When marketing algorithmic trading strategies, robo-advisers, or quantitative investment products, you'll likely want to show hypothetical performance results. However, SEC Marketing Rule 206(4)-1 and FINRA Rule 2210 impose strict disclosure requirements to prevent misleading presentations. This guide covers every requirement for compliant hypothetical performance advertising.
Critical Compliance Warning
Hypothetical performance is one of the most scrutinized areas in SEC and FINRA examinations. Incomplete disclosures can result in enforcement actions, client rescission rights, and reputational damage. Never present hypothetical performance without all required disclosures prominently displayed.
1. SEC Marketing Rule Requirements
The SEC Marketing Rule (effective November 4, 2022) establishes comprehensive requirements for investment advisers presenting hypothetical performance in advertising.
Definition of Hypothetical Performance
Under Rule 206(4)-1(e)(8), hypothetical performance includes:
- Backtested performance: Performance achieved by applying a strategy to historical data
- Model performance: Performance generated by theoretical portfolio construction
- Targeted returns: Expected or projected returns based on assumptions
- Pro forma performance: Performance calculated "as if" certain conditions existed
Core Requirements (Rule 206(4)-1(d)(6))
All hypothetical performance presentations must include:
Mandatory Disclosure Elements
Hypothetical nature: Clear and prominent statement that performance is hypothetical and does not represent actual trading
Inherent limitations: Disclosure that hypothetical performance has inherent limitations and differs from actual performance
Material assumptions: All material assumptions, objectives, and criteria used to calculate performance
Material changes: Any material changes to assumptions, objectives, or criteria during the performance period
Limitations statement: Explanation of why hypothetical results may not reflect actual future results
Policies and Procedures
Advisers must adopt written policies and procedures requiring:
- Reasonable basis for believing hypothetical performance presentation is relevant to the likely financial situation of intended audience
- Documentation of the basis for this determination
- Prior principal approval before dissemination
- Periodic review of all hypothetical performance advertisements
2. Backtested vs. Simulated Results
Understanding the distinction between backtesting and forward simulation is crucial for proper disclosure:
Backtested Performance
- Strategy applied to historical data that existed before development
- Higher risk of overfitting and data mining
- Subject to look-ahead bias and survivorship bias
- Must disclose data period and methodology
- Cannot represent how strategy would have performed in real-time
Forward-Tested (Paper Trading)
- Strategy applied to data after development in real-time
- Lower risk of overfitting (if truly out-of-sample)
- Still subject to slippage and execution assumptions
- More credible than backtesting but still hypothetical
- Must disclose simulation period and constraints
Overfitting Risk
Backtested performance is particularly susceptible to overfitting: optimizing a strategy to historical data until it produces impressive results that won't replicate going forward. SEC staff scrutinizes whether advisers have tested strategies on truly out-of-sample data or repeatedly refined models until achieving desired backtest results.
3. Required Disclosures & Warnings
The following disclosures must accompany all hypothetical performance presentations:
Primary Warning (Must Appear Prominently)
Standard Hypothetical Performance Warning
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.Additional Required Disclosures
| Disclosure Category | Required Content |
|---|---|
| Time Period | Exact start and end dates of backtesting/simulation period; reason for selecting this period |
| Transaction Costs | Assumptions about commissions, spreads, slippage, and market impact; whether results are gross or net of fees |
| Dividends/Interest | Treatment of dividends, interest income, and corporate actions |
| Rebalancing | Frequency and methodology of portfolio rebalancing; whether rebalancing costs included |
| Tax Treatment | Whether results reflect tax consequences (typically they don't) |
| Leverage | Use of leverage, margin requirements, borrowing costs |
| Benchmark | If comparing to index, disclosure of index composition and whether comparison is appropriate |
| Software/Data | Data sources, software platforms, and any known data errors or limitations |
4. Model Assumptions Documentation
The SEC requires advisers to document and disclose all material assumptions underlying hypothetical performance. This includes:
Categories of Material Assumptions
What Makes an Assumption "Material"?
