Advertising Compliance
– Tiptoeing thru the Minefield
For
investment advisers, tiptoeing through compliance issues for investment
performance advertising is like negotiating a minefield. But, as completion for managed assets
intensifies, adviser performance advertisements may become more important to
the success of investment firms.
The
Investment Advisers Act of 1940, as amended along with its rules do not require advisers to submit
advertisements to the SEC pre-use, but beware, the SEC staff may request distributed
advertising materials as well as materials that support the calculation of
advertised performance during an SEC audit.
Advisers
must read carefully the regulations, no-action letters and SEC enforcement
actions to minimize legal risk and best guess what advertising is permissible
and what is not. Rule 206(4)-1 of the
Advisers Act govern the advertisements of advisers. The rule applies to those advisers registered
with the SEC -- which are the advisors we will consider here.
Rule
206(4)-1 refers to advertising practices considered false and misleading.
The
rule says that it is “fraudulent, deceptive, or manipulative act, practice, or course
of business” for any registered adviser to:
1.
directly or indirectly, publish, circulate, or distribute any
advertisement [w]hich refers, directly or indirectly, to any testimonial of any
kind concerning the investment adviser or concerning any advice, analysis,
report or other service rendered by such investment adviser ;
2.
directly
or indirectly publish, circulate, or distribute
any advertisement which refers to the adviser’s past specific
recommendations that were or would have been profitable, unless the advertisement sets out or offers to provide a list of all
recommendations made within the immediately preceding period of not less than 1
year, accompanied by certain disclosures;
3.
directly
or indirectly publish, circulate, or distribute
any advertisement that a graph, chart, formula or other device can in
and of itself determine which securities to buy or sell or when to buy or sell securities;
or can assist persons in making such decisions, unless it prominently discloses
the limitations thereof and the difficulties regarding its use;
4.
directly
or indirectly publish, circulate, or distribute
any advertisement that represents that any report, analysis or other
service will be provided without charge, unless such materials or services will
be provided without any obligation whatsoever;
5.
directly
or indirectly publish, circulate, or distribute
any advertisement that contains any untrue statement of a material fact,
or is otherwise false or misleading.
Item
1 has been clarified by the SEC’s Division of Investment Management to account
for social media sites. If the site’s
testimonial is independent of the advisor and the advisor has not submitted the
commentary, if there is no material connection between the site and the advisor
and the site publishes all the unedited comments then the testimonial rule will
not be triggered.
Note
the conduct standard for an adviser’s advertisements is stricter than that for some
other product or service vendors. Each adviser is accountable for all of the
information that is included in an advertising piece that it creates and/or
distributes. If information is obtained
from external sources, those sources are required to be identified, the
information must be truthful and supportable, and if it includes any
performance, the investment adviser must have documentation supporting the
calculation of that performance.
What
is an Advertisement?
Whether
any material is subject to Rule 206(4)-1 depends upon whether it is an
“advertisement”.
The SEC Rule 206(4)-1
broadly defines "advertisement" to include any notice, circular,
letter, or other written communication addressed to more than one person, or any notice or other announcement in any
publication or by radio or television, that offers any analysis,
report, or publication concerning securities, or which is to be used in making
any determination as to when to buy or sell any security, or which security to
buy or sell, or graph, chart, formula or other device to be used in making any
determination as to when to buy or sell any security, or which security to buy
or sell, or other investment advisory service with regard to securities.
In
general, “whether any particular communication – or series of communications –
constitutes an advertisement under rule 206(4)-1(b) depends upon all of the
facts and circumstances.”
Although
Rule 206(4)-1 does not list specific communications that are considered
advertisements, the SEC has a broad view of what is advertisement, which
generally includes materials designed to maintain
existing clients or solicit new clients.
This
includes form letters, presentation booklets, requests for proposals, brochures,
radio and television broadcasts, magazine or newspaper pieces and electronic
communications such as internet postings, unsolicited emails or social media
items.
Communications
that are generally not considered advertisements include oral or written
communications that respond to an unsolicited
request by a client, prospective client or consultant for specific information
about the adviser.
