Backtested performance

Backtested performance shows what would have happened if an investment strategy had been used during a specific period in the past. Investment managers create these simulations by applying their current investment approach to historical market data. The results are because no real money was invested during that time period.

The regulatory treatment of backtested performance has changed significantly over time. In the past, the SEC took a strict view against showing model performance results. However, a landmark case called the Clover Capital no-action letter indicated that backtested results could be acceptable if presented properly with adequate warnings. The SEC's current position is found in the Amended Marketing Rule, which became mandatory on November 4, 2022. This rule allows investment managers to show hypothetical performance results under specific conditions with appropriate disclosures about limitations.

The rules governing backtested performance changed dramatically with the SEC's Amended Marketing Rule. The SEC now recognizes that these simulations can provide valuable information when investors understand their limitations. The current regulatory framework allows backtested performance when advisers meet strict disclosure and procedural requirements. This acknowledges that such results can help investors understand how investment strategies behaved during different market conditions.

However, not all regulators take this flexible approach. FINRA continues to prohibit the use of backtested performance through , which governs public communications by broker-dealers. FINRA has consistently enforced this prohibition through disciplinary actions. They have concluded that using backtested information that does not reflect actual results for investment managers or funds was misleading and violated standards of fair dealing and good faith. Recent attempts to align FINRA rules with SEC standards have faced setbacks, with the SEC staying approval of proposed FINRA amendments in 2024.

Investment managers who want to use backtested performance must provide comprehensive warnings about its limitations. These disclosures must clearly state that the results do not represent actual trading. They must also explain that the results may not reflect how economic and market conditions would have affected the manager's real-time decision-making.

Additional required disclosures include any material changes in investment objectives, strategies, or market conditions that affected the model results. If applicable, managers must disclose that certain securities or strategies in the backtested results relate only partially to the services they actually provide. When the adviser's actual performance results differed significantly from the model results, this difference must be disclosed.

The Amended Marketing Rule allows hypothetical performance under specific circumstances. Advisers must provide sufficient information so recipients can understand the criteria and assumptions behind the performance results. They must also provide information about the risks and limitations of using hypothetical performance when making investment decisions.

The rule requires advisers to adopt and implement policies and procedures reasonably designed to ensure that hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience. This represents a shift from strict prohibitions to a principles-based approach focused on appropriate disclosure and audience targeting.

The SEC continues to bring enforcement actions against advisers who present model performance in misleading ways. These cases demonstrate that while backtested performance is now explicitly allowed, its presentation must meet strict standards for accuracy and transparency. Enforcement activity particularly focuses on cases where backtested performance is mixed with actual historical performance results. This mixing creates false impressions about how long a fund has actually been operating.

Using backtested performance creates specific record-keeping requirements for . Rule 204-2(a)(16) requires registered advisers to maintain all information and documents that support their . Registered advisers must keep these performance records and supporting documentation for five years from the end of the fiscal year when the advertisement containing the performance results was last published or communicated.

These record-keeping requirements ensure that advisers can prove their backtested performance presentations are accurate. They also help demonstrate compliance with disclosure requirements during regulatory examinations.

Backtested performance serves several important functions in hedge fund marketing and investor education. It allows managers to demonstrate how their strategies would have performed during historical periods, including market stress scenarios and different economic environments. This information proves particularly valuable for newer managers who lack extensive live track records. It is also useful for established managers launching new strategies.

However, backtested performance has significant limitations that must be carefully considered. Historical backtesting cannot fully account for the practical challenges of implementing strategies in real-time. These challenges include market impact, liquidity constraints, operational considerations, and the psychological pressures of managing actual capital. Additionally, backtested results may suffer from various forms of bias, including survivorship bias, look-ahead bias, and overfitting.

Modern compliance considerations extend to digital platforms and social media communications. Any backtested performance shared through websites, social media, or digital marketing materials must comply with the same disclosure and substantiation requirements as traditional marketing materials. The broad definition of "advertisement" under the current rules encompasses most digital communications. This requires careful attention to compliance across all marketing channels.

Backtested performance must be carefully coordinated with other forms of performance presentation to avoid creating misleading impressions. When combined with actual performance, clear distinctions must be maintained between simulated and actual results. The presentation must enable investors to understand which portions of the performance history reflect actual trading and which reflect backtested simulation.

This coordination becomes particularly important when managers present composite performance information. It is also crucial when they transition from backtested to live performance tracking for new strategies.