An assumption is material if a reasonable investor would consider it important in evaluating the hypothetical performance. When in doubt, disclose. The SEC takes the position that more disclosure is better than less.
- Market assumptions: Liquidity, market depth, ability to execute at displayed prices, absence of market disruptions
- Execution assumptions: Fill rates, order routing, execution quality, price improvement
- Data assumptions: Point-in-time data availability, corporate action adjustments, survivorship-free data
- Strategy assumptions: Availability of shorting, borrowing costs, position limits, diversification constraints
- Fee assumptions: Management fees, performance fees, custody fees, fund expenses
- Reinvestment assumptions: Cash management, dividend reinvestment, interest on cash balances
- Risk management assumptions: Stop-loss execution, position sizing, portfolio constraints
Documentation Requirements
Assumption Documentation Checklist
Written memorandum documenting all material assumptions used in performance calculation
Justification for each assumption based on market reality or conservative estimates
Analysis of how different assumptions would impact results (sensitivity analysis)
Comparison to actual trading costs if adviser has real account experience
Records of any changes to assumptions over time and reasons for changes
Source documentation for third-party data, benchmarks, or analytical tools
5. Walk-Forward Analysis
Walk-forward analysis is a best practice for reducing overfitting risk and demonstrating strategy robustness. While not strictly required, advisers using walk-forward testing strengthen their compliance posture.
Walk-Forward Methodology
- In-sample optimization: Develop and optimize strategy parameters using historical data (e.g., 2015-2018)
- Out-of-sample testing: Test optimized strategy on subsequent data not used in development (e.g., 2019)
- Rolling forward: Move forward in time, re-optimize on new in-sample period (e.g., 2016-2019), test on new out-of-sample (e.g., 2020)
- Repeat: Continue process through available data
- Aggregation: Report combined out-of-sample results as hypothetical performance
Disclosure for Walk-Forward Results
Walk-Forward Analysis Disclosure
The hypothetical performance shown reflects walk-forward analysis methodology. The strategy was initially developed and optimized using historical data from [START DATE] to [END DATE]. The optimized parameters were then tested on subsequent out-of-sample data from [START DATE] to [END DATE] that was not used in the optimization process. This process was repeated [X] times using rolling periods. While walk-forward analysis reduces the risk of overfitting compared to simple backtesting, the results remain hypothetical and subject to all limitations of hypothetical performance. The strategy parameters were optimized during the in-sample periods, which creates the possibility of inadvertent data mining across the entire tested period.6. Cherry-Picking Prohibition
Both the SEC Marketing Rule and FINRA Rule 2210 prohibit selectively presenting favorable hypothetical results while omitting unfavorable results.
Prohibited Cherry-Picking Practices
- Showing only profitable strategies while omitting failed or underperforming strategies developed using the same methodology
- Selecting the "best" backtest period and omitting results from other time periods
- Presenting optimized parameters without disclosing parameter sensitivity
- Highlighting top-performing sectors or asset classes without showing strategy applied across all intended instruments
- Reporting only certain risk metrics while omitting relevant negative metrics
Affirmative Obligations
To avoid cherry-picking violations, advisers must:
- Show representative results: If presenting one strategy, disclose whether adviser has developed other strategies using similar methodology and their general performance
- Disclose survivor bias: If showing current strategies, note if adviser previously discontinued underperforming strategies
- Present range of outcomes: Show best, worst, and median scenarios or parameter sensitivity
- Include downside metrics: Maximum drawdown, worst month, losing periods, Sharpe ratio alongside raw returns
- Disclose parameter optimization: Acknowledge if parameters were optimized and whether other parameter sets were tested
7. Time Period Selection
The choice of time period for backtesting or simulation is one of the most scrutinized aspects of hypothetical performance. SEC examiners look for evidence of manipulative period selection.
