Backtesting: Handle With Care

When using backtested results in prospectuses or any other advertising material, it is important to highlight any differences between data used to produce the backtested presentation and the reference asset underlying any security or other instrument. For example, if a structured note is linked to an index that has three components, such as an equity index, US Treasury bills and a cash element, such as the secured overnight financing rate ("SOFR"), the backtested results of that index should simply be the result of applying the index methodology to past historical results of those three components. If, for any reason, the backtesting is applied to something other than those three hypothetical components, that should be disclosed. In this example, because SOFR did not exist prior to April 2018, if the backtested results covered a period prior to that time, there should be an explanation of what replaced historical SOFR results prior to April 2018 and why it did so.

In an SEC cease and desist order against a registered investment adviser (the "RIA"), the failure to follow these practices resulted in violations of the Investment Advisers Act of 1940 (the "Advisers Act").¹

The RIA produced advertisements for its proprietary algorithmic trading strategy (the "Strategy"). The advertisements included hypothetical, backtested performance of the Strategy. However, there were undisclosed differences between the funds used to produce the backtested information and the funds used in actual clients' portfolios using the Strategy. The backtested Strategy relied on different securities when constructing a model portfolio, and a small number of the funds used in the backtest were not adequately correlated with the securities they replaced in the live Strategy.

According to the SEC, the RIA failed to adopt and implement policies and procedures reasonably designed to prevent the distribution of false or misleading advertisements. This failure was a violation of Section 206(4) of the Advisers Act.²

Footnotes

1 The cease and desist order is available at: https://www.sec.gov/litigation/admin/2022/ia-5945.pdf.

2 Section 206(4) of the Advisers Act reads, in part: "It shall be unlawful for any investment adviser... to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative."

Originally published in REVERSEinquiries: Volume 05, Issue 01.
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