In a case that has variously been called unique and interesting, the SEC has fined CMG Capital Management Group of Malverne, Pennsylvania, $70,000 related to the use of hypothetical backtested performance data in its advertising.
Backtesting is a way of seeing how well a strategy would have worked after the fact, by discovering how it would play out using historical data.
The firm, which has $230 million in assets under management, was not fined for the use of the data per se. Rather, it was fined for failing to have policies and procedures in place that would have prevented this from happening and for not preserving the advertisements.
According to the SEC’s order, between April 2017 and July 2018, CMG advertised hypothetical, backtested performance results for its CMG Opportunistic All Asset Strategy without disclosing certain dissimilarities between the backtest and the live versions of the strategy. Among other things, the order found that the backtest and the 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.
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CMG also failed to preserve copies of the advertisements marketing the strategy that were distributed to prospective clients between January 2016 and June 2016, a violation of the books and records provisions of a section of the Investment Advisers Act of 1940.
The SEC has previously sanctioned investment advisors for advertising hypothetical backtested performance as actual performance, utilizing hypothetical assumptions instead of actual historical data to calculate backtested performance, and failing to disclose whether the period selected for the backtest contributed to the performance of a hypothetical portfolio.
An updated Marketing Rule under the 1940 Act takes effect Nov. 4, and even under that rule “using hypothetical backtested performance is not prohibited. It’s not as if you can’t do it. The question is whether you should do it,” said Jason Ewasko, managing director at Cipperman Compliance Services in Wayne, Pennsylvania. “Obviously for many firms, they believe using hypothetical backtested performance is an effective marketing tool, but our firm takes the position that because it’s been fraught with peril, in the words of one law firm, it’s a better idea not to do it.”
Ethan Corey, senior counsel at Eversheds Sutherland, headquartered in London, the firm that came up with the phrase “fraught with peril,” said the SEC has had its antenna up for many years for any issue involving backtesting.
“It’s been on the SEC’s radar screen for about 25 years,” he said, noting that the first such case was in 1996. “They’ve basically always been uptight about backtesting. What happened with CMG, where it gets interesting, was they advertised hypothetical backtested performance for their strategy, and that’s actually not that uncommon. But they didn’t say ‘How we’re managing the live portfolio is different.’”
He said typically when a firm is launching a new strategy, it will backtest and show the results to prospects in one-on-one presentations. But CMG included it in its advertising.
“So using (backtesting) is not what the SEC dinged them for,” he said. “It was not having the proper policies and procedures in effect to prevent the distribution of the false and misleading advertisement.”
The updated marketing rule, Ewasko said, actually comes out and says hypothetical backtested performance may be helpful but is more likely to be misleading. “If that isn’t a clear warning, I don’t know what is,” he said.
He called the case “fairly unique, with about as glaring an error as you’ll see.”
Corey agreed.
“I haven’t seen other cases like this,” he said. “In the past, the SEC has gone after advisors who have included false and misleading backtested results in advertising materials. But I think the SEC didn’t sanction the advisor directly for the fact that they did use false and misleading ad materials because we are in the time of the run-up to the updated marketing rule.
“It’s a shot across the bow for advisors that are using hypothetical backtested performance,” he said. “The SEC is watching.”
