SEC Backtracks on Net Performance Requirements in New Marketing Rule FAQs

On March 19th, the staff of the Securities and Exchange Commission (the “SEC”) issued two new FAQs under the Marketing Rule (Rule 206(4)-1 under the Investment Advisers Act of 1940) that will allow investment advisers to (i) provide gross performance for individual investments or a group of investments in a private fund or other portfolio (an “extract”) without also presenting individual net performance and (ii) disclose certain portfolio or investment characteristics (e.g., yield) as a “gross” number without a corresponding net number. In both circumstances, the adviser will be required to clearly label that the gross number is “gross” and also present the fund-level or portfolio-level gross and net performance as detailed below.¹ These FAQs represent a much appreciated walk back of an FAQ that had been issued two years prior that required that every “gross” performance number include a corresponding “net” performance even for individual investments within a portfolio or fund.

Background

The Marketing Rule prohibits the presentation of any gross performance unless the advertisement also presents net performance (i) with at least equal prominence (and in a format designed to facilitate comparison with) the gross performance, (ii) calculated over the same time period as the gross performance and (iii) using the same type of return and methodology as the gross performance (the “Net Performance Requirement”).

In the lead up to the compliance date for the Marketing Rule, there was debate about whether the Net Performance Requirement would apply to a table laying out the component performance of the individual investments or a group of investments in a portfolio or fund where the gross and net performance is presented at the portfolio-level or fund-level. However, a few months after the Marketing Rule compliance date, the SEC staff issued an FAQ that required net performance to be presented alongside gross performance at the individual performance level. Investment advisers seeking to implement this FAQ ran into several practical challenges with respect to how to calculate net performance at the individual investment level, including, among other issues, how to allocate fund-level or portfolio-level expenses to individual investments, particularly when considering the time component. The resulting net performance figures at the individual investment level often had questionable value to investors and had to be accompanied by disclosure to address potential concerns that they could be misleading, although they were required.

Another outstanding issue was whether certain performance-related characteristics were subject to the performance requirements of the Marketing Rule, including the Net Performance Requirement. Examples of these performance-related characteristics include yield, coupon rate, contribution to return, volatility, sector or geographic returns, attribution analyses, the Sharpe ratio, the Sortino ratio, and other similar metrics.

New FAQs

The first new FAQ provides relief from the prior FAQ’s position that all gross performance of individual investments is subject to the Net Performance Requirement. Under this new FAQ, an investment adviser may present gross performance of individual investments without net performance subject to certain conditions discussed below. The second new FAQ provides similar relief with respect to performance-related characteristics that are calculated on a “gross” level.

In both circumstances, such disclosure of the gross performance of individual investments or the gross performance-related characteristics must satisfy the following requirements:

• The figure must be clearly identified as “gross” and that it does not reflect the deduction of all fees and expenses that a client or investor has paid or would have paid.
• The advertisement containing the figure must include gross and net performance at the portfolio-level or fund-level in compliance with the Net Performance Requirement. If such portfolio-level or fund-level is not on the same page as the figure, then it should be cross-referenced (so that the recipient can understand the overall effect of fees) and preferably would be on an earlier page before the figure.
• The gross and net performance of the portfolio or fund is presented with at least equal prominence to, and in a manner designed to facilitate comparison with, the figure.
• The gross and net performance of the portfolio or fund covers the same time period as the figure.

These FAQs represent helpful SEC staff guidance that reduces the burden of investment advisers calculating net performance figures of questionable value for investors. We will continue to monitor to see if additional Marketing Rule FAQs or other guidance are released to address other areas of the Marketing Rule.

 

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^[1] Marketing Compliance Frequently Asked Questions, available at https://www.sec.gov/rules-regulations/staff-guidance/division-investment-management-frequently-asked-questions/marketing-compliance-frequently-asked-questions.

 

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee similar outcomes.