PROGRAM AVAILABILITY IS DEPENDENT ON YOUR COUNTRY OF RESIDENCY AND FINANCIAL STATUS.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. THE RISK OF LOSS IN TRADING THE CASH MARKET, FOREX, FUTURES CONTRACTS OR OPTIONS CAN BE SUBSTANTIAL AND THEREFORE INVESTORS SHOULD UNDERSTAND THE RISKS INVOLVED IN TAKING POSITIONS. INVESTORS MUST ASSUME RESPONSIBILITY FOR THE RISKS ASSOCIATED WITH SUCH INVESTMENTS.
BID/ASK SPREADS, COMMISSION, CLEARING, EXCHANGE AND REGULATORY FEES WILL HAVE AN ADVERSE IMPACT ON THE NET OVERALL PERFORMANCE OF YOUR ACCOUNT. PRIOR TO MAKING A DECISION TO PARTICIPATE IN ANY INVESTMENT MAKE SURE YOU FULLY UNDERSTAND THE FEES ASSOCIATED WITH TRADING.
EXAMPLES OF HISTORIC PRICE MOVES OR EXTREME MARKET CONDITIONS ARE NOT MEANT TO IMPLY THAT SUCH MOVES OR CONDITIONS ARE COMMON OCCURRENCES OR ARE LIKELY TO OCCUR.
ACTUAL PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT.
YOU SHOULD CAREFULLY CONSIDER WHETHER TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR CIRCUMSTANCES AND FINANCIAL RESOURCES.
THE INFORMATION PROVIDED IN THIS REPORT CONTAINS RESEARCH, MARKET COMMENTARY AND TRADE RECOMMENDATIONS. IT SHOULD BE KNOWN THAT THE REPRESENTATIVES OF OUR FIRM MAY TRADE FUTURES AND OPTIONS FOR THEIR OWN ACCOUNTS OR THOSE OF OTHERS. DUE TO VARIOUS FACTORS (SUCH AS MARGIN REQUIREMENTS, RISK FACTORS, TRADING OBJECTIVES, TRADING INSTRUCTIONS, TRADING STRATEGIES AND OTHER FACTORS) SUCH TRADING MAY RESULT IN THE LIQUIDATION OR INITIATION OF FUTURES OR OPTIONS POSITIONS THAT DIFFER FROM THE OPINIONS AND RECOMMENDATIONS FOUND IN THIS REPORT.
A word of caution to professional’s who may present performance
The use of theoretical performance, such as performance of a model portfolio, is not an uncommon practice, but little guidance from regulators exists concerning its use. I will address the issues concerning the use of theoretical performance, summarize the regulatory implications and risks of using such presentations.
A model portfolio is a fictional one that does not include assets under management. Models are often presented as an ideal combination of securities for a client’s portfolio. 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.
Backtested performance results 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 technique is often used when actual accounts may add or subtract positions creating a discrepancy between the “model portfolio” and actual performance. Discrepancies in capitalization may also occur for example investor A may trade 1,000-3,000 shares per trade with $1,000,000 in his account, investor B a consistent 1,000 shares with $250,000 in his account, the actual composite (the average of the two accounts) would not match the performance of either investor A or B, there is no firm guidance or consistency among regulators as to how to disclose these discrepancies.
Hypothetical performance may have been derived from actual performance but not in the context in which it is being reported. For example, a firm may not have any actual balanced portfolios, but it invests separately in stocks, bonds, futures or currencies. For a prospective client with a balanced mandate, the firm might combine the firm’s actual performance results into a hypothetical balanced portfolio. All three of these approaches (model, hypothetical, and backtested) can be categorized as “theoretical” or “simulated” performance.
Is there a regulatory problem with using theoretical or simulated returns? A number of years ago, the U.S. Securities and Exchange Commission (SEC) found cases of firms failing to adequately identify and disclose the limits of backtested results. Other regulatory agencies have similar concerns. For example, the Ontario (Canada) Securities Commission (OSC) recently identified cases where hypothetical performance was presented in a way that may have misled clients to believe it was performance of actual portfolios. As a result, the OSC has suggested that firms present only actual performance. But firms may have legitimate reasons for presenting hypothetical returns when actual returns are not available. I do not want to suggest that firms cannot use hypothetical results – just that if they are used, they should only be used in certain ways.
To this point, there has been limited guidance developed on the use of model, hypothetical, and backtested performance. To address this issue, the U.S. Investment Performance Committee (USIPC) is engaged in developing guidelines on best practices, including recommended disclosures. The best practices, which will be presented later, reflect the work in progress of the USIPC as well as the OSC.