Written
communications to existing advisory clients about the performance of their
accounts are also generally not considered advertisements under Rule 206(4)-1. Be sure it is clearly titled as performance
for the existing client and be sure to put the client’s name in the
presentation.
Performance
Advertising
The SEC Division of
Investment Management takes the position that an adviser may advertise its past
performance (both actual performance and hypothetical or model results) only if
the advertisement meets certain conditions. In general the advertisement cannot be
misleading. “No action” letters have
provided guidance on this and the most famous of these is the Clover Capital
Management letter of 1986.
An advertisement
using performance data must disclose all material facts necessary to avoid any
unwarranted inference. Among other things, an investment adviser may not
advertise its performance data if the adviser: (1) fails to disclose the effect
of material market or economic conditions on the results advertised; (2) fails
to disclose whether and to what extent the advertised results reflect the reinvestment
of dividends or other earnings; or (3) suggests or makes claims about the
potential for profit without also disclosing the potential for loss. (4) If benchmarks are used for comparison
purposes, be sure to explain the index and be sure to mention factors that
might make the benchmark less than relevant to the investment strategy. (5)
describe the investment strategy (6) disclose if results are only related to a
subset of clients and why this subset was chosen, and (6) if showing a model,
adhere to the comments in the 1986 Clover Capital no action letter.
In addition,
generally an adviser may not advertise gross performance data (i.e.,
performance data that does not reflect the deduction of various fees,
commissions, and expenses that a client would pay) unless the adviser also
includes net performance information in an equally prominent manner.
The SEC staff has
taken the position, however, that an adviser may provide gross performance
information, accompanied by appropriate disclosure regarding the impact of fees
and expenses, in certain circumstances that present minimal risk that the
client will not understand the impact of fees and expenses, such as when the
client is a sophisticated institution and the adviser presents the information
to the client "one-on-one."
Neither the SEC nor
the Division will pre-approve advertisements for compliance with the above
requirements, although, as mentioned above, advertisements are subject to
review during SEC audits.
GIPS Compliance
Presentations Advertising
All advertisements
that include a claim of compliance with Global Investment Performance Standards
(GIPS) by following the GIPS advertising guidelines must disclose the
following:
1.
The definition of
the firm.
2.
How the
prospective client can obtain a compliant presentation and the firms list of
compliant descriptions
3.
The GIPS
compliance statement for advertisements:
“Firm xyz claims
compliance with the Global Investment Performance Standards (GIPS).” If verified by a third party an additional
statements may be made. “Firm xyz has been independently verified for the dates
mm-yy. The verification reports are available on request”.
The Firm
The firm must be an
investment firm held out to clients or prospective clients as a distinct
business entity. A distinct business
entity is a “unit, division, department or office that is organizationally and
functionally segregated from other units, divisions, departments or offices and
that retains discretion over assets it manages and should have autonomy over
the investment decision making process.”
For smaller firms, defining the firm may be easy, but can be a challenge
for larger firms.
Consider a regional
bank with both personal trust and an institutional trust business. Each
division has its own management team, traders, marketing department, and
accounting. Under these conditions,
either or both may claim GIPS compliance.
However, suppose
both were to use the same security approved lists and/or investment processes,
or perhaps the same trading desks - then neither alone may be able to claim
GIPS compliance. For example, if the
trading desk were shared, and if mispriced securities information were shared
across the two divisions, the firm identity may be shared and both divisions may
be considered one firm.
The Second Part
of Compliance - Presentations
A key product of
GIPS is the presentation that shows the performance of a composite. The composite serves as the vehicle to ensure
that the right performance is presented to the advisor’s prospective clients.
That is, it represents the return that the manager has achieved, historically,
with respect to the investment style and objectives the prospective client is
interested in.
A composite is a
collection of all of a firm’s discretionary accounts with a similar style. The
composite performance is a weighted average of all of the returns of the
accounts in the composite.
The GIPS
presentation requires at least five years (or since inception of the firm or
strategy, if less than five years), building to 10 years of composite
performance.
In addition, GIPS compliant
firms must show benchmark performance, total firm assets, a host of other disclosures,
including composites membership details, risk reporting, dispersion, monitoring
rules and much more. GIPS is one
standard - that the returns within this composite must usually be calculated
using a time-weighted returns calculation.