Best Practices for Time Period Selection
| Practice | Description |
|---|---|
| Maximum Available Data | Use all available data for which the strategy is theoretically applicable; avoid arbitrary start/end points |
| Include Crisis Periods | Ensure backtest period includes market stress events (2008, 2020 COVID crash, etc.) |
| Document Selection Rationale | Write memo explaining why specific period was chosen (e.g., data availability, strategy applicability) |
| Disclose Excluded Periods | If any data periods are excluded, explain why (e.g., instrument didn't exist, market structure changed) |
| Multiple Period Testing | Test strategy across different regimes (bull, bear, sideways markets) |
| Regime-Specific Disclosure | Note if strategy is designed for specific market conditions and may underperform in others |
Red Flags for Period Selection
SEC examiners view the following as potential evidence of manipulation:
- Backtest period starts immediately after a major market crash (appears to avoid stress testing)
- Backtest period ends at a market peak (appears cherry-picked for maximum returns)
- Period excludes recent years without clear rationale
- Multiple strategies use different, non-overlapping time periods without explanation
- Period selection changed after initial disappointing results
8. Survivorship Bias
Survivorship bias occurs when backtesting uses only securities that survived to the present, excluding delisted, bankrupped, or merged companies. This inflates hypothetical returns.
Types of Survivorship Bias
- Company survivorship: Stocks that went to zero (Enron, Lehman Brothers) are excluded from historical data
- Strategy survivorship: Only successful strategies are marketed; failed development efforts are omitted
- Fund survivorship: Comparing to indices that only include surviving funds
- Data vendor survivorship: Some data providers only maintain history for currently active instruments
Mitigation and Disclosure
Survivorship Bias Controls
Use survivorship-bias-free datasets (vendors like CRSP, Compustat Point-in-Time)
Include delisted securities in backtest universe
Document data source and whether it accounts for survivorship
If survivorship-free data unavailable, disclose limitation and potential impact
For strategy survivorship, disclose other strategies developed but not marketed
Survivorship Bias Disclosure
The hypothetical performance results were calculated using data from [DATA SOURCE]. [IF BIAS-FREE: This data source includes delisted securities and is designed to be free of survivorship bias.] [IF NOT BIAS-FREE: This data source may not include all delisted securities from the tested period. To the extent delisted securities are excluded, the hypothetical results may be higher than would have been achieved had all securities been included, as delisted securities generally performed poorly prior to delisting.] [IF MULTIPLE STRATEGIES DEVELOPED:] The Adviser has developed [X] quantitative strategies using similar methodologies. [Describe performance of other strategies in general terms or explain why other strategies are not presented.]9. FINRA Rule 2210 Standards
Broker-dealers and registered representatives are subject to FINRA Rule 2210 (Communications with the Public), which imposes additional requirements beyond SEC rules.
FINRA-Specific Requirements
| Requirement | Details |
|---|---|
| Pre-Approval | Retail communications containing hypothetical performance must be approved by registered principal before use |
| Fair and Balanced | Must provide sound basis for evaluating facts; not omit material facts or qualify statements in misleading manner |
| Performance Standards | Must comply with Supplementary Material .05 (performance standards) regarding calculation methodology |
| Time Period Consistency | If showing multiple strategies, must use consistent time periods unless differences are clearly disclosed |
| Recordkeeping | Must retain all hypothetical performance communications for 3 years (first 2 in accessible location) |
FINRA Regulatory Notices
- Regulatory Notice 15-02: Guidance on hypothetical performance in communications with the public
- Regulatory Notice 10-06: Sweep of communications promoting structured products (relevant for exotic strategies)
- FINRA Rule 2210.05(c): Specific requirements for performance claims
Hybrid Advisers
If you're registered as both an RIA (SEC) and a broker-dealer (FINRA), you must comply with BOTH the SEC Marketing Rule and FINRA Rule 2210. When standards conflict, apply the stricter standard. Most commonly, this means following FINRA's pre-approval requirement even for RIA advertisements.
10. Sample Disclosure Language
Below are compliant disclosure templates for different hypothetical performance scenarios. Customize these to your specific facts.