To understand the logic of best practices, however, one must understand what is potentially wrong with the use of theoretical results. Model performance could produce results that are superior to those that actual clients will experience for a number of reasons. First, models can be manipulated. That is, if some aspect of the model did not work, it can be replaced, and no one would ever know. Second, models may not reflect transaction costs and fees, the ones represented in this report do and the amount is disclosed. Also, the timing of a model’s trades may have been “optimized,” meaning that sales may have been assumed to occur at the exact price represented for all accounts, in this reports I am labeling the percentage of trades %A where executing all orders at the disclosed price could be questioned . Finally, models are not subject to the vagaries of external cash flows.
Similarly, with backtesting, we have the benefit of hindsight. A strategy that is run backward is typically adjusted based on the results obtained until the results are at a level that is deemed to be attractive. In contrast, with actual portfolios, if we make a mistake, we have to live with it. At least in the case of hypothetical portfolios, we are basing their construction on actual results. But even in this situation, the pieces may be combined in a way that shows the results in the best possible light.
Regulators have provided little specific guidance in the area of performance reporting for investment advisers. In the US the limited guidance that exists is contained in 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 (e.g., Clover Capital Management and Investment Company Institute). Regulators approach performance advertising under the rubric of fraud. It does not recommend a particular performance calculation methodology, preferring instead to focus on disclosure. But because of the fiduciary relationship between client and adviser, an adviser is held to a higher standard of objectivity and clarity than the “truth in advertising” standard of commercial advertising. The SEC standard requires that an advertisement not contain “any untrue statement of a material fact” or that “is otherwise false or misleading.” Whether an advertisement is false and misleading depends on the facts and circumstances surrounding its use, including
The form and content of the advertisement;
The adviser’s ability to perform what is advertised;
Implications or inferences arising out of the advertisements in the total context;
Sophistication of the clients or prospective clients. (Regulators will presume clients to be unskilled and unsophisticated.)
The most sensitive aspect of this, with regard to model performance results, is whether the model results imply something about the adviser’s competence or about future investment results that would not be true had the advertisement included all material facts.
The Clover no-action letter set forth certain advertising practices the SEC believes are inappropriate under Rule 206(4)-1. This is not intended to address all advertising practices, and following the list does not create a “safe harbor” that may be relied on. With respect to advertising model or actual performance results, the SEC prohibits using an advertisement that
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 make 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;
Fails to disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed.
Regulators also have certain targeted criteria that apply to the reporting of model results. For model results, the SEC prohibits using an advertisement that
Fails to disclose prominently 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;
Fails 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 the effect of any such change on the results portrayed;
Fails to disclose, 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;
Fails to disclose, if applicable, that the adviser’s clients had investment results materially different from the results portrayed in the model.
Emerging Best Practices If we go beyond the limited guidance provided by the SEC and other organizations, what would “best practices” look like? Seven best practices should be kept in mind when presenting theoretical performance:
Clearly label all theoretical results as such (e.g., Backtested Global 130/30 Strategy).
Do not link theoretical with actual performance in any way. This means more than just not geometrically linking the returns. This means that if you must include theoretical and actual performance in the same presentation, then show them on separate pages, and clearly label them.
Do not state that “past performance is not indicative of future results.” Even though we are accustomed to this language, in the context of model performance, it implies that what is being shown is actual performance.
Provide clear and prominent disclosure that the returns are theoretical, and describe all the 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.
Maintain sufficient records to support calculations and presentations.
Consult with attorneys and your compliance department regarding applicable laws and regulations.
Recommended Disclosure Points In addition, the following disclosure points may be helpful as a start for firms crafting disclosure in this area:
Provide a basic description of the model, assumptions, inputs, and quantitative parameters necessary to interpret the results.
Clearly indicate that the results are theoretical and additionally provide a warning that the performance results are not based on the performance of actual portfolios.
Disclose the fact that a proprietary model was used to generate the results.
Disclose any material facts or material differences between the model and the benchmark.
Indicate how advisory fees, trading costs, or other fees were treated in the model.
Disclose, if applicable, that backtested results were constructed with the benefit of hindsight.
Disclose any material changes to the model, its assumptions, the inputs, or any other relevant factors.
Disclose the limitations of the model.
Disclose (but do not link) any actual performance results for portfolios managed under the strategy during the time period.
Disclose any assumptions regarding cash balances and external cash flows.
Disclose and describe the treatment of reinvestment of dividends, interest, capital gains, and withholding taxes.
Disclose the possibility of loss.
Disclose the dates over which the theoretical performance results are presented.
Conclusion Although the potential exists for theoretical performance results to mislead, still, in the hands of sophisticated investors, and with the proper disclosures, they can provide useful information to prospective and current clients.
Know and trust your client
Ontario Securities commission
Securities Exchange Commission
Commodity Futures trading Commission
In re Schield Management Company et al., SEC Release No. IA-1872
In re Market Timing Systems, Inc. et al., SEC Release No. IA-2047
In re Patricia Owen-Michel, SEC Release No. IA-1584
In re LBS Capital Management, Inc., SEC Release No. IA-1644
In re Leeb Investment Advisors et al., SEC Release No. IA-1545