By: Alexandra Hughes, Spring 2016 Clinic GRA
On April 15, 2016, the SEC’s Office of Investor Education and Advocacy issued an Investor Bulletin discussing Performance Claims. The SEC stated that investors “will likely come across sales and marketing materials that describe an investment’s performance” but that performance claims may be presented in a way that doesn’t disclose everything an investor would or should want to know. The SEC advises that before making an investment decision, the investor should understand how information underlying a performance claim “is calculated and presented—and whether or not the claim is reliable and applies to [the investor’s] particular circumstances.”
The Investor Bulletin breaks down understanding performance claims made about an investment into two categories: (1) understanding how the information underlying the performance claim is calculated and presented and (2) evaluating the reliability of that performance claim. Understanding these issues is vital to the prudent investor. The SEC recommends that before an investor relies on a performance claim, they understand these two categories. A summary of the Investor Bulletin is below.
- Understanding how performance is calculated and presented
- Consider the factors that are and are not included in the performance claim.
- Consider the fees related to investing in the product. Payment of fees reduces investment returns. Thus, if fees are excluded from performance calculations, this can affect the presentation of the performance information.
- Consider your financial circumstances and recognize that performance is only one of many factors (e.g., age, income, other investments, and debt) that should be taken into account when making an investment decision.
- Consider market and economic conditions since performance claims cannot be evaluated in a vacuum.
- Consider methodology: A performance claim should describe its calculations process. Investors should understand the factors that were included in, and important to, the calculations.
- Evaluating the reliability of a performance claim
- Beware of performance guarantees, since it is “virtually impossible to guarantee returns on investments that have market risk.” Market risk refers to the market forces which determine the profitability of an investment.
- Beware of “backward looking” performance since this is not based on actual historical performance but makes use of an “algorithm” or “model” to determine how the investment “may have performed if it had existed or been in operation” in the past. Further, “backward looking” performance does not predict the future success of an investment.
- Beware of performance strategies that cherry-pick past performance since these claims may exclude periods of bad returns and only include periods of good returns, which prevents the investor from seeing the entire picture of the investment’s history.
- Beware of benchmark performance. The SEC’s example of a benchmark is “a market index that tracks how a particular segment of the market is performing, like the S&P 500.” This strategy may not evaluate the investment’s performance appropriately because it does not compare “apples to apples” or does not take into account fees related to an investment, which will reduce an investor’s returns.