SEC charges investment adviser in connection with use of backtested performance

On January 13, 2022, the Securities and Exchange Commission (SEC) announced settled charges against CMG Capital Management Group, Inc. (CMG), a registered investment adviser for failing to adopt and implement policies and procedures reasonably designed to prevent false or misleading advertisements concerning the hypothetical, backtested performance of the firm’s algorithmic strategies, and for failing to preserve certain advertisements. The use of hypothetical, backtested performance by investment advisers has long been fraught with peril, as the SEC has previously sanctioned investment advisers for, among other things:

  • advertising hypothetical backtested performance as actual performance, and further inflating advertised performance by approximately 350% due to a calculation error;1
  • failing to disclose whether the period selected for the backtest contributed to the performance of a hypothetical portfolio.3

With the advent of the update to Rule 206 (4) -1 (Marketing Rule) under the Investment Advisers Act of 1940, as amended (Advisers Act), and the fast- approaching compliance date of November 4, 2022 (sooner if an adviser is already relying on any portion of the amended Marketing Rule), this case serves as a reminder of the complexities and hazards of advertising hypothetical, backtested performance and of the need for advisers to quickly acquaint themselves with the new requirements of the Marketing Rule.


to the SEC’s order, between April 2017 and July 2018 (before the revisions to the Marketing Rule were adopted), CMG advertised hypothetical, backtested performance results without disclosing certain dissimilarities between the backtest and the live versions of their strategy. Specifically, the backtest and live strategy relied on different securities when constructing a model portfolio, and certain funds used in the backtest were not adequately correlated with the securities they replaced in the live strategy. Although CMG had written advertising policies, the SEC found them to be insufficient to prevent violations like the one that occurred. These errors were further compounded by CMG’s failure to preserve copies of “tear sheets” advertising the performance of their strategy from January to July 2016.

Ultimately, CMG was found to have violated Rule 206 (4) -7 under the Advisers Act for failure to adopt and implement written compliance policies and procedures reasonably designed to prevent violations by the investment adviser and its supervised persons of the Advisers Act and rules thereunder , and to have violated Advisers Act Rule 204-2 (a) (11) for failure to retain a copy of each advertisement circulated or distributed to ten or more persons.

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The SEC censured CMG, ordered CMG to cease and desist from committing or causing any violations and any future violations of Sections 204 (a) and 206 (4) of the Advisers Act and rules promulgated thereunder, and levied a civil monetary penalty of $ 70,000.

Interestingly, while the SEC found that CMG failed to disclose dissimilarities between the backtest and the actual strategy, it did not sanction CMG for violations of the Marketing Rule. Instead, as noted above, the SEC sanctioned CMG for deficient compliance procedures and for books and records violations. The SEC may have chosen to refrain from sanctioning CMG for Marketing Rule violations because, as the SEC noted in its order, CMG voluntarily adopted a policy prohibiting the use of hypothetical, backtested performance results in advertising materials.

Marketing Rule

In December 2020, the SEC announced a major overhaul of its nearly 60-year-old Marketing Rule, which it combined with an updated solicitation rule4 within the body of the Marketing Rule. The updated Marketing Rule defines hypothetical performance as “performance results that were not actually achieved by any portfolio of the investment adviser” and explicitly includes, but is not limited to, “performance that is backtested by the application of a strategy to data from prior time periods when the strategy was not actually used during those time periods. “

In adopting the updated Marketing Rule, the SEC acknowledged that “backtested performance may help investors understand how an investment strategy may have performed in the past if the strategy had existed or had been applied at that time.” However, the SEC cautioned that “backtested performance included in an advertisement is more likely to be misleading to the extent that the intended audience does not have the resources and financial expertise to assess the hypothetical performance presentation.” To address this concern, the updated Marketing Rule requires advisers to take “certain steps to address its potentially misleading nature.” In particular, hypothetical performance may not be included in an advertisement unless the investment adviser:

  • adopts and implement policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement;
  • provides sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating the performance;
  • provides (or, if the intended audience is an investor in a private fund, provides, or offers to provide promptly) sufficient information to enable the intended audience to understand the risks and limitations of using the hypothetical performance in making investment decisions.

Books and Records Rule

In conjunction with the adoption of the amended Marketing Rule, the SEC also updated the “Books and Records Rule” (Advisers Act Rule 204- (2)) to require advisers to retain copies of all advertisements, whereas advisers previously only had to retain copies of advertisements provided to ten or more persons. In addition, advisers will have to retain copies of all information provided, or offered to be provided, pursuant to the Marketing Rule’s conditions on advertising hypothetical performance, as well as records concerning the “intended audience” of the hypothetical performance.

GIPS Standards

While the SEC declined to require specific disclosures when advertising hypothetical performance, advisers that claim compliance with the Global Investment Performance Standards (GIPS) must include several specific disclosures. In particular, GIPS 2020 requires an adviser advertising hypothetical performance (“theoretical performance” in GIPS parlance) to:

  • disclose that the results are theoretical, and are not based on the performance of actual assets, and whether the theoretical performance was derived from the retroactive or prospective application of a model;
  • disclose a basic description of the methodology and assumptions used to calculate the theoretical performance sufficient for the prospective client or prospective investor to interpret the theoretical performance, including if it is based on model performance, backtested performance, or hypothetical performance (performance derived from blending actual performance of multiple composites or pooled funds);
  • disclose whether the theoretical performance reflects the deduction of actual or estimated investment management fees, transaction costs, or other fees and charges that an actual client portfolio would have paid or will pay;
  • clearly label the theoretical performance as supplemental information.

Eversheds Sutherland Observation: This enforcement action reinforces the need for advisers to be exacting in the supervision of their use of hypothetical, backtested performance in their marketing materials and serves as a helpful reminder of the new requirements imposed by the updated Marketing Rule and its fast-approaching compliance date of November 4, 2022.


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