Performance advertising

Performance advertising covers how hedge funds present their investment results in marketing materialsDocuments, presentations, and other communications used to promote investment opportunities to prospective investors.. This practice represents a critical component of fund marketing strategies. Fund managers regularly include performance data in their marketing presentations, pitch books, monthly reports, and materials they provide during due diligenceThe comprehensive investigation and evaluation process conducted before making an investment or business decision. processes.

Investment performance often serves as the foundation of marketing efforts. Historical returns can be among the most compelling factors for potential investors when they decide whether to invest in a fund. The Investment Advisers Act of 1940 Investment Advisers Act of 1940 The Investment Advisers Act of 1940 is the primary U.S. legislation regulating investment advisers, including hedge fund managers, establishing registration requirements, fiduciary duties, disclosure obligations, and compliance standards for advisers meeting certain thresholds. allows advisers to include performance information in their marketing communications. However, managers must ensure such presentations comply with anti-fraud protectionsRegulatory requirements that prohibit deceptive or misleading practices in financial communications and transactions. and do not mislead prospective investors.

The regulatory framework that governs performance advertising builds on anti-fraud principles rather than specific prescriptive rules. What ultimately constitutes fraudulent or misleading advertising depends on the facts and circumstances involving its use. Regulators consider several factors: the form and content of the advertisement, the implications or inferences drawn from the advertisement in its total context, and the sophistication of the prospective client or investor.

For hedge funds, regulators interpret "advertisements" broadly. This category includes flip books, marketing presentations, letters to investors, periodic performance reports, due diligence questionnaires Due diligence questionnaire (DDQ) A due diligence questionnaire (DDQ) is a detailed information document that hedge fund managers prepare to answer standard questions about their operations, investment strategy, risk management, staff, and compliance procedures. This document helps potential investors evaluate and compare different funds before making investment decisions. , websites, press releases, press interviews, speeches, and similar materials.

The 1986 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. represents the most important SEC guidance concerning performance advertising to date. In this letter, the SEC staff identified several practices that are considered misleading when presenting performance results.

These prohibited practices include several key areas. First, managers cannot fail to disclose how material market conditions affected performance. Second, they cannot present results without adjusting for management fees, brokerage costs, and other expenses. Third, they must include information about dividend reinvestment or other earnings treatment. Fourth, they cannot highlight profit potential while failing to disclose loss possibilities. Finally, they cannot make index comparisons without explaining relevant factors that could affect the comparison's validity.

The SEC permits advisers to show gross-of-fee returns Gross-of-fee returns Gross-of-fee returns represent investment performance calculated before deducting management fees and performance-based compensation, providing a measure of a hedge fund's investment performance before considering the impact of the fee structure. results in certain contexts, but only under specific conditions. The adviser must also present net-of-fee returns Net-of-fee returns Net-of-fee returns represent investment performance calculated after deducting all fees and expenses, including management fees and performance allocations, providing investors with the actual returns they would have received from their investment in the hedge fund. with equal prominence. Additionally, they must include disclosure that explains how net-of-fees performance was calculated and clarifies that the gross performance does not reflect the payment of advisory and other fees and expenses incurred in the management of the accounts.

This requirement ensures that investors can understand the actual returns they would have received after accounting for all fees and expenses. Gross performance shows returns before fees are deducted, while net performance shows what investors actually received after all costs.

In December 2020, the SEC adopted amendments to the Advertising Rule that significantly modernized performance advertising requirements. The Amended 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. became fully effective in November 2022. This rule replaced the previous complete prohibition on past specific performance with a principles-based restriction.

The new rule allows case studies and similar information about individual investments, provided they are presented in a fair and balanced manner. The rule also permits hypothetical performance Hypothetical performance Hypothetical performance refers to simulated, back-tested, or projected investment results that do not reflect actual trading by a hedge fund manager, subject to specific disclosure requirements when presented to potential investors due to their inherent limitations and potential for misleading representation. under certain circumstances and provides guidance on "extracted performanceThe presentation of investment results from specific investments or a subset of investments from a larger portfolio, requiring disclosure of the complete portfolio performance when used in marketing materials." presentations.

