Is Your Risk Assessment SEC Marketing Rule-Compliant?

August 2023, by Helen Yang, CFA, Wealth Management Outlook

The SEC marketing rule that went into effect in November 2022 prohibits the use of gross performance numbers in advertisements unless the advertisement also presents net performance.

Is a risk tolerance assessment considered a form of advertisement?

If it only contains psychological questions that don’t mention investments and their potential upsides and downsides, it is not a form of advertisement. But such questionnaires can’t help investors fully under- stand what they are getting into, and investors may not realize that they can lose money, not to mention how much they can lose, without such information.

To address this issue, questions like this can be asked:

If you have three portfolios to choose from, which one would you choose?

A. Portfolio A has 4% average return, with possible one-year gain of  15% and loss of -10%

B. Portfolio B has 5.5% average return, with possible one-year gain of 25% and loss of -20% 

C. Portfolio C has 7% average return, with possible one-year gain of 35% and loss of -30% 

Now that you are presenting performance numbers to prospects/clients in order to win/keep their business, it becomes advertising and is subject to the SEC marketing rule.

This question doesn’t specifically state whether the performance numbers are gross or net of fees, but it is safe to say that they are gross of fees, because it is a static question with numbers that remain the same, which clearly don’t reflect the fees charged by advisors, as advisors may charge different fees. Furthermore, an advisor may charge different fees for different clients, hence each client may get different numbers if fees are properly applied.

Other tools present similar choices graphically, but it is the same idea, with the same problem.

How can we build a risk tolerance assessment that is com- pliant with the SEC marketing rule?

First, it makes sense to present the advisor’s model port- folios for investors to choose from. If you go to a restaurant, you’d expect its own menu, not the menu from another restaurant, or the FDA standard menu.

Second, the assessment needs to show performance numbers net of fees or net of max fee, and ideally, should also show the performance gross of fees to illustrate the impact of fees.

It also means that it should apply the fees for each client; otherwise, it may be misleading.

The risk tolerance test, shown in the chart, fulfills all these requirements. In this chart, each bar represents a model portfolio offered by the advisor, with the entire model set covering the risk spectrum from conservative to aggressive. The investor is asked to choose an upside/downside tradeoff that they feel most comfortable with.

The interactive tool allows advisors and clients to see what the upside/downside looks like for net of max fee, net of fees or gross of fees, taking into consideration the fees applicable for each client and each model.

This is what it takes for a risk tolerance assessment to be compliant with the SEC marketing rule. If the assessment shows the same performance numbers for all advisors or all clients, it is either not applying the fees properly or at all and is not compliant with the SEC marketing rule.

Original article here.