware of the SEC when it comes to claims of GIPS compliance

The CFA Institute recently released its Guidance Statement on the Application of the GIPS Standards to Asset Owners. The Guidance Statement becomes effective on January 1, 2015. Overall, this Guidance Statement clarifies how the Global Investment Performance Standards (GIPS) can be applied by asset owners looking to claim compliance with GIPS.

What Led to This Guidance Statement

Asset owners can be pension plans, endowments, foundations, and other similar organizations that manage assets but not necessarily market to prospective clients. An asset owner’s prospective client is its oversight body. Some asset owners need to demonstrate to the oversight body that they follow an established set of best practices surrounding performance and disclosure. Compliance with GIPS is a logical answer to that. However, GIPS was initially created for marketing to prospective clients. As such, it was essential that certain clarifications and modifications be made so that GIPS could be applied by asset owners.

The following are some key provisions covered by the Guidance Statement.

Definition of Firm

Under the current standards, the firm is the investment firm, subsidiary, or division held out to clients or prospective clients as a distinct business entity. This definition, when applied to asset owners, is the entity that has discretion and autonomy over the pool of assets (also referred to as the fund). For some asset owners, such as pension plans, this could be defined by legislation.  For others, such as endowments or family offices, this would likely be the entity set up by the governing body to manage the pool of assets.

Discretion

Some asset owners manage assets internally and others outsource. The outsourcing of investment management is similar to a fund-of-funds manager using external managers. The ability to hire and fire external managers (i.e. sub-advisors) results in discretion for the asset owner.

Composite Creation

Asset owners typically manage a multi-asset total fund. This total fund generally consists of numerous underlying portfolios. For the traditional manager, those underlying portfolios are accounts. For the asset owner, those underlying portfolios represent the various investment strategies that comprise the total fund.

In the case of an asset owner who manages only one multi-asset fund, there is only one required composite. If there is more than one fund, the asset owner must determine whether there are different mandates. A different mandate would trigger a different composite. A similar mandate means the same composite; however, the Guidance Statement offers the option for the asset owner to create separate composites even if they are the same mandate. This is due to the unique governance responsibilities of asset owners. Furthermore, additional composites may be created for underlying strategies, where appropriate. In those cases, all other requirements of GIPS, including guidance statements, such as the Guidance Statement on the Treatment of Carve-Outs, are required to be followed.

Compliant presentations for all created composites must be provided to those with direct oversight responsibility, such as the governing board or entity with oversight responsibility.

Gross and Net

Gross and net returns are complicated for asset owners.

• Full gross-of-fees return – This information must only be presented as supplemental information and only reflects the deduction of only transaction costs.
• Gross-of-fees return – This optional return is reduced by imbedded investment management fees and any other investment management fees paid outside of the pooled fund. This would not include fees paid to externally managed separate accounts.
• Net-of-external-costs-only return – This optional return reflects the reduction of all costs for externally managed separate accounts.
• Net-of-fees return – Required return which reflects the reduction of all investment management costs. In addition to the above noted fees, investment management costs may include overhead, allocated technology, and other costs of the asset owner. This is the only return that is required to be presented.

The key here for asset owners is full disclosure so that a reader can understand what is presented.

Other

The Guidance Statement also addresses other topics, such as the following:

• Recordkeeping and Error Correction – Asset owners must follow the Guidance Statement on Recordkeeping Requirements and the Guidance Statement on Error Correction.
• Cash – Discretionary cash held for investment must be included; operating cash (i.e. checking) should not be included.
• Performance – Time-weighted returns (TWR) are required; money-weighted returns (MWR) are recommended.
• Inclusion/Exclusion – Because new and terminated portfolios are actually investments in a total fund, they are included as soon as funded when new and included through the last day managed when terminated.
• Composite Minimums – All discretionary portfolios (i.e. investments) within the total fund must be included. Therefore, there can be no minimum for the total fund. Composite minimums would apply if an asset owner chose to create additional strategy specific composites.
• Disclosure of Composite Description – There are additional disclosures to meet the standards. Some of those that would be expected to be disclosed would include asset allocation of the total fund as of the most recent annual period end; investment objective; actuarial rate of return or spending policy; and description of asset classes/groupings and related exposures.
• Benchmark – Since asset owners typically use a blended benchmark that changes periodically, disclosure of the recent components and weights is required along with making available historical information.

We will be happy to provide further information relating to this subject. For more information, contact Craig B. Evans, Manager, Audit & Accounting at cevans@kmco.com or 215.441.4600.

Related content:

• Are preliminary GIPS disclosures a good idea?
• Beware of the SEC when it comes to claims of GIPS compliance
• Decoding GIPS

We will be happy to provide further information relating to this subject. For more information, contact Thomas A. Peters, Director, Audit & Accounting at tpeters@kmco.com or 215.441.4600.

Related content:

• Are preliminary GIPS disclosures a good idea?
• Beware of the SEC when it comes to claims of GIPS compliance
• Decoding GIPS