1. What exactly is a “model” portfolio?
A model portfolio is a fictional account that does not include actual assets under management and is typically presented as an ideal combination of securities for a client’s portfolio. It is sometimes known as a “paper traded” portfolio because no buy or sell orders are placed by the manager. Although the firm may have clients with actual portfolios that follow the underlying investment strategy and hold identical securities, a model may vary in regards to security pricing and the timing of buys and sells. As a result, a firm may not have any client portfolios that precisely mirror the model.
2. What is the difference between a backtested model and a live model?
Backtested models are created by applying an investment strategy or methodology to historical market data. The goal is to show performance returns that theoretically would have been achieved if the investment approach had been in existence during the period shown. This method, however, is applied with the benefit of hindsight. A live model portfolio is typically one that is managed in real time, similar to an actual portfolio with actual dollars invested. The firm makes active decisions in real time regarding changes to asset allocation, trades, etc. Live models are often run contemporaneously with actual portfolios.
3. Can portfolio performance still be considered hypothetical if it is derived from actual results?
Yes, the performance of any portfolio where the manager does not actually implement trades specifically to derive the presented performance would be considered hypothetical, as the firm did not have any actual portfolios that were dedicated to the presented investment strategy. Any hypothetical performance is considered model performance even if the underlying information is derived from actual results. For example, taking various asset class performance returns from several actual accounts to create a multi-asset class return would be considered a hypothetical blend and would need to be disclosed as such.
4. What are some of the key risks involved in presenting model performance?
Great care should be taken when presenting model performance, as presenting performance of a model portfolio has been viewed skeptically by the SEC. In particular backtested performance has been viewed as highly suspect by the SEC due to the overall nature of backtesting and more specifically that performance does not involve market risk and has the benefit of hindsight. Firms should keep in mind the form and content of the advertisement, the advisor’s ability to perform similarly to the model, and the sophistication of the prospective client, when considering the appropriateness of presenting model performance.
5. Do the GIPS® Standards allow a firm to show model performance if the firm is claiming compliance with GIPS?
Yes, the GIPS Standards do allow a firm to present model, hypothetical, backtested, or simulated returns (not linked) as supplemental information. Supplemental information must be clearly labeled and identified as supplemental to a particular compliant presentation, and may not be shown in a false or misleading manner. Supplemental information must comply with all applicable laws and regulations regarding the calculation and presentation of performance, so additional disclosure would be required.
6. What are some of the common disclosure requirements for showing model performance?
The Investment Advisers Act of 1940 Rule 206(4)-1 (which prohibits an adviser from engaging in a fraudulent, deceptive, or manipulative act, practice, or course of business by use of any false or misleading advertisements) and a handful of SEC staff no-action letters on performance advertising do address disclosure language for presenting model performance. The Clover Capital Management No-Action letter in particular, is one of the most significant no-action letters on the subject of performance advertising and sets forth certain advertising practices the SEC believes to be inappropriate under Rule 206(4)-1.
The SEC indicated that the following practices were misleading and thus prohibited in connection with the presentation of either model or actual returns:
- fails to disclose the effect of material market or economic conditions on results portrayed;
- includes model or actual results that do not reflect the deduction of fees and commissions and any other expenses that a client would have paid or actually paid;
- fails to disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings;
- suggests or makes claims about the potential for profit without also disclosing the possibility of loss;
- compares model or actual results with an index without disclosing all material facts relevant to the comparison; and
- fails to disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed.
In addition to other disclosure requirements, practices that would be deemed to be misleading when presenting model performance results include failing to disclose:
- the limitations inherent in model results, particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser’s decision making if the adviser were actually managing the client’s money;
- if applicable, that the conditions, objectives, or investment strategies of the model portfolio changed materially during the time period portrayed in the advertisement and the effect of any such change on the results portrayed;
- if applicable, that any of the securities contained in, or the investment strategies followed with respect to, the model portfolio, do not relate, or only partially relate, to the type of advisory services currently offered by the adviser; and
- if applicable, that the adviser’s clients had investment results materially different from the results portrayed in the model.
7. Are there additional disclosures required for presenting backtested performance?
Yes, in addition to the disclosure requirements outlined in the Clover Capital No-Action letter, firms should be aware there are additional disclosures for backtested models. For example, firms must disclose that the advertised performance does not represent the results of actual trading but rather were achieved through the retroactive application of a model developed with the benefit of hindsight. Firms should also disclose the inherent limitations of data derived with such hindsight and the reasons why actual results may differ.
8. What kind of records should I maintain for a model portfolio?
Advisers must maintain all records necessary to support any performance information presented in advertisements or other communications. The firm should have sufficient documentation to demonstrate performance calculations by maintaining worksheets, system reports, etc. for a model portfolio including any third party records to support pricing and other assumptions made.
9. What is the best way for me to present my model performance in advertisements or marketing?
Do not link theoretical with actual performance in any way — this applies to both presentational and mathematical linking.
Provide clear and prominent disclosure that the returns are theoretical, and describe key assumptions made and their limits.
Theoretical results should be shown only to consultants and sophisticated clients or prospects that have sufficient experience and knowledge to assess the product, presentation, and risks.
Remember sufficient records must also be maintained to support not only the calculations, but the presentations overall.
Consult with your compliance department and attorneys regarding applicable laws and regulations.
10. Is it possible for model performance to be “audited”?
Yes! We can review the calculation of performance to ensure adherence to methodologies established.
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