The SEC's Modernized Marketing Rule and Performance Measurement Issues for Investment Advisers

On May 4, 2021, the SEC’s Modernized Marketing Rule for Investment Advisers became effective, beginning an 18-month transition period after which investment advisers will be required to comply with a series of new rules regulating their marketing activity.1  The SEC explains that “this amended rule replaces an outdated and patchwork regime on which advisers have relied for decades,” and recognizes that “it may result in practice changes for advisers, including private fund advisers.”2  Of particular interest are certain limitations on how investment advisers may present historical and hypothetical returns.3  While many or perhaps most investment advisers already comply with these standards, those who fail to comply could face significant investigation and litigation costs.  The new rule may therefore warrant a fresh review of reporting procedures for investment managers.

At the center of cases involving investment performance is the difference between what investors expected based on an investment manager’s marketing materials and the returns they actually earned.  Investors may blame advisers, claiming that shortfalls are attributable to unsuitable investment choices, mismanagement, breaches of duty, and other allegations.  These cases often hinge on gaps between actual results and the return investors expected based on an investment’s stated strategy, reported historical performance, hypothetical portfolios, or purported exposure to risk. 

Some cases, such as those that allege investment advisers misled investors about trading strategies or returns, can be relatively straightforward.  For instance, many of the SEC’s “Most Frequent Advertising Rule Compliance Issues” relate to failures to reflect returns net of fees or measurement of returns against inappropriate benchmarks.4  In these cases, measuring the impact of underperformance may be a simple matter of adjusting historical returns or benchmarks against which performance is measured.

In other cases, more subtle issues may arise.  An often overlooked step in evaluating investment performance is identifying which transactions and holdings are relevant.  While it may be tempting to focus on those transactions or holdings specifically called into question, that approach may miss the broader context in which the transactions in question occurred.5  Indeed, it is often inappropriate to evaluate the impact of a particular transaction or set of transactions without considering the broader risk-exposure impacts on the entire portfolio and its strategy.  For instance, buying put options on a security not held in a portfolio may appear to be inconsistent with a stated investment objective, or even speculative, until one considers that the underlying security is highly correlated with other holdings in the portfolio (which may be more thinly traded and difficult to hedge).

In addition, the timeframe over which returns are measured can be critical.  An SEC action involving Pacific Investment Management Company LLC (“PIMCO”) highlighted one of the issues with reporting returns over different stages.  In 2016, the SEC alleged that strong performance of the PIMCO Total Return ETF in the initial period after inception “was attributable to buying smaller-sized bonds known as ‘odd lots’ as part of a strategy to bolster performance out of the gate.”6  According to the SEC, PIMCO failed to disclose to investors that the returns generated from the odd lot strategy may not be sustainable as fund size grew.

The impact of PIMCO’s alleged odd lot purchases on the fund’s total returns is, of course, a function of the timeframe over which one chooses to examine the fund returns.  For instance, odd lot marks could have an outsized effect on returns near inception of the fund when total assets are lower, but a relatively muted effect on more recent quarterly and annual returns when total assets are higher.  In addition, the case underscores how investment reporting decisions made early in a fund’s life, such the marking-to-market of less liquid holdings, can persist over the life of funds that report inception-to-date and other long-term performance metrics.

From the SEC’s perspective, PIMCO’s odd lot reporting portrayed an exaggerated picture of success.  But even accepting the SEC’s position, the extent to which this success was unattainable to new investors depends on the timeframe that investors consider as well as the timeframe after which the SEC determined the strategy to longer be representative of the fund’s expected performance. 

Another issue that may arise in litigation and investigation proceedings is whether deviations from a stated strategy actually caused investors to suffer substandard returns.  Both the SEC and courts have sided with investors when funds deviate from stated strategies, especially those funds that purport to adhere to quantitative or rules-based criteria.7  But deviations from a stated strategy in and of themselves may or may not cause return shortfalls.

For instance, in the SEC’s investigation of Sterling Global Strategies (“Sterling”), the commission alleged that Sterling presented misleading historical performance to prospective investors based on gains from a back-tested hypothetical portfolio.8  The SEC argued that, in addition to other violations, the hypothetical portfolio was reallocated based on month-end closing prices, whereas the investments in the actual portfolio were allocated using closing prices from two days prior to month-end.  This inconsistency alone, according to the SEC, inflated the back-tested portfolio results by 9.6 percent.

While the SEC contended that the two-day lag between signal and investment was essential to Sterling’s ability to execute the strategy (implying that the results of the hypothetical portfolio were unachievable), it is unclear whether the Commission determined that the entirety of the return differential was attributable to the two-day lag.  If the SEC simulated returns of the hypothetical portfolio using a two-day lag and then compared those returns to the advertised hypothetical portfolio results (using no lag), such a simple comparison may not be an appropriate measure of harm to investors arising from deviations from the strategy.  For instance, the results of such a simulation would reflect differentials attributable to both systematic return overstatements (e.g., reliance on price signals unavailable two days before execution) and confounding factors (e.g., unpredictable adverse market movements during the two-day lag period).  Thus, disaggregating these elements may be a critical step in assessing the harm caused by inconsistencies between actual and back-tested portfolios.

Fortunately, common financial, econometric, and statistical tools can be applied to disaggregate effects.  Techniques such as difference-in-differences analysis and event studies are prime examples often applied by experts in securities litigation.  These approaches and other techniques can be combined with investment performance reporting standards to account for unique constraints or idiosyncratic situations. 





5Economists sometimes refer to the bias of focusing on the most easily observed data as the streetlight effect or lamp post fallacy.  As The Economistexplained: “a policeman sees an inebriated man searching for his keys under a lamp post and offers to help find them. After a few fruitless minutes, the officer asks the man whether he’s certain he dropped his keys at that particular location. No, says the man, he lost them in the park. Then why search here, asks the officer. The man answers: ‘Because that’s where the light is.’”  “Free Exchange: Where economists focus their research,” The Economist, December 10, 2020.


7See, e.g.In re Sterling Global Strategies, LLC., Investment Advisers Act Release No. 5085 (Dec. 20, 2018) and In re F-Squared Investments, Inc., Investment Advisers Act Release No. 3988 (Dec. 22, 2014).  See also, e.g., Eisenberg, Jonathan (ed.), Litigating Securities Class Actions, Vol. 1., LexisNexis, 2020, § 10.02[5][d], citing In re Evergreen Ultra Short Opportunities Fund Sec. Litig., 705 E Supp. 2d at 89; In re Regions Morgan Keegan Secs, 743 F. Supp. 2d 744. 760 (W.D. Tenn. 2010); In re Charles Schwab Corp. Sec. Litig., 257 F.R.D. 534,543 (N.D. Cal. 2009; In re Oppenheimer Rochester Funds Group Sec. Litig., 838 F. Supp. 2d 1148. 1169-71 (D. Colo. 2012).


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