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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. 

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.