Insight Analytical Note

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Marketing rule case shows how SEC may apply “fair and balanced” standard to HF performance

Summary:

  • On June 14th 2024, the Securities and Exchange Commission (“SEC”) brought a settled action against a hedge fund manager1 for violating the marketing rule’s fair and balanced standard.
  • The SEC charged this investment manager with violations of Rules 206(4)-1 (the marketing rule) and Rule 206(4)-8. The manager paid a $100,000 penalty.
  • This case has broad implications for how hedge funds market performance including including/excluding performance results, case study selection and disclosure and footnote placement.

Allegations and Conduct:

  1. Performance cherry picking – This investment adviser managed a hedge fund with approximately $180 million under management.
  • When advertising the fund to investors, the manager developed a page in the pitch book that advertised a 44.8% return under the heading of “FUND OVERVIEW”. However, that performance was only experienced by a single investor who had invested in the fund at inception and was eligible to invest in many investments that other fund investors were not.
  • According to the SEC, this performance was presented “without an accompanying qualification or disclaimer on that page suggesting such results were anything other than performance results of the Fund.”
  • The actual fund performance was negative 5.7% on a net basis.

Takeaways:

  • Representative Investor Performance:
    • Many hedge funds use “representative investor” performance to demonstrate fund performance. In addition, many hedge funds include side pocket investments in their performance advertising which may not be accessible to all fund investors. In this case, the “representative investor” selected for marketing had a vastly different performance than other investors, but even in less extreme cases managers should consider whether the performance they’re displaying accurately portrays the performance of the fund as applicable to its target audience.
  • Same Page Disclosure:
    • The SEC stated that the manager displayed its misleading fund performance “without an accompanying qualification or disclaimer on that page [Emphasis Added] suggesting such results were anything other than performance results of the Fund”. While this is one data point, the SEC’s order appears to elevate the importance of same-page disclosure to mitigate risk.
  • Case Study Selection:
    • The principles displayed here are also applicable to case study selection. While selecting a representative study sample could be challenging, context and same-page disclosure could mitigate some risk. However, investments similar to the case studies should be accessible to future investors.

1 In the Matter of Twenty Acre Capital LP; Administrative Proceeding File No. 3-21965