FAQ: Pitfalls and Best Practices for Presenting Third-Party Performance

More firms continue to be implicated as fallout from the F-Squared Investments, Inc. enforcement action continues. The latest development occurred March 22, when a federal judge ordered that F-Squared founder and former CEO Howard Present personally pay $13 million, including a $1.58 million civil money penalty, following his loss at trial this past October. This is a direct result of the Securities and Exchange Commission’s (SEC) increased focus on how advisers present third-party investment performance. In each instance, the presenting firm failed to perform proper due diligence into the performance provided by a third-party. Investment Advisers that include third-party or sub-adviser performance results in their advertising materials should be aware that they are responsible for the third-party’s reported performance as if it were their own record. This includes, but is not limited to, ensuring proper calculations of net-of-fee returns, including proper disclosure when using hypothetical returns, and maintaining appropriate books and records to support performance track records. In order to avoid a similar fate as F-Squared and any associated advisers, firms have a duty to verify performance claims of others such that any potentially false or misleading information is not disseminated to prospective investors.

Track records – What do you need to substantiate performance?

Due diligence is a must for any adviser that relies on third-party investment performance figures. For example, advisers should always seek to obtain books and records to substantiate performance. While it may not always be easy to get all records in all circumstances, investment advisers should endeavor to obtain an assortment of supporting records that will provide them with the best possible understanding of how the performance results were derived. If an adviser is showing a track record with 30 years of investment performance, then the books and records for all 30 years should be obtained. Advisers and sub-advisers need to make certain that the information is complete, accurate, and supports the performance information being shown. The recordkeeping rule governing performance advertising applies to all performance information reported by the adviser in its advertising materials, including any performance relating to sub-advisers. Some examples of records may include: 

• Portfolio statements of investments and valuations
• NAV packages
• Broker statements and custody statements
• Audited financial statements
• Composite return schedules
• Corporate action reports
• Income received/earned reports
• Transaction reports, including cash flow 
• Calculation methodology information
• Management fee information, including incentive fee calculations
• Performance calculation schedules 
• Periodic returns (monthly, annual, cumulative, annualized, etc.)
• Any materials distributed that include performance
• Policies on how performance was calculated and distributed

What should an adviser do with respect to hypothetical and/or back-tested performance?

Hypothetical and/or back-tested performance results are inherently false or misleading without proper disclosure and this is an area that the SEC is keenly interested in. Advisers or sub-advisers that include such performance should exercise utmost care to ensure that the advertised performance is clearly identified as hypothetical/back-tested and is in compliance with any guidance issued by the SEC. 

Performance results generated from back-tested models may draw increased regulatory scrutiny and pose serious compliance risks because investors have no guarantee that the adviser would have used the signals generated by these methods in a real-time basis, and such results do not represent actual performance data. At a minimum, the disclosure should include:

• That 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;
• That the returns should not be considered indicative of the skill of the adviser;
• That the client may experience a loss; 
• If applicable, that the results do not take into account the costs of hedging or leverage;
• Whether the back-tested performance reflects the deduction of advisory fees, brokerage, or other expenses;
• That 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;
• That the adviser, during the period in question, was not managing money at all, or according to the strategy depicted; and
• That the back-testing is for a strategy that the client accounts will follow or, if not, what difference there will be.

What should advisers do when self-reporting returns through third-party performance consultant databases? 

If you’re using a performance database, such as Hedge Fund Research, you may consider incorporating some general controls. For example:

• All performance numbers advertised in the database should come from a central source;

• Only information from approved marketing pieces (e.g., performance numbers or narrative information from quarterly/monthly letters) should be entered into the database;
• Take screenshots of the information entered into the database for record-keeping and testing purposes (in the event information cannot be downloaded);
• Periodically test and review information on sites by going into the database or reviewing screenshots (if applicable);
• Compare information throughout the site in the event information that was input manually was not transposed properly; 
• Consider having separate persons to enter and check the performance numbers to ensure the numbers are accurate (maintain a record of doing so); and,
• Review databases’ procedures to screen who has access to the databases. You should get assurance that the database is only accessible by individuals that are eligible to invest in private funds (e.g., accredited investors or qualified purchasers). 

With a long track record, do you need daily trading records, or for early periods are audited financials sufficient?

Generally, the expectation around recordkeeping for performance reporting is around the fund or portfolio-level detail (e.g. market values, cash flows, gross and net returns). It is possible the exam staff requests daily portfolio trading reports for certain historical time periods; however, the focus over time has been on the account statements. An adviser must ensure that support for fund or portfolio records reflects all debits, credits, and other transactions in an account for the period of the statement, and worksheets necessary to demonstrate the calculation of the performance, or rate of return, are available. Audited financials should suffice as documentation for the respective end-of-period returns, but many advisers presented intra-year returns using unaudited valuations for portfolios.

Resources

For an overview of best practices and case studies/observations related to third-party performance, view our webcast now available on demand.

About the Authors

Charlie Stout is a Partner and Diversified Financial Practice leader for ACA Compliance Group. After joining in 2005, Charlie provided GIPS^® compliance consultation and performance risk services for investment management firms across all asset classes. His primary responsibilities today include developing implementing solutions that address the latest regulatory and risk management challenges for multi-divisional financial services firms, such as global asset managers, banks, and insurance companies. He continues to provide customized advice on performance and compliance issues for key client relationships. In addition to his consulting work, Charlie speaks at various conferences and events and writes articles for leading industry publications. He also serves as the Co-Chair of the Performance Committee for NCREIF. Charlie earned his Bachelor of Science in Finance from the University of South Carolina. Prior to joining ACA, he served as a representative for a large financial services firm providing investment and insurance solutions. He has also earned the Chartered Alternative Investment Analyst (CAIA) status and the Certificate of Investment Performance Measurement (CIPM). His professional memberships include the CFA Institute, the CIPM Association, and the CAIA Association.

Michelina Cuccia joined ACA in January 2010 and now serves as a Director for ACA’s diversified financial clients and prospects. Her primary responsibilities include managing client relationships and projects and providing customized advice on compliance issues based on client-specific risks and conflicts. Michelina conducts mock SEC examinations and annual compliance reviews of investment advisers, hedge funds, private equity fund managers, and investment companies. In addition, Michelina also assists clients during SEC inspections and in creating customized policies, procedures, and forensic testing programs. In particular, she focuses on developing and overseeing the implementation of solutions that effectively address the latest regulatory and operational challenges. Prior to joining ACA, Michelina was a Deputy Chief Compliance Officer at a hedge fund/registered investment adviser firm and an Executive Director at a large institutional financial services firm. Michelina began her compliance career in the New York Regional Office of the U.S. Securities and Exchange Commission. At the SEC, she conducted examinations of mutual funds, investment advisers, transfer agents, administrators, and insurance firms. Michelina received her Master of Business Administration in Finance from Fordham University.