Updating Interpretive Guidance for a Rapidly Evolving Mutual Fund Marketplace

The landscape of institutional investing, particularly when it comes to mutual funds, is highly competitive and constantly evolving. Recognizing and seizing opportunities for innovation is critical to success in a crowded marketplace–not just when it comes to designing and marketing products, but also in navigating a complex regulatory environment. Fund providers and consultants that are able to open a strategic dialogue with regulators in order to advance the changes their clients demand may find themselves better positioned for success.

The recent updates to the Financial Industry Regulatory Authority Inc.s (FINRAs) guidance on pre-inception index performance (PIP) data[1] demonstrate the importance of advocating for flexibility and agility in regulatory compliance, especially at a time when industry consolidation and pressure on fees continue to tighten budgets. It is also the latest example of a recent trend by FINRA staff to recognize that communications provided solely to institutional investors do not require the same level of investor protections as communications provided to retail investors and further harmonizes FINRA and the Securities and Exchange Commissions advertising standards.[2] In recent years, FINRA staff has not only issued the guidance discussed in this article related to the use of PIP data, but has also permitted the use of related performance information in institutional marketing materials distributed by mutual funds and continuously-offered closed end funds.

Leveling the PIP playing field

PIP data illustrates how the index upon which a particular passively managed investment fund is based would have performed prior to the launch of the product itself, which can provide valuable context for institutional investors seeking performance insights under historical market conditions. Until recently, FINRA guidance allowed passively managed exchange-traded funds (ETFs) to include PIP data when marketing to institutional investors, but did not permit similarly situated passively managed open-end mutual funds to do the same. As a result, mutual fund providers offering index-based products to intermediary platforms, retirement plans or other institutional investors perceived themselves to be at a disadvantage relative to ETF products, who had PIP data at their disposal to support marketing efforts. For example, an ETF provider launching a new large-cap strategy could show retirement planners 10 years of PIP data, whereas a mutual fund provider offering the same strategy to a retirement planner would be prohibited from showing any PIP data.

Foreside, on behalf of ABR Dynamic Funds, worked with FINRA to obtain new interpretive guidance that permits open-end mutual funds to use PIP data under similar conditions to those required for ETFs. The resulting Foreside Letter provides mutual funds with an improved way to demonstrate value to institutional investors, as well as satisfy institutional investor demands for increased transparency and more robust data about these products.

The Foreside Letter applies to open-end mutual funds seeking to market the performance of a selected index. Such an index must be created according to a pre-defined set of rules that cannot be altered except under extraordinary market, political or macroeconomic conditions, similar to passively managed ETFs. FINRA remains of the view that FINRA rules prohibit the distribution of any performance data other than actual performance to retail investors. Accordingly, FINRAs long-standing position prohibiting the presentation of hypothetical back-tested performance (including PIP data) in material aimed at retail investors remains unchanged.

Transparency, agility, and flexibility are paramount

Institutional investors evaluating funds for their platforms are increasingly hungry for data to inform their decision-making. Frequently, institutional investors seek information during due diligence that may not be permissible for a fund to share (such as PIP data) and will discount a fund that does not provide the requested information.

Conflicting demands between investors and regulators can create challenges for mutual fund providers and the platforms they are sold through, especially as the indexing trend continues to gain momentum. The fast-moving evolution of the mutual fund industry demands flexibility and understanding from regulators, including FINRA. Guidance such as the Foreside Letter is an important step in the evolution of FINRAs marketing guidance, and towards creating more universal standards that address the needs of todays institutional investors and service providers.

Fortunately, FINRA staff has generally demonstrated their willingness to provide informal views as to whether concepts or materials are consistent with existing guidance and regulation. Accordingly, when a fund provider wades into new territory where it is questionable as to whether existing guidance applies or requires clarification, it may be advisable to approach FINRA staff for a discussion. Maintaining this open dialogue is especially important when it comes to issues like the inherent conflicts between traditional open-end mutual funds and the growing ETF industry. These products often compete for the same institutional customers, yet they are sold and marketed differently, and in some cases held to different regulatory standards.

Updating guidance to allow inclusion of PIP data in institutional marketing materials for passively managed index-based mutual funds is just one example of how the evolving mutual fund industry requires fresh guidance and regulatory interpretations from time to time.

To view the full text of the Foreside Letter, visit: http://www.finra.org/industry/interpretive-letters/january-31-2019-1200am

[1] See, Interpretive letter to Meredith F. Henning, Foreside, FINRA (Jan. 31, 2019).

[2] See also, FINRA Interpretive Letter to ALPS Distributors, Inc. (Apr. 22, 2013) and FINRA Interpretive Letter to Clair Pagnano, K&L Gates LLP, on behalf of Evanston Alternative Opportunities Fund (June 9, 2017).

David Whitaker is President at Foreside; Richard Kerr is a Partner and Matthew J. Rogers an Associate at K&L Gates LLP.