RIA Compliance and Practice Management Blog

Performance Advertising: Why an RIA Firm Should Exercise Caution

Posted by RIA in a Box

Jun 21, 2014 12:34:33 PM

Is a registered investment adviser (RIA) firm allowed to advertise portfolio performance?  The short answer is “yes”. However, the real question is whether your investment advisory firm should even consider performance advertising from a business standpoint. Before even considering the compliance responsibilities, we always encourage the investment adviser to first decide if performance marketing is essential to the firm's marketing strategy? Even when done properly from a regulatory standpoint, firms that highlight investment performance tend to experience higher levels of client churn. Clients that select an investment adviser based on investment performance are much more likely to leave the firm when an adviser's investment portfolio underperforms the market.

Business considerations aside, there is generally no prohibition against investment advisers advertising performance, however it needs to be done very carefully to avoid RIA compliance issues. This is not easy to do, as it can be difficult to comply with all the regulatory requirements and disclosures. As such, as RIA compliance consultants, we recommend that investment advisory firms exercise extreme caution when it comes to performance advertising and avoid it unless deemed absolutely necessary. Performance advertising is considered a “red flag” to regulators and your firm should be prepared for a regulator to focus a significant amount of time on this issue during a state or SEC regulatory examination. Many state regulators utilize special exam modules to walk the examiner through the process. When violations are found, they are normally severe.

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RIA firms that wish to advertise performance are generally governed by the SEC rule 206(4)-1 or similar state rules. A good starting point in understanding some of the issues that need to be addressed can be found in the SEC staff no-action letter issued on October 28, 1986 to Clover Capital Management. Although it's been nearly thirty years since the letter was issued, it still provides some great insight into what may or may not be acceptable when it comes to performance advertising.

Some of the key takeaways from the letter related to advertising actual and model results were that advertisements that did the following would be prohibited:

  • Failed to disclose the effect of material market or economic conditions on the results portrayed;
  • Failed to reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid;
  • Failed to disclose whether, and to what extent the results portrayed reflect the reinvestment of dividends and other earnings;
  • Failed to disclose about the potential for profit without also disclosing the possibility of loss;
  • Failed to disclose all material facts relevant to comparisons with an index;
  • Failed to disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed;
  • Failed to disclose prominently the limitations inherent in model results;
  • Failed to disclose, if applicable, that the conditions, objectives, or investment strategies of the model portfolio changed materially during the time period portrayed in the advertisement and, if so, the effect of any such change on the results portrayed;
  • Failed to disclose, if applicable, that some of the securities and/or investment strategies used in the model portfolio do not relate, or only partially relate, to the advisory services currently being offered;
  • Failed to disclose, if applicable, that actual client investment results were materially different from the results portrayed;
  • Failed to disclose prominently, if applicable, that the results portrayed relate only to a select group of the adviser's clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material.

While the no-action letter provides a good first glimpse into some potential problem areas when it comes to performance marketing, like any SEC staff no-action letter, it is not the ultimate authority. Advertisements differ from firm to firm and what works in one situation may not be sufficient for the next.   

Investment adviser firms advertising back-tested models is another area of increased regulatory focus. While not specifically prohibited, many regulators have expressed concerns with the fairness of back tested models. In such cases, additional disclosures and consideration will be required.

As a general rule, RIA firm advertisements must be fair and balanced. As investment adviser compliance consultants, we always remind investment advisory firms that they should be prepared to disclose the good, the bad and the ugly, whether it is asked for or not. 

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Topics: RIA Compliance

RIA in a Box LLC is not a law firm, investment advisory firm, or CPA firm. RIA in a Box LLC does not provide legal advice or opinions to any party or client. You should always consult your relevant regulatory authorities or legal counsel if applicable.

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