Template 1: Backtested Strategy Performance
Backtested Performance Disclosure (Full Version)
HYPOTHETICAL PERFORMANCE RESULTS The performance data shown represents backtested results. Backtested performance is hypothetical and does not represent actual trading. The results are based on applying the [STRATEGY NAME] to historical market data from [START DATE] to [END DATE]. IMPORTANT LIMITATIONS Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular investment strategy. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular investment strategy in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific investment strategy which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results. MATERIAL ASSUMPTIONS The backtested results are based on the following material assumptions: • Transaction Costs: Results assume [X] basis points in commissions and [X] basis points in slippage per transaction. Actual costs may be higher or lower. • Data Source: Historical data provided by [DATA SOURCE]. Data is assumed to be accurate but has not been independently verified. • Rebalancing: Portfolio rebalancing occurred [FREQUENCY] using [METHODOLOGY]. Rebalancing costs of [X]% are included/excluded. • Survivorship Bias: Data [does/does not] include delisted securities. [If not: Results may be overstated due to exclusion of failed companies.] • Market Impact: Results assume ability to execute all trades at closing prices without market impact. Actual implementation, especially for larger accounts, would likely experience price impact. • Dividends: Dividend income is [included/excluded] and [reinvested/not reinvested]. • Fees: Results are [gross/net] of management fees. [If gross: Actual investor returns would be reduced by advisory fees of approximately X% annually.] TIME PERIOD SELECTION The backtest period from [START DATE] to [END DATE] was selected because [RATIONALE: e.g., it represents the complete history of available data for the instruments traded, includes multiple market cycles, etc.]. This period includes [NUMBER] market downturns, including [SPECIFIC EVENTS]. STRATEGY DEVELOPMENT This strategy was initially developed in [MONTH/YEAR]. The parameters shown in this backtest were optimized using [METHODOLOGY]. [If optimized: Other parameter sets were tested and generally produced lower returns, which could indicate overfitting to historical data.] [IF MULTIPLE STRATEGIES:] The Adviser has developed [X] other quantitative strategies using similar methodologies during the same period. [Describe general performance or explain why others not shown.] Past performance, whether actual or hypothetical, is not indicative of future results. Investment involves risk of loss.Template 2: Model/Targeted Performance
Model Performance Disclosure
MODEL PERFORMANCE DISCLAIMER The performance shown is based on a theoretical model and does not represent actual trading results. The model portfolio was created for illustrative purposes to demonstrate how the [STRATEGY NAME] would construct and manage a portfolio under the stated assumptions. The model performance is hypothetical and has inherent limitations. No actual securities were purchased or sold. The model does not reflect the impact of economic and market factors on decision-making in an actual account. Since trades have not actually been executed, results may have under- or over-compensated for the impact, if any, of certain market factors such as lack of liquidity, transaction costs, and slippage. ASSUMPTIONS AND CRITERIA The model performance is based on the following assumptions: • Initial Portfolio: Starting value of $[X] on [DATE] • Asset Allocation: [DESCRIBE ALLOCATION METHODOLOGY] • Rebalancing: [FREQUENCY AND METHODOLOGY] • Costs: [TRANSACTION COSTS, MANAGEMENT FEES] • Cash Management: [TREATMENT OF CASH, DIVIDENDS] • Risk Constraints: [LEVERAGE LIMITS, CONCENTRATION LIMITS, ETC.] [Continue with remaining standard hypothetical performance disclosures...]Template 3: Targeted/Projected Returns
Targeted Returns Disclosure
TARGETED RETURN PROJECTIONS The targeted returns shown are hypothetical projections based on assumptions about future market conditions and the performance of the strategy. These targets are goals only and are not guarantees or predictions of future performance. THERE IS NO ASSURANCE THAT THE TARGETED RETURNS WILL BE ACHIEVED. Actual returns may be significantly higher or lower than the targets shown. The targeted returns are based on [DESCRIBE BASIS: historical averages, risk-factor models, Monte Carlo simulation, etc.]. The targeted returns assume: • [ASSUMPTION 1] • [ASSUMPTION 2] • [etc.] These assumptions may not be realized. Changes in market conditions, volatility, interest rates, and other factors will cause actual results to differ, possibly materially, from the targets shown. [Continue with standard hypothetical performance warnings...]Hypothetical Performance Compliance Checklist
Pre-Publication Review Checklist
Prominent statement that performance is hypothetical, not actual
Standard CFTC/NFA warning language (if applicable) or equivalent SEC warning
All material assumptions documented and disclosed
Time period selection justified and disclosed
Transaction costs, slippage, and fees disclosed
Survivorship bias status disclosed
Data sources identified
Limitations of hypothetical performance explained (hindsight, no financial risk, etc.)
