On March 19th, Staff from the Securities and Exchange Commission (SEC) issued much needed (and anticipated) relief in the form of two new frequently asked questions (FAQs) related to rule 206(4)-1 under the Investment Advisers Act of 1940 (the Marketing Rule).
Key Takeaways
- The Staff’s “open door” policy, in which it invites comments from industry participants on their top-of-mind concerns and regulatory “sticking points,” is underway.
- Don’t skip the footnotes! The FAQs provide useful additional context. For example:
- gross and net performance of the total portfolio do not need to be presented on the same page to meet the “prominent” requirement – in some cases, presenting this information prior to the extracted performance and/or portfolio characteristic may be sufficient;
- while the FAQ provides some examples of typical portfolio characteristics or risk metrics (e.g., yield, coupon rate, contribution to return, volatility, sector or geographic returns, attribution analysis, Sharpe Ratio, Sortino Ratio), the Staff provides in a footnote other examples which in its view, would not be covered by the FAQ (e.g., total return, time-weighted return, return on investment, internal rate of return, multiple of invested capital, or total value to paid in capital); and
- with regard to portfolio characteristics and risk metrics, the Staff is not opining on whether any such characteristics or metrics constitute “performance” under the Marketing Rule (and thus would be subject to all other aspects of the Marketing Rule).
- Note that the FAQs primarily address a narrow aspect of the Marketing Rule – specifically, rule 206(4)-1(d)(1), which requires that any presentation of gross “performance” also present net performance – it does not alter other obligations when presenting “performance” or the more general obligations under the general prohibitions (rule 206(4)-1(a)) or section 206 antifraud provisions.
The Issues
The first FAQ addresses a widely-know “pain point” for investment advisers when seeking to include in marketing materials individual portfolio positions (or groups of positions from within a portfolio), which falls within the definition of “extracted performance” under the Marketing Rule and must therefore be presented on a net basis. Doing so has been challenging for advisers because such fees are typically charged at the portfolio level. This presents the adviser with a difficult decision:
- developing an allocation approach that at best, serves a regulatory purpose but no business purpose and, at worst, may result in misleading investors; or
- deciding not to present the information despite believing that the information is meaningful to clients and potential clients.
The second FAQ presents a different but related challenge for advisers: determining if a portfolio characteristic or risk metric falls within the meaning of “performance” (which is not defined in the Marketing Rule) and, therefore, must also be presented on a net basis. Such a result similarly restrains an adviser’s ability to present meaningful information about an adviser’s strategy and risk management processes because those metrics often do not lend themselves to net-of-fee presentation (as required under the Marketing Rule).
What the FAQs Permit
The Staff has set forth a “safe harbor” where it essentially offers a no-action position for an adviser who includes in an advertisement either “extracted performance” (which would include presenting case studies or lists of individual investments) or characteristics of a portfolio or investment, in both cases on a gross basis only, if:
- the extracted performance and/or portfolio characteristic is clearly identified as being calculated “gross” (or without the deduction of fees and expenses);
- the extracted performance and/or portfolio characteristic is accompanied by a presentation of the total portfolio’s gross and net performance;
- the gross and net performance of the total portfolio is presented with at least equal prominence to, and in a manner designed to facilitate comparison with, the extracted performance and/or portfolio characteristic; and
- the gross and net performance of the total portfolio is calculated over a period that includes the entire period over which the extracted performance and/or portfolio characteristic is calculated.