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FINRA Allows Limited Use of Pre-Inception Index Performance Data with Intermediaries

FINRA has issued an interpretive letter allowing a broker-dealer to use pre-inception index performance data to market index-based registered funds to institutional investors including intermediaries.  To use pre-inception data, the index must be developed according to “pre-defined rules that cannot be altered” except under extraordinary conditions, and the member firm may only disseminate the data to institutional investors including intermediaries that will not use the information with their retail clients.  FINRA imposes several conditions including (i) the data includes no less than 10 years of performance information, (ii) the material shows the impact of the deduction of fees and expenses, (iii) the material includes actual fund performance, and (iv) the firm includes extensive disclosure including the reasons why the data would have differed from actual performance during the period.  FINRA previously allowed pre-inception performance data to institutional investors other than intermediaries with the same conditions.

The change here is allowing broker-dealers to provide the information to intermediary financial advisers and putting the burden on the intermediaries to prevent use directly with their retail clients.    Regardless, we recommend against using hypothetical backtested performance data because of SEC concerns as well as the significant regulatory and disclosure limitations. 

Asset Manager Fined $1.9 Million over Hypothetical Back-Tested Performance

 

 

The SEC fined a large asset manager $1.9 Million for failing to fully disclose that it used hypothetical back-tested performance data in advertisements.  The SEC asserts that the respondent claimed that it could prove back to 1995 that its stock strategy combining fundamental and quantitative research outperformed either approach alone.  Although the firm labeled such research as “hypothetical,” the SEC faults the firm for failing to disclose that its research was based on back-tested quantitative ratings for a time period before it generated its own quantitative models or research.  Using the longer period helped boost the claimed outperformance.  The outperformance data was used in marketing to institutional investors, RFP responses, and a white paper.  The SEC also criticizes the compliance program because compliance personnel that reviewed the materials were not informed that the materials included back-tested data.

OUR TAKE: Do not market hypothetical, backtested performance.  No amount of disclosure can ever insulate you from the SEC’s retrospective criticisms and analysis that you cherry-picked time periods or data.  Also, compli-pros should note that marketing materials delivered solely to institutional investors are subject to the same rules as more widely-distributed marketing materials (with a few exceptions such as allowing presentation of gross performance together with net performance).

Adviser Marketed Misleading Hypothetical Backtested Performance

 

The SEC censured and fined an investment adviser and its principal for misleading advertisements that utilized hypothetical backtested performance.  According to the SEC, the adviser continually updated its models but failed to fully disclose that the models’ out-performance resulted from these post hoc revisions.  The SEC alleges that the respondents revised the models to specifically account for unforeseen events such as market movements.  The SEC charges the firm and the principal, who also acted as the Chief Compliance Officer, with engaging in manipulative practices and for failing to implement a reasonable compliance program.  As part of the settlement, the firm agreed to retain a dedicated Chief Compliance Officer and an outside compliance consultant.

OUR TAKE:  As we have advised many times in the past: (i) do not advertise hypothetical backtested performance and (ii) retain a dedicated Chief Compliance Officer that has regulatory credentials.  Also, rather than continue to bring these cases whereby a dual-hatted principal continues to fail as Chief Compliance Officer, the SEC should solve this pandemic by requiring all advisers to undergo periodic third party compliance reviews.

 

Three Firms Fined for Marketing Hypothetical Third Party Performance

The SEC censured and fined three more investment advisers in connection with marketing F-Squared’s misleading hypothetical performance information.  One of the firms agreed to pay $8.75 Million in disgorgement, fines, interest and another agreed to pay over $700,000, while the third firm, which has ceased its business, agreed to pay a $200,000 fine.  The SEC alleges that the firms incorporated misleading F-Squared-provided performance information into their marketing materials without conducting adequate due diligence into the performance claims, despite significant red flags such as hypothetical backtested performance, outlier returns, lack of actual performance history, and lack of data transparency. The SEC charged the firms with failing to implement adequate compliance policies and procedures to verify third party performance claims and maintain required records.  The defunct firm, which also sponsored a registered mutual fund, was also charged with several Investment Company Act violations including violations of Section 15, which requires a shareholder-approved written agreement with all sub-advisers.  The SEC has previously brought several cases related to incorporating misleading F-Squared performance.

OUR TAKE: Investment advisers must adopt and implement procedures to test performance claims made by third parties, and firms can’t claim ignorance and innocence if the third party refuses to provide backup data.  Also, we do not believe firms should ever use hypothetical backtested performance data, because the SEC usually alleges that such information is too misleading.