RCA - Fall 2001 - Exchange-Traded Fund Performance

Exchange-traded funds (ETFs) are investment companies registered under the Investment Company Act of 1940 that offer shares that trade in the secondary market, including national securities exchanges. Currently, all ETFs invest in a portfolio of securities that closely tracks a specific index. Some ETFs are structured as open-end management investment companies and some are structured as unit investment trusts (UITs). Investors may purchase and redeem shares from the ETF only in large quantities (creation units), which are priced at the ETF’s net asset value (NAV). Because ETFs are listed on exchanges, individual ETF shares can be bought and sold throughout the trading day at the current market price. Furthermore, ETF shares can be sold short and bought on margin.

As these products have grown in popularity, NASD member firms have sought to advertise ETF performance. NASD Regulation notes that performance communications used prior to prospectus delivery for ETFs structured as open-end management investment companies must comply with the standardized performance requirements set forth in SEC Rule 482 under the Securities Act of 1933.1 Rule 482 requires performance communications to include one-year, five-year, and ten-year average annualized total returns computed in accordance with a standard formula.2 Under Rule 482, these standardized returns must be current to the most recently ended calendar quarter prior to submission of the communication for publication.

The formula for computing standardized returns is based on the fund's NAV as of the ending date of the performance period. Due to market action, ETF shares trading on an exchange may be available for purchase at a premium or discount to NAV. Consequently, communications that quote only NAV-based performance for an ETF may fail to provide the reader with a sound basis for evaluating the facts with respect to an investment in the ETF. NASD Conduct Rule 2210(d)(1)(A) requires NASD members' communications to provide such a sound basis and prohibits the omission of material information necessary to make a communication fair and not misleading.

Accordingly, NASD Regulation has taken the position that in addition to quoting standardized performance based on NAV, performance communications for ETFs must also include equally prominent disclosure of returns based on the closing market price of the shares for the same time periods as standardized returns. Such data must be accompanied by disclosure of the basis for each set of figures (e.g., "these total returns are based on the closing market price of the ETF on [date]"). The NASD Regulation staff has discussed its position with the SEC staff, which concluded that this position is not inconsistent with the SEC’s exemptive orders issued to ETFs that permit their operation.3

With respect to ETFs that are structured as UITs, the standardized performance requirements of Rule 482 do not apply. Nevertheless, compliance with Rule 2210(d)(1)(A) would require performance communications for these ETFs that are based on NAV to reflect equally prominent performance based on the closing market price of the shares for the given time period, along with appropriate disclosure of the basis for such information.

1 For communications that are preceded or accompanied by a prospectus, the same performance standards apply pursuant to SEC Rule 34b-1 under the Investment Company Act of 1940.

2 If a fund has been in existence for less than the required time periods, then standardized average annualized total returns for the period since the fund's inception must be shown.

3 In recent exemptive orders issued to ETFs, the SEC has required the prospectuses and annual reports of ETFs to show cumulative total return and average annual total return based on both NAV and market price. See, e.g., In the Matter of Barclays Global Fund Advisors, SEC Investment Company Release No. 24451 (May 12, 2000).