So advertisements
that claim compliance and present performance must also present either:
one, three and five year annualized composite returns through the most recent
period, or period to date composite returns in addition to one, three and five
year annualized composite returns through the same period, or period to date
composite returns in addition to five years of annual composite returns
calculated through the same period.
The GIPS
Compliant Statement
Note GIPS standards
have no rule for reporting performance to existing clients, other than existing
clients may, at times, be thought of as “prospective” clients when they inquire
about a firm’s other strategies or products.
Unfortunately, in
the absence of any client reporting standards, some investment firms have made
a leap to the only performance standard that is referenced today: GIPS. That leap
has often been selective. Rather than
trying to achieve full compliance with GIPS, some firms just read the standard
that states they need to use time-weighted returns to calculate performance. This has one unfortunate consequence for the
client. Instead of informing clients about account performance or progress
toward goals, clients are actually learning how their manager (or the person
making investment decisions) is performing. Although it’s very important to know how a
manager is performing, it is more important for clients to understand their
individual performance – how much money did they start with and how much do
they have now.
The Global Investment
Performance Standards are a set of firm-wide rules and the firm must apply them
consistently across the entire firm and its clients. The rules may not be “cherry picked”, so that
some are followed and others not.
Statements that refer to the performance of a single existing client
portfolio as having been “calculated in accordance the GIPS” are prohibited
under the rules, as are statements such as “in compliance with GIPS except for
… ”.
GIPS compliant presentations
must be made to all prospective clients, firms cannot choose who they want to
present compliant presentations to and who they do not want to do this for.
Construction of
the Composites
Composites
are used to display performance however the GIPS compliant firm must provide a
complete description of to a prospective client that makes a request for it and
include terminated composites for at least 5 years after the composite
termination date. A five year history
building to 10 years is required unless the firm is less than 5 years old. Assets presented to clients must be firm-wide
and must include all actual, fee-paying discretionary portfolios in at least
one composite. Non-fee-paying discretionary portfolios may be included with
appropriate disclosure. Firms must have
a clear written definition of their meaning of the term “discretionary” and the
how it meets the firm’s ability to implement its intended strategy(s).
One
last comment. Firms sometimes use
back-testing to construct model portfolios or to develop new investment
strategies and use these to create hypothetical returns history. Clearly these models are not permitted in GIPS
compliant composites. Only portfolios
that have genuine holdings may be included. Note that SEC division rules are less strict
in regard to models in advertisements.
But the firm cannot advertise GIPS compliance with hypothetical models.
We
now turn to equity composites. Real
estate, private equity and Wrap/SMAs have exceptions as well as additional
considerations and methodology and will not be considered.
The
Data for Equity Composite Compliance
Among
other things:
Composites
must be defined according to similar investment objectives and strategies and
must include all discretionary portfolios in those objectives and strategies.
After
January 1, 2011 all portfolios must be valued at fair market.
For
periods after January 1, 2001 all portfolios must be valued monthly.
For
periods after January 1, 2010 firms must value portfolios as of calendar month
end or last business day of the month.
For
periods after January 1, 2005 firms must use trade-date accounting.
Calculation
Methods
1.
Total
returns must be used.
2.
Time-weighted
rates-of-return that adjust for external cash flows must be used.
3.
Periodic
and sub-period returns must be geometrically linked.
4.
Returns
from cash must be included in all return calculations.
5.
Actual
trading expenses must be included.
Telemet
Equity Performance
Telemet’s
equity attribution
module,
bundled into its investment platform, meets the requirements necessary for
creating GIPS compliant equity composites using time-weighted rates of return
that are geometrically linked using actual trading costs.
For
information on this module and other Telemet services please contact a Telemet
representative.
In
Conclusion
GIPS
compliance and advisor advertising standards are highly technical, uncertain
and complex. Understanding these requires
a high level of expertise and risks abound. The discussion presented here is in no manner
an exhaustive treatment of this complex topic and the reader is strongly
encouraged to look to legal counsel and verification agencies that specialize
in GIPS compliance and advertising presentation constraints and pitfalls.
Additional
Resources: