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News January 5, 2015 Issue

Major ETF Manager Pays $35 Million to Settle Performance Advertising Charges

A lie backed by an algorithm is still a lie.

That, at least, is the view of the SEC in separate actions filed December 22 against F-Squared Investments, a Massachusetts-based exchange-traded funds investment manager, and its former CEO. The firm settled an administrative action for $35 million in disgorgement and penalties, while the case against the former CEO is just getting underway in U.S. District Court.

The settlement included an admission of guilt, something most settlements don’t, but which is increasingly sought by the SEC since Mary Jo White, the former U.S. attorney for the Southern District of New York, became chair of the Commission approximately 18 months ago.

Both cases center around the veracity of F-Squared’s advertising performance claims of its index product, AlphaSector, the investments of which could be rebalanced periodically based on buy-sell signals from an algorithm. The firm and its former CEO, Howard Present, "defrauded investors through false performance advertising about its flagship product," the agency said. The advertising performance claims in question occurred during a five-year period, from September 2008 to September 2013.

"F-Squared falsely advertised a successful seven-year track record for the investment strategy based on the actual performance of real investments for real clients," the SEC said. "In reality, the algorithm was not even in existence during the seven years of purported performance success."

Back-tested /Not back-tested

It’s not that the data from those seven years, April 2001 to September 2008, didn’t exist. It’s that the data, while allegedly advertised as real performance data, "was actually derived through back-testing," the agency said. "Back-testing" is the application of a quantitative model to historical market data to generate hypothetical performance during a prior period. However, since AlphaSector was not actually created until late 2008, it couldn’t have had real performance data from that period, the SEC said. Further, F-Squared "specifically addressed the investment strategy as ‘not back-tested’" in its advertising, the agency charged.

Just to make matters a bit worse: Even the back-tested data wasn’t accurate, according to the administrative order instituting the settlement. "The hypothetical data contained a substantial performance calculation error that inflated the results by approximately 350 percent."

"We allege that not only did F-Squared and Present attract clients to this investment strategy by touting a track record they presented as real when it was merely hypothetical, but the hypothetical calculations also were substantially inflated," said co-chief of the SEC Enforcement Division’s Asset Management Unit

Julie Riewe.

That’s the problem with data. You have to be accurate with it.

"Advisers should be careful if they advertise their performance, and pay particular attention to the
distinctions between true actual performance, model performance and back-tested performance," said

Rogers & Hardin partner Stephen Councill. "Not disclosing that results are back-tested always troubles the SEC because it is far easier to identify a successful strategy with the benefit of perfect hindsight. Here, it appears the adviser went so far as to misrepresent that the results were not back-tested."

The error

The mistake that allegedly inflated results by 350 percent involved the misapplication of the ETF trend data that detected price momentum. This data, known as in/out signals, indicated whether an ETF was in or out of the AlphaSector portfolio range, and was used to determine when to buy or sell.

The error was that F-Squared "systematically applied the in/out signals one week before the ETF price changes that caused changes in signals. … As a result, the advertised historical performance of the AlphaSector strategy from April 2001 to September 2008 was based on implementing signals to sell before price drops and to buy before price increases that had occurred a week earlier," the SEC said.

The SEC provided the following hypothetical example to show the difference the error made in AlphaSector’s advertised hypothetical and back-tested historical performance:

"If an investor made a hypothetical investment of $100,000 on April 1, 2001 … , the investment would have been worth approximately $128,000 on August 24, 2008 if invested in the S&P 500 Index. With accurately timed (but still hypothetical and back-tested) signal implementation, the same investment in F-Squared’s hypothetical ETF sector rotation strategy would have been $138,000. However, by implementing the hypothetical and back-tested signals one week early, F-Squared advertised the investment as worth $235,000."

During this period advertising inflated back-tested performance, F-Squared’s fortunes moved "from losing money to becoming a highly profitable investment manager," the SEC said. "By 2014, F-Squared’s ETF strategy was the largest in the market, with approximately $28.5 billion in assets following the strategy."

Advertisements and registration

The SEC’s assertion of false performance advertising comes down to "two materially false claims" in AlphaSector’s advertisements and Forms ADV:

  • The in/out ETF signals that formed the basis of the AlphaSector index returns "had been used to manage client assets from April 2001 to September 2008;" and
  • Implementation of the in/out ETF signals "resulted in a track record that significantly outperformed the S&P 500 Index from April 2001 to September 2008."

Nor is the SEC’s issue with F-Squared and Present merely that they allegedly passed off back-tested performance data as real performance. The agency also charged that, beginning in late 2009, the firm’s AlphaSector advertisements "explicitly claimed that the track record … was not back-tested."

The SEC also charged that the firm’s various Forms ADV from October 2008 to September 2013 "inaccurately claimed that the investment models underlying the index had been used to manage actual client assets between April 2001 and September 2008."

Penalties that are real

The settlement that F-Squared agreed to includes numbers that it is unlikely to find hypothetical.

Aside from admitting that it violated federal securities laws and being censured, F-Squared agreed to pay disgorgement of $30 million and a civil money penalty of $5 million.

The firm was charged with violating multiple parts of the Advisers Act, including Sections 206(1) and (2), which prohibit fraud, and Section 206(4) and its Rule 206(4)-1(a)(5), which outlaws advertisements containing "any untrue statement of material fact, or which is otherwise false or misleading," according to the administrative order. In addition, the firm was charged with violating Rule 206(4)-7, the Compliance Program Rule, for failing to adopt reasonable written compliance policies and procedures; Rule 206(4)-8, for making false statements to investors; Section 207 for making false statements in registration materials; and paragraph (a)(16) of Rule 204-2, the Books and Records Rule, for failing to make and keep accurate performance documentation records. An attorney representing F-Squared did not respond to a voice mail or email seeking comment.

"Despite F-Squared’s admission that it committed securities fraud and the $35 million disgorgement and penalty amounts, the SEC merely censured F-Squared rather than barring or suspending it from acting as an investment adviser," noted

DLA Piper partner Nicolas Morgan. "The SEC’s decision to censure rather than bar or suspend F-Squared appears to have resulted from the firm’s cooperation with the SEC’s investigation, its decision to separate from its CEO and its voluntarily retaining an independent compliance consultant. The SEC is signaling that firms will be rewarded for cooperating and undertaking remedial measures."

The complaint against Present, which charges the former CEO with many of the same allegations filed in the administrative action against his former firm, was filed in the U.S. District Court for the District of Massachusetts, and may continue for months unless a settlement is reached. The court case also seeks disgorgement and a civil money penalty. In such situations, where disgorgement and a fine have been paid as part of a related action, as was the case here with the administrative settlement, a court will sometimes take this into account, but that is by no means certain. An attorney representing Present did not respond to a voice mail or email seeking comment.