Advertising with Blended Back-Tested and Actual Results Draws SEC Attention
The SEC for several years has made it clear that it does not like the use of hypothetical and/or back-tested performance results in advertising. A recent settlement not only shows that the agency’s Division of Enforcement has not changed its view, but that it may file enforcement actions against advisers that blend back-tested performance results with actual results.
The settlement, with advisory firm Massachusetts Financial Services Company (MFS), alleged that the firm, over an approximately 10-year period from 2006 through 2015, advertised an investment research philosophy that blended performance results from a “fundamental” management style with those from a “quantitative” management style – and claimed that investments based on the blended performance models would work better than relying on either fundamental or management models alone.
Unfortunately, while the fundamental performance ratings were all determined in real time, a significant portion of the quantitative performance ratings was not, according to the settlement order. They instead were determined “using a retroactive, back-tested, application” of the firm’s quantitative model, the agency said.
“In some advertisements, MFS also falsely claimed that the hypothetical portfolio was based on MFS’s own quantitative stock ratings dating back to the mid-1990s, even though before 2000 MFS did not have a quantitative research department or generate its own quantitative stock ratings,” the SEC said.
The advisory firm was censured by the SEC and ordered to pay a civil money penalty of $1.9 million. That may seem like a lot of money – and it is – but may not be that significant to this advisory firm, given that as of December 2017 it reported approximately $378 billion in assets under management.
Also interesting is that the $1.9 million is pure civil money penalty – it does not include disgorgement. There may be a number of reasons for that, including that the settlement order does not tie specific monetary loss figures to the victim of the alleged violations, but one reason “might be because of the Supreme Court’s Kokesh ruling,” said Morrison & Foerster partner and former SEC senior trial counsel Michael Birnbaum.
The 2017 Kokesh ruling tied SEC disgorgements to a five-year statute of limitations, and since the alleged violations here stretch from 2006 to 2015, only the last two years would fall within the statute limitation period, he said.
MFS, as part of the settlement, was found to have violated Section 206(2) of the Advisers Act, which prohibits fraud, as well as Section 206(4) and its Rule 206(4)-1(a)(5), which outlaws the publishing, circulating and distributing of advertisements containing misleading statements of material fact. In addition, the SEC found that the adviser violated Rule 206(4)-7, the Compliance Program Rule, for failing to adopt and implement written compliance policies and procedures reasonably designed to prevent inaccurate advertisements.
The settlement demonstrates “a lesson that everyone should understand by now,” said Gibson Dunn partner Gregory Merz. “The SEC looks at hypothetical, back-tested performance with a great degree of skepticism.”
In this case, he said, MFS “did a lot of things right. The SEC is not claiming that it miscalculated the hypothetical performance returns, the hypothetical performance returns were provided only to institutional investors and professional financial intermediaries, and the actual performance record of the blended strategy was also provided.” What generally got the firm into trouble, he said, were three problems noted by the agency:
- Disclosures regarding the hypothetical, back-tested nