Interpretive Letter to Bradley J. Swenson, ALPS Distributors, Inc.

Additional guidance regarding the use of pre-inception index performance in institutional communications

April 22, 2013

Mr. Bradley J. Swenson
Chief Compliance Officer
ALPS Distributors, Inc.
1290 Broadway, Suite 1100
Denver, CO 80203

Re: Interpretive Guidance Regarding the Use of Pre-Inception Index Performance in Institutional Communications

Dear Mr. Swenson:

In your letter of April 19, 2013, you request interpretive guidance regarding the use of pre-inception index performance ("PIP") data in communications regarding certain exchange traded products ("ETPs") distributed solely to "institutional investors" as defined in FINRA Rule 2210(a)(4)1, excluding financial intermediaries who intend to share the PIP data with persons other than institutional investors. ALPS Distributors, Inc. ("ADI") believes that PIP data is useful to institutional investors in analyzing ETPs and that such institutional investors should be able to understand the potential benefits and drawbacks of such information.

Your letter defines ETPs to comprise publicly traded securities structured as exchange traded notes, grantor trusts or registered investment companies. ADI markets passively-managed ETPs that are based on newly created indexes that have been developed according to pre-defined rules that cannot be altered except under extraordinary market, political or macroeconomic conditions. PIP data models the performance of such an index had it existed prior to the inception date of the index.

Background

Your letter states that:

  • institutional investors have specifically requested that ADI provide them with PIP data because they find it useful in helping them make better investment decisions; and
  • institutional investors typically use PIP data to help formulate proprietary investment strategies and that such entities have no economic incentive to distribute communications containing PIP data to non-institutions.

ADI proposes the use of PIP data in institutional communications only, as that term is defined in FINRA Rule 2210(a)(3), subject to the criteria set forth below:

  1. Any piece of marketing material that includes PIP data would be clearly labeled "For use with institutions only, not for use with retail investors";
  2. Any PIP data would be used only with respect to an Index created according to a pre-defined set of rules that cannot be altered except under extraordinary market, political or macroeconomic conditions;
  3. PIP data will be used to market passively managed ETPs and would not be used to market actively managed ETPs, in which active changes to underlying securities are permitted by the methodology of the ETP;
  4. Any piece of marketing material containing PIP data would include an offer to provide the rule set or methodology of the ETP index upon request and any electronic marketing material would include a hyperlink to such information;
  5. The presentation of PIP data will reflect the deduction of fees and charges applicable to the ETP;
  6. PIP data will reflect a period of time that includes multiple securities market environments, and at a minimum, ten years since the inception of the index;
  7. PIP data will be current as of the most recently ended calendar quarter;
  8. PIP data will be clearly labeled and presented separately from actual performance along with disclosure of the applicable dates for the PIP data and the dates for the actual ETP performance since inception;
  9. For any ETP in existence for greater than one year, the use of PIP data will be accompanied by the prominent presentation of actual performance of the ETP since inception that reflects the deduction of fees and charges of the ETP;
  10. PIP data will not be inconsistent with information in the prospectus but may be used regardless of whether the fund prospectus contains the data;
  11. In addition to disclosures required to meet the content standards of Rule 2210(d) PIP data will be accompanied by the following disclosures:
    1. The ETP is a new product and any performance prior to the date of index inception is hypothetical;
    2. If the PIP data is produced by an index provider that is paid by the fund sponsor to produce the data, this arrangement and the identity of the index provider will be disclosed;
    3. The PIP data results are based on criteria applied retroactively with the benefit of hindsight and knowledge of factors that may have positively affected its performance, and cannot account for all financial risk that may affect the actual performance of the ETP;
    4. The actual performance of the ETP may vary significantly from the PIP data;
    5. Any known reasons why the PIP data would have differed from actual performance during the period shown. For instance, this may include assumptions regarding transaction costs, liquidity, or other market factors.

In addition, your letter represents that all marketing materials that contain PIP data shall comply with all other applicable FINRA rules and federal securities laws and be subject to the same supervisory and approval requirements that ADI applies to all other firm communications.

Your letter states that communications containing PIP data would be labeled clearly for use with institutions only. If the institutional investor is a financial intermediary, ADI will instruct the intermediary not to circulate communications containing PIP data to clients who are not institutional investors. ADI has no reason to believe these institutional investors have distributed or would distribute institutional communications in a manner inconsistent with FINRA requirements. If ADI becomes aware that an intended recipient has distributed materials containing PIP data to clients who are not institutional investors, ADI will cease distributing such materials to that recipient.

Discussion

FINRA Rule 2210 subjects institutional communications to certain content and supervision standards. In particular, institutional communications must be fair and balanced and must provide a sound basis for evaluating the facts in regard to any particular security. Institutional communications may not omit material information, include false, exaggerated, or misleading statements, or misstate material facts. A firm must establish written procedures for the review of institutional communications by a registered principal that are appropriate to the firm's business, size, structure, and customers. When those procedures do not require prior-to-use review, the firm must adopt training and surveillance procedures to ensure compliance with the rule.

FINRA staff believes that FINRA Rule 2210 permits the use of PIP data in institutional communications in the manner proposed in your letter. However, in applying the suitability standards for recommendations to institutional customers, a firm must be careful to not give excess weight to PIP data, and to the extent PIP data informs the firm's understanding of the security and its performance characteristics, the firm must consider the correlation between PIP data and actual performance for similar ETPs managed by the sponsor, investment adviser or index provider.

In determining whether or not to use PIP data with institutional investors, firms should consider:
 

  1. The assumptions, rules and criteria used to create the PIP data, in sufficient detail as to permit the firm to clearly understand how the PIP data could be replicated, using readily-available market data;
  2. The reputation of the entity that created the PIP data, and if the sponsor of the ETP paid for creation of the model, how any material conflicts of interest have been addressed or mitigated;
  3. The conditions under which the PIP data may not be effective in predicting how the ETP may perform (e.g., very low or high interest rate environments);
  4. The source of the data used to produce the PIP data;
  5. The extent to which the PIP data has been tested under varying market conditions and scenarios, based on both an analysis of historical data and simulations or stress tests; and
  6. Any reasons why the PIP data would have differed from actual performance of the ETP during the period shown (e.g., transaction costs, market liquidity).

While we do not object to the use of PIP data in institutional communications as discussed herein, this letter does not affect FINRA's long standing position that the presentation of hypothetical back tested performance in communications used with retail investors does not comply with FINRA Rule 2210(d).

The opinions expressed in this letter are staff opinions only and have not been reviewed or endorsed by the FINRA Board of Governors. This staff letter responds only to the issues raised, and does not address any other rule or interpretation of FINRA, or all the possible regulatory and legal issues involved.

If you have any questions regarding this letter, please contact me at (240) 386-4623, Tom Pappas at (240) 386-4553, or Amy Sochard at (240) 386-4508.

Sincerely,

Joseph E. Price
cc: Steven B. Price, Deputy Chief Compliance Officer, ALPS Distributors, Inc.

1 Pursuant to FINRA Rule 2210(a)(4), the term "institutional investor" means any: person described in Rule 4512(c), regardless of whether that person has an account with the FINRA member; governmental entity or subdivision thereof; employee benefit plan that meets the requirements of Section 403(b) or Section 457 of the Internal Revenue Code and has at least 100 participants, but does not include any participant of such a plan; qualified plan, as defined in Section 3(a)(12)(C) of the Act, that has at least 100 participants, but does not include any participant of such a plan; FINRA member or registered associated person of such a member; and person acting solely on behalf of any such institutional investor.