Hypothetical and
Unaudited Returns:
Challenges and Acceptance
in the Marketplace
August 31, 2010
Today’s Presentation
• GIPS: Distinguishing between
Supplemental, Additional, and Model
Common Applications:
Inception of a Strategy
Portable Strategies
UMA Strategies
• FINRA Rule 2210 and SEC Rule 482
• Q&A
• The presentation will cover both RIA and
B/D regulations/best practices.
• Audited/Unaudited is consultant
terminology, not CPA terminology
Consultant terminology: audited/ unaudited
returns
CPA terminology: performance examination,
review, compliance attestation
Supplemental Information
GIPS Guidance Statement:
Use of Supplemental Information
• GIPS: Firms are “encouraged to present all relevant
information beyond that required and recommended”
– Fair representation and full disclosure
– Cannot contradict compliant information
• Supplemental information:
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–
–
–
–
Performance-related
Part of a compliant presentation
Supplements or enhances required/recommended provisions
Clearly labeled
Not examined by independent verifier as part of verification
Supplemental Information
• What is NOT supplemental: (no need for label)
– Additional information: Additional benchmarks, added
disclosure, monthly updates to the annual presentation
– Non-Performance Related information: general
information regarding the firm, strategy or details about the
process
– Misleading information: linking model, backtested
results or non-portable performance to actual, ongoing
performance results
Supplemental Information
Examples of Supplemental Information
Supplemental information must relate directly to the compliant presentation.
Examples of supplemental information include, but are not limited to:
• Carve out returns that exclude cash
• Non-portable returns
• Model, hypothetical, backtested, or simulated returns
• Representative account information, such as:
Portfolio-level country weightings
Portfolio-level sector weightings
Portfolio-level risk measures
• Attribution
• Composite or portfolio-level specific holdings
• Peer group comparisons
• Risk-adjusted performance
Supplemental Information
• You may prepare and present information according
to specific requests from prospective clients.
• You may present compliant and noncompliant
information on the same page.
– When in doubt: separate.
– If presented separately, relate it to the compliant
presentation.
• Compliant firms: must provide fully compliant
presentation prior to or accompanying supplemental
information.
Inception of a Strategy
• During the initial 18-month period of building a
performance record, investors are more
understandable of unaudited returns
• More scrutiny is placed on risk management,
infrastructure and operational due-diligence
• After this “grace period” unaudited returns send up a
red-flag, and place you at a competitive
disadvantage
Inception of a Strategy
Investor Sentiment
• Paradigm Shift post-2008 - Power lies with the investors
• Institutional Program Check-list:
- Will ask for the scheduled delivery timeframe for audited
results
• Audited returns suggest professionalism, transparency, and
fund quality
• Provides data accuracy
Inception of Strategy
Sample of seeded track record
Inception of Strategy
Sample of paper track record
Inception of a Strategy
Consultants View
• Paper portfolios vs Seed money
– Does it add credibility to have a paper portfolio audited? No.
• Size
– How much does size of inception portfolio matter?
• Time Period
– Length of time before it’s marketable?
Portable Strategies
GIPS Guidance Statement on Performance
Record Portability
a. Performance
track records of a past firm or affiliation must be linked to or
used to represent the historical record of a new firm or new affiliation if:
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–
–
b. The
i. Substantially all the investment decision-makers are employed by the new firm (i.e., research department, portfolio
managers, and other relevant staff),
ii. The staff and decision-making process remain substantially intact and independent within the new firm, and
iii. The new firm has records that document and support the reported performance.
new firm must disclose that the performance results from the past firm
are linked to the performance record of the new firm,
c. In addition to 5.A.4.(a) and 5.A.4.(b), when one firm joins an existing firm,
performance of composites from both firms must be linked to the ongoing
returns if substantially all the assets from the past firm’s composite
transfer to the new firm.
d. If a compliant firm acquires or is acquired by a noncompliant firm, the
firms have one year to bring the noncompliant assets into compliance.
Portable Strategies
Other “fair representation and full disclosure”
considerations:
• M&A: Determining/disclosing assets under management
• M&A: Determining a “surviving” composite
– link to the ongoing performance of the merged composite
– recommend that the performance of the “non-surviving”
composite be made available as supplemental information upon
request
• Events that impact the firm’s operations and/or investment
process (for example, change in ownership, merger or
acquisition, departure of key investment professional, etc.)
must be disclosed.
Portable Strategies
Portable Strategies
Presentational Linking:
Could be misleading
Portable Strategies
A Quick Solution
Portable Strategies
Portable vs. Non-portable
• Non-portable track records are not considered during the
investment selection process:
• 3(c)1 Funds:
– Limited to 100 investors
– Must all be Qualified Clients to charge performance fee
– Manager cannot use previous track record from another fund
• 3(c)7 Funds:
– Limited to 499 investors
– Must all be Qualified Purchasers
– Manager is able to market previous performance
UMA Strategies
Unified Managed Accounts – combine a diversified
portfolio of multiple instruments and managers into one
account with a single registration, largely through the
use of model arrangements
– Advisory firms don’t have trading discretion
– Assets through UMA or other agreements where there is no
discretionary portfolio management responsibility are:
– NOT part of a composite
– NOT part of the GIPS firm assets
– NOT included in ADV assets
UMA Strategies
Could UMA assets be included as
Supplemental Information?
As of 2005, composite assets are $238 million
and an additional $24 million employ the strategy
through a model unified managed accounts
program not included in XYZ assets.
[If on a separate page, state: This is supplemental information. Please see full disclosure presentation located….]
UMA Strategies
Firm assets: $462
As of 2005, firm assets are $462 million,
which includes $260 million in equity investments and
$102 million invested in fixed income and cash equivalents.
The firm also has model advisory contracts for $69 million, which we have no trading discretion for and do not include in firm assets.
[If on a separate page, state: This is supplemental information. Please see full disclosure presentation located….]
NOTE: Nowhere does the presentation add together firm assets and model UMA assets, which could be misleading.
FINRA Rule 2210
Hypothetical Returns
• Prohibits funds from referencing hypothetical
performance returns in any written sales literature
• What it does permit:
(1) Hypothetical illustration of a mathematical
principle
(2) A verbal discussion of the performance that
would have been achieved, so long as it is not in any
written format or on any leave behind material
FINRA Rule 2210
Performance Standards
• Prevents funds from excluding material information,
if such information would cause the communication
to be misleading
• Prevents “cherry picking” and presenting specific
years’ performance or investment ideas, without
representing the whole
• For any performance or benchmark information
presented, the method of calculation and benchmark
comparison must be explicitly stated
SEC Rule 482
Performance Standards
• Overlap with FINRA Rule 2210
– Require standardized performance information
– Prohibits the exclusion of materially relevant information
• Addition to FINRA Rule 2210
– Claims that “boilerplate disclaimers” are insufficient to
avoid misleading investors
– Must adhere to federal antifraud securities
provisions
In Summary
• The capital raising environment is more competitive
than ever
• $9.2 BB of the $9.7BB allocated to hedge funds in Q2, went to funds
>$5BB AUM
• Movement towards a regulated environment
• Adherence to institutional standards and compliance is of paramount
importance
• Treat your fund as a business
• Put forth best practices
• Investor flight to quality
Q&A
Contact info:
David T. Rondeau, Sean Long
Principals
Southport Harbor Associates
David direct: 203.292.8166
Sean direct: 203.292.8167
www.southport-harbor.com
Kim Cash, Partner
Ashland Partners & Company
Cell: 541.601.7512
kim@ashlandpartners.com