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News November 23, 2015 Issue

Failure to Verify Subadviser’s Performance Claims Leads to $16.5 Million Settlement

It doesn’t matter if the data came from your subadviser – if it raises red flags, you still have to check it out.

Virtus Investment Advisers, a Hartford, CT-based adviser, on November 16 agreed to pay $16.5 million as part of a settlement with the SEC over its alleged use of false historical performance data when advertising its funds. The performance data it used came from its subadviser, F-Squared Investments, a Massachusetts-based exchange-traded funds investment manager.

The nub of the SEC’s case against Virtus is that it used the performance data from F-Squared without adequately checking it out after concerns were raised. That, the agency said, is simply not acceptable.

"Virtus accepted F-Squared’s historical performance misrepresentations at face value and ignored red flags that called these statements into question," said SEC Division of Enforcement director Andrew Ceresney. "If an investment adviser chooses to advertise, it is responsible for the content and accuracy of its ads."

Subadviser representations

"The takeaway here," said Zaccaro Morgan partner Nicolas Morgan, "is that the SEC will pursue enforcement actions against advisers who parrot subadvisers’ performance information to investors when the adviser has received indications from multiple sources casting doubt on the information and negligently fails to follow up."

"The SEC cannot reasonably have intended this case to send the message that a fund adviser must investigate every representation made by its subadvisers," he said. "Likely, it was the circumstances involved in this particular case, with all of the indications casting doubt on the subadviser’s representations, that created a need to investigate the representations."

"The facts of the case suggest that the adviser’s concerns about the performance information were a key factor in bringing this case," said DLA Piper senior counsel Patrick Hunnius. "However, the SEC’s legal analysis suggests that Virtus was obligated to affirmatively verify the subadviser’s claimed performance (and document that verification) regardless of whether or not there were any red flags. If that was the SEC’s thinking, the administrative order instituting the settlement comes perilously close to imposing strict liability on advisers for any false statement they pass on from a subadviser."

The Virtus settlement may be only the tip of the iceberg. The SEC, in a release accompanying the settlement, said that it "continues to investigate the conduct of other
advisers that potentially misled investors and others with advertisements containing F-Squared’s false historical performance data."

The F-Squared story

F-Squared got into the news quite a bit after the firm reached a $35 million settlement with the SEC in December 2014 for allegedly passing off back-tested performance data as real data (ACA Insight, 1/5/15).

That case, as well as a separate and still-pending court case against the firm’s former CEO, centered around the veracity of F-Squared’s advertised performance of its index product, AlphaSector, the investments of which could be rebalanced periodically based on buy-sell signals from an algorithm. The firm and the former CEO "defrauded investors through false performance advertising," the agency said at the time. The 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-testing" is the application of a quantitative model to historical market data to generate hypothetical performance during a prior period. In the F-Squared case, since AlphaSector was not actually created until late 2008, it couldn’t have had real performance data from that period, the agency said. Further, it charged, F-Squared "specifically addressed the investment strategy as ‘not back-tested’" in its advertising.

The question of verification

Virtus and F-Squared in early 2009 began discussions to have F-Squared subadvise two Virtus-advised mutual funds, the SEC said. Those funds would follow F-Squared’s AlphaSector ETF "sector rotation strategy," which was based on an algorithm that signaled when to buy or sell nine industry ETFs.

F-Squared and its former CEO "described the strategy falsely to Virtus by, among other things, representing that: a) the AlphaSector strategy had been used to manage client assets from April 2001 to September 2008, often calling it a ‘live’ track record; and b) the track records had significantly outperformed the S&P 500 Index from April 2001 to September 2008," the agency said.

But the SEC said that this was not the case: "In reality, no assets tracked the strategy until 2008 and the back-tested track record was substantially overstated."

Between September 2009 and May 2015, according to the agency, six Virtus-advised mutual funds and some Virtus-advised separately managed accounts invested in F-Squared’s AlphaSector funds. The funds proved very popular, with assets under management growing from $191 million in 2009 to approximately $11.5 billion in 2013, the agency said.

Although the SEC charged and ultimately settled with F-Squared, it did not let Virtus off the hook. "Virtus was negligent in not knowing that the F-Squared track record and performance were false," the agency said in its administrative order instituting the settlement. It noted that even though Virtus had "expressed skepticism" at the outset of the potential relationship with F-Squared about AlphaSector’s "so-called ‘live’ track record," the firm "took no steps to determine whether F-Squared’s buy or sell signals were generated or used in any trading decisions during the April 2001 through September 2008 period."

Even when concerns about AlphaSector and F-Squared were brought to it, Virtus failed to respond, the SEC said. "For example, beginning in 2011, market participants told certain Virtus wholesalers that the AlphaSector indexes were backtested and [that] ‘live’ assets had not been tracking those indexes since 2001. When Virtus questioned [the F-Squared former CEO] about this, [the former CEO] did not provide answers to many of the questions, but Virtus did not follow up to obtain the requested information or change how it used and marketed AlphaSector."

In addition, in May 2013, according to the agency, principals from the firm that provided F-Squared with the signals for AlphaSector "informed Virtus that they believed the AlphaSector index’s track record may have been miscalculated. … Virtus took no steps to follow up on the concerns raised."

"By failing to take steps to verify F-Squared’s claims, Virtus solicited investors using materially false and misleading AlphaSector performance data," said the Division Asset Management Unit co-chief Julie Riewe.

Advertising and sales

From 2009 through September 2013, Virtus allegedly used the claimed AlphaSector track record as a "lead marketing point" for its AlphaSector products, despite warnings in 2009 from FINRA that the track record in its marketing was actually back-tested.

More specifically, FINRA, on October 1, 2009, informed Virtus that "[b]ack-tested performance is misleading," the SEC said. On November 24, 2009, the agency said, "FINRA notified Virtus that the ‘performance prior to October 13, 2008 … is back-tested. We are concerned that the process could be manipulated to obtain desired outcomes.’"

Despite these warnings, "Virtus nonetheless included the misleading ‘returns’ of the back-tested AlphaSector index in appendices to certain Virtus Alpha Sector Funds’ prospectuses and marketing materials," the SEC said.

In addition to problems with performance reporting in its marketing materials, the agency continued, the firm "did not take adequate steps to correct the misstatements of its sales force and wholesalers even though some within Virtus had contradictory understandings of how to describe accurately the historical performance of AlphaSector."

Violations and penalties

Virtus was charged with a number of violations of the Advisers Act, including Section 206(2), which prohibits fraud; 206(4) and its Rule 206(4)-1(a)(5), which prohibit the making of untrue statements of material fact; Rule 206(4)-7, the Compliance Program Rule, for failing to have reasonably designed compliance policies and procedures that would have prevented the alleged violations; Rule 206(4)-8, for making untrue statements of material fact to an investor or prospective investor; and Section 204 and its Rule 204-2(a)(16), for failing to keep accurate, true and current records. An attorney representing Virtus, when reached by telephone, declined to comment on the settlement.

The firm was censured, ordered to pay disgorgement of $13.4 million and prejudgment interest of $1.1 million, as well as a civil money penalty of $2 million. The SEC said that it took note of Virtus’ hiring of an independent compliance consultant in April 2015 when considering the settlement.