Variations of Hypothetical Performance

July 31, 2015

Investment advisers will often use hypothetical performance results to market their investment track record.  One common reason this is done is when a firm is trying to launch a new strategy that they do not currently manage assets for.  Another reason could be that the manager feels that the hypothetical portfolio represents the purest version of their investment strategy (free from the noise caused by client restrictions and cash flow activity).

While the use of hypothetical information in marketing materials is not prohibited, it is generally highly scrutinized by regulators and requires clear and specific disclosure. Most advisers that use hypotheticals are perfectly fine with making these disclosures and labeling their results accordingly. The problem that we see is that many advisers don’t realize that what they are presenting is considered hypothetical information and, as result, they neglect to include the necessary disclosures.

The confusion is caused because many individuals have a somewhat limited view of what constitutes hypothetical performance.  The common interpretation is that hypothetical performance depicts results that do not represent actual trading of securities (i.e., a “paper portfolio” that does not hold any real assets). While this is an accurate definition, it doesn’t necessarily tell the whole story. A more comprehensive definition would be expanded to include results that do not represent actual trading of securities or involve assumptions that produce results that are not reflective of an actual investor’s experience. Performance information may be based on a foundation of actual results, but if assumptions are added to the calculations which cause the results to differ from what actual clients would have experienced, the information becomes hypothetical.

Some examples of the various types of hypotheticals are outlined below:

Model Portfolio Results

  • A model portfolio is generally thought of as a paper portfolio that does not hold any actual assets and is commonly understood to be hypothetical. It does not reflect actual trading of securities or the management of real assets, but investment decisions are typically made and documented in real time to best reflect how an actual portfolio would be managed.

Backtested Results

  • A backtest is a model portfolio that is constructed retroactively with the benefit of hindsight. It involves applying a model to historical financial data in order to produce results that reflect investment decisions that theoretically would have been made if the strategy had actually been employed during the historical time periods.

Actual + Model or Index Results

  • Often advisers will want to show how their strategy would have performed when combined with other strategies or asset classes. For example, a fixed income manager may want to show how combining their strategy with an equity portfolio would have impacted the overall performance of the combined portfolio.  To approximate this, the manager may aggregate their performance with a fixed percentage allocation to an equity index, like the S&P 500.  Even though the fixed income portion of the combined portfolio represents actual performance, combining the results with those of the S&P 500 creates a hypothetical return series since it does not reflect how actual assets were being managed.

Actual + Actual Results

  • This is probably the most confusing one to many people. Consider a manager with two distinct investment strategies, Strategy A and Strategy B.  The manager offers the strategies separately or in combined portfolios with varying asset allocation targets. When meeting with prospective clients interested in a blended portfolio, the manager may elect to blend the performance of accounts managed to the dedicated investment strategies using the prospect’s intended asset allocation target (e.g., 50% of Strategy A combined with 50% of Strategy B) rather than present the results of actual blended accounts. Even though the components of the blend represent actual performance of accounts managed to those strategies, the combining of the strategies into one return series using an assumed asset allocation creates a hypothetical return.

If you have questions about whether your performance is hypothetical or if you need help ensuring your disclosures are complete and accurate, please contact us at info@guardianperformancesolutions.com.