SEC Marketing Rule: Do you switch to model fees?

Under the GIPS^® Standards, investment advisers can include non-fee-paying accounts in composites without having to apply a model fee, so long as the composite’s GIPS Report includes appropriate disclosure. However, the SEC now expects advisers to apply a model fee to these non-fee-paying accounts, to provide more accurate and transparent information to potential clients that’s more in line with what they would have achieved. This means advisers will need to decide whether to switch to using model fees in their composites that historically have included non-fee-paying accounts.

There’s a number of factors advisers should consider when deciding whether to apply model fees to their portfolios. These include the type of fees charged, the intended audience for the performance information, and the level of compliance risk the adviser is willing to accept.

Applying model fees to portfolios

The SEC Marketing Rule suggests advisers should apply a model fee to portfolios that pay either no fee or significantly reduced fees. Are more firms moving to the use of model fees as a result?

The Marketing Rule generally permits the use of actual fees when calculating net-of-fees performance; however, this may not always be appropriate, in particular, if there’s non-fee-paying accounts in the composite. It’s suggested in most situations, if non-fee-paying portfolios are included within a composite, a model fee should be applied.

It’s common knowledge the GIPS^® Standards allow firms to include non-fee-paying accounts in composites. Under the GIPS^® Standards, firms have the option of presenting actual net-of-fee performance and simply disclosing the percentage of non-fee-paying accounts included in the composite, eliminating the need to apply a model fee.

However, the SEC expects a model fee to be applied in these cases where non-fee-paying accounts are included in the composite. Advisers, therefore, need to consider switching to model fees. As some advisers look to using model fees holistically moving forward, they need to be cautious. For example, if you have performance-based fee-paying accounts, then applying a model fee will likely be challenging.

Advisers must also monitor the model fee they’re applying on an ongoing basis, to ensure it continues to be representative of the fees currently offered today. This is imperative as the SEC wants to ensure the performance information presented is appropriate to the intended audience and reflects the fees they would be charged today.

Presenting different net returns to different types of prospects

Are firms producing multiple versions of marketing materials with different returns? If so, how are they managing version control and ensuring the appropriate materials are provided to the correct intended audience?

Advisers may offer different fees to different types of prospects and potentially produce separate net-of-fee return series and multiple versions of the same presentation, using those different net-of-fee returns. While many firms discuss taking this route, few have done so due to version control challenges and risks.

Many advisers feel it’s more beneficial to have one set of materials they can provide to everyone. In calculating net-of-fee performance, advisers typically take a conservative approach by looking across their entire investor audience and applying the highest model fee applicable. This way, they can eliminate overstating performance for anyone they provide performance to.

Some firms have composites which include multiple product types (eg., separate accounts, various types of funds, all with different fee schedules) within the same composite. In this type of situation, an adviser may maintain multiple versions of the composite net-of-fee returns, applying a model fee applicable to separate accounts in one instance and a model fee applicable to the various funds in the other. Another example: rather than creating a GIPS Pooled Fund Report, advisers can produce a GIPS Composite Report which contains that fund. While fund fees will differ, the adviser could apply a fee schedule for that fund and to the composite as a whole. Though this method may be better to use for one-off instances, it may also be more difficult to manage on a recurring basis.

Next steps to navigating model fees

In general, it’s advisable for advisers to apply model fees to their portfolios in order to comply with the SEC Marketing Rule. However, there may be some cases where it’s not feasible or appropriate to do so. At the same time, there’s a number of methods available for calculating composite returns net of model fees. As the best method for calculating composite returns using model fees will vary depending on your firm’s specific circumstances, advisers should consult with their compliance advisers to determine the best options. Also, consider using a composites analytics engine to help you calculate the model fees, overall composites performance and risk.

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