Downside metrics included (drawdown, worst period, volatility)
No cherry-picking of favorable periods or strategies
Benchmark comparison appropriate and disclosed (if used)
Tax consequences disclosed (typically results are pre-tax)
Parameter optimization disclosed (if applicable)
Written policies & procedures followed
Principal approval obtained (if required by FINRA or internal policy)
Reasonable basis determination documented
Books and records maintained (calculations, assumptions, approval)
Comparison: Hypothetical vs. Actual Performance
Understanding when you can transition from hypothetical to actual performance advertising, and the differences in requirements:
| Aspect | Hypothetical Performance | Actual Performance |
|---|---|---|
| Definition | Backtested, modeled, or simulated results | Real client account results (verified by custodian) |
| Disclosure Burden | Extensive warnings and assumptions required | Lower burden; must comply with GIPS standards if applicable |
| Credibility | Lower (subject to hindsight bias) | Higher (real money at risk) |
| SEC Scrutiny | High scrutiny; frequent exam deficiencies | Moderate scrutiny; focus on cherry-picking and calculation |
| GIPS Compliance | Not eligible for GIPS compliance | Can claim GIPS compliance if standards met |
| Transition Timing | N/A | Can advertise actual results once strategy manages real assets |
| Track Record Portability | Generally not portable | Portable under certain conditions (same team, similar strategy) |
| Risk of Enforcement | High if disclosures inadequate | Lower if GIPS-compliant and no cherry-picking |
Best Practice: Transition Strategy
Once you have 12-24 months of actual client performance, transition to showing actual results with hypothetical as supplementary information. Actual results, even if less impressive than backtests, are far more credible to sophisticated investors and reduce regulatory risk. Consider obtaining GIPS verification to further enhance credibility.
Enforcement Trends and Recent Cases
The SEC has brought numerous enforcement actions against advisers for misleading hypothetical performance advertising:
- In the Matter of Lincoln Investment Planning (2020): Settled charges for distributing sales materials with hypothetical performance lacking required disclosures; $900,000 penalty
- SEC v. Bravata (2018): Cherry-picked backtests showing only best-performing periods; omitted significant losses in other periods
- In the Matter of Virtus Investment Advisers (2019): Used hypothetical performance to market fund without disclosing it was backtested; $3 million penalty
Common Enforcement Triggers
- Presenting hypothetical returns prominently (e.g., in headline) while burying disclosures in footnotes
- Using small font or light-colored text for mandatory warnings
- Omitting required disclosures entirely from certain media (e.g., social media posts)
- Updating performance results without updating disclosures
- Failing to maintain documentation of assumptions and reasonable basis determination
Additional Resources
- SEC Marketing Rule Adopting Release (IA-5653)
- FINRA Rule 2210: Communications with the Public
- FINRA Regulatory Notice 15-02: Hypothetical Performance
- SEC IM Guidance Update 2023-01: Marketing Rule FAQs
Related Guides
- Robo-Adviser Compliance Checklist - Algorithm disclosure requirements
- Form ADV Filing Guide - Advertising compliance disclosures
- SEC Examination Playbook - What examiners look for in marketing materials
- Compliance Manual Template - Policies and procedures for hypothetical performance