Hypothetical performance

Hypothetical performance, also called model performance, shows simulated or backtested performance investment results. These results do not reflect what an investment adviser actually achieved through real trading. Instead, they represent what might have happened based on computer models or historical analysis.

The Securities and Exchange Commission (SEC) has changed its stance on this topic significantly over time. Previously, regulators treated hypothetical performance in marketing materials as potentially fraudulent. However, this changed with the Clover Capital no-action letterA significant SEC no-action letter that provided new guidance allowing investment managers to use hypothetical performance in their marketing materials under specific conditions., which provided new guidance. The SEC now allows investment managers to use model performance in their marketing materials under the current regulatory framework. Despite this permission, the SEC emphasizes an important caveat: if managers do not take adequate precautions, hypothetical performance can still mislead investors.

Hypothetical performance is now explicitly permitted under the SEC's current Marketing RuleThe SEC's current regulation governing investment adviser advertising and marketing practices, which permits hypothetical performance with proper disclosures and became fully effective in November 2022., but only when specific conditions are met. Advisers must provide sufficient information that enables recipients to understand the performance criteria and underlying assumptions used in the analysis. This means explaining not just the results, but the methodology behind them.

Additionally, for all investors, advisers must provide—or for private fund investors, provide or offer to promptly provide—sufficient information addressing hypothetical performance risks and limitations in investment decision-making. This requirement ensures that investors understand the inherent uncertainties involved when considering hypothetical results.

This regulatory approach represents a significant evolution from historical prohibition approaches. Rather than imposing outright bans, the current framework emphasizes principles-based regulation. The focus has shifted toward ensuring proper disclosure and context rather than preventing the use of hypothetical performance entirely. The current rule became fully effective in November 2022, marking a new era in performance advertising regulation.

The SEC permits hypothetical performance but requires specific safeguards to prevent misleading presentations. Investment managers must include prominent disclosures that explain the inherent limitations of model performance results. These disclosures must make clear that the results do not represent actual trading.

Additionally, the disclosures must explain that hypothetical results may not reflect how economic and market conditions would have influenced the adviser's real-world decision-making. In actual market scenarios, advisers face psychological pressures, liquidity constraints, and other factors that computer models cannot fully capture.

Investment managers must also provide several additional mandatory disclosures. First, they must explain the effects of any material changes in investment objectives, strategies, or market conditions that influenced the model performance. Second, they must clarify when certain securities or strategies in the model performance relate only partially to the services they actually provide to clients. Third, when applicable, they must acknowledge that their actual performance results differed materially from the model results.

Current recordkeeping rules create specific obligations for registered advisers who use hypothetical performance. These advisers must maintain all information and documents that support their presented performance results, including any hypothetical performance data.

The preservation period is substantial: registered advisers must preserve such performance records and supporting information for five years. This five-year period begins from the fiscal year end when advertisements containing the performance results were last published or communicated to investors. This requirement ensures that regulators can review the basis for historical marketing claims even years after they were made.

While the SEC allows hypothetical performance with proper disclosures, the Financial Industry Regulatory Authority (FINRA) takes a different approach. FINRA specifically prohibits the use of hypothetical performance results under Rule 2210. This creates a regulatory split that managers must navigate carefully.

FINRA has consistently interpreted Rule 2210 to ban hypothetical or backtested performance in marketing materials. The organization has demonstrated this stance through multiple enforcement actions. In these cases, FINRA stated that using hypothetical and backtested information—or any information that does not reflect actual results for investment managers, funds, or fund of funds—was misleading and violated fair dealing and good faith standards.

FINRA has also taken action against misleading presentation formats. In one notable case, FINRA determined that certain sales literature presented hypothetical performance results in charts that were combined with actual historical fund performance. FINRA concluded these presentations created false impressions that particular funds had longer track records than they actually possessed. The regulator found that this hypothetical returns usage violated Rule 2210.

The SEC has pursued enforcement actions against advisers who presented model performance that regulators considered misleading. These enforcement cases provide important lessons for the industry. They demonstrate that while hypothetical performance is not inherently prohibited under current SEC rules, advisers must exercise significant care in both presentation and disclosure practices.

The key takeaway from these enforcement actions is that permission to use hypothetical performance comes with substantial responsibilities. Managers cannot simply include boilerplate disclosures and assume they are protected. Instead, they must ensure that their presentations, taken as a whole, provide investors with a fair and balanced view of what the hypothetical results mean and do not mean.

When presenting hypothetical performance, hedge fund managers should follow several best practices to ensure compliance and investor protection. First, all material assumptions and methodologies should be clearly disclosed in language that investors can understand. Technical jargon should be explained or avoided when possible.

Second, limitations and risks should be prominently featured rather than buried in fine print. The distinction between hypothetical and actual results should be emphasized throughout the presentation, not just mentioned once. Third, transaction costs, fees, and market impact should be appropriately reflected in the analysis to make it more realistic.

Finally, the performance should be presented in context with appropriate benchmarks and risk metrics. This contextual information helps investors understand not just the returns, but the level of risk that was assumed to generate those returns. Without this context, even technically accurate hypothetical performance can be misleading.