SEC staff issued additional guidance in March 2025 that further clarified these requirements. The guidance particularly addressed the presentation of extracted performance and performance-related characteristics. Under certain conditions, advisers may now present gross performance of individual investments or portfolio characteristics without corresponding net-of-fee calculations. However, they must display the overall portfolio's gross and net performance prominently in the same marketing materials.

The Amended Marketing Rule now permits the use of hypothetical performance in specific circumstances. Advisers may use hypothetical performance when they provide sufficient information to enable the recipient to understand the criteria and assumptions underlying the performance. They must also provide sufficient information addressing the risks and limitations of using hypothetical performance in making investment decisions.

The Amended Marketing Rule also provided clear guidance on the use of "extracted performance" for the first time. Advisers may use extracted performance as long as their advertisements contain or offer to promptly furnish the performance results of all investments in the larger portfolio from which this information was extracted.

Extracted performance refers to showing the results of specific investments or a subset of investments from a larger portfolio. For example, a manager might highlight their successful technology investments while also making available the performance of their entire portfolio.

The traditional prohibition on testimonials evolved under the Amended Marketing Rule. The new second prong includes any endorsement or testimonial for which an investment adviser provides compensation, directly or indirectly. This applies to compensated testimonials or endorsements made orally or in writing to one or more persons.

The rule was designed to capture advertisements that include traditional endorsements and testimonials as well as activity traditionally covered by the Cash Solicitation RuleFormer SEC rule governing compensated referrals and solicitations that was integrated into the broader endorsement provisions of the Amended Marketing Rule.. Under the Amended Marketing Rule, an "endorsement" now includes a placement agent's referral of an investor to a private fund.

A placement agent is a professional who helps connect investors with investment opportunities. When these agents receive compensation for making referrals, their activities now fall under the endorsement rules.

Investment managers may engage the services of broker-dealersA person or firm engaged in the business of buying and selling securities for the account of others or for its own account. to help distribute interests in their funds. This arrangement subjects such activities to FINRA's advertising rules. The most important of FINRA rules governing advertising is Rule 2210. This rule requires that all advertising distributed by member firms be presented in a "fair and balanced" manner and contains certain content standards that must be satisfied by broker-dealers marketing fund interests.

FINRA has interpreted Rule 2210 to generally prohibit its members from marketing investment funds that use unrelated performance results of other products. This prohibition covers private or public funds, accounts, portfolios, or compositesAggregated performance data that combines results from multiple accounts or trading programs to show overall performance. managed by the fund adviser but not directly related to the fund being marketed.

Rule 204-2(a)(16)SEC regulation requiring investment advisers to maintain specific books and records in true, accurate, and current condition. requires registered advisers to keep in their possession information and documents used to form the basis for performance results presented. A registered adviser must keep such performance records and back-up information for a period of five years from the end of the fiscal year in which the advertisement with the performance results was last published or communicated.

For the first two years, these records must be kept in an appropriate office of the adviser for ease of access. This requirement ensures that regulators can verify the accuracy of performance claims and that advisers maintain proper documentation for their marketing materials.

Legal counsel typically reviews marketing materials before they are distributed to prospective investors or intermediaries. This review seeks to ensure compliance with advertising and anti-fraud rules. The legal review process helps identify potential issues before materials reach investors.

It is also a good practice for hedge fund managers to conduct periodic reviews of their marketing materials and offering documentsLegal documents provided to prospective investors that describe the terms, risks, and other material information about an investment opportunity.. These reviews ensure that managers are presenting information consistently across all materials. Managers should verify that there are no material differences between information in the marketing materials, due diligence questionnaires, Form ADV Form ADV Form ADV is the uniform form used by investment advisers to register with the SEC and state securities authorities, containing detailed information about the adviser's business, ownership, clients, employees, business practices, affiliations, and disciplinary history. (if applicable), and offering documents.

This consistency helps avoid confusion among investors and reduces regulatory risk. When investors see different information in different documents, it can raise questions about the accuracy and reliability of the fund's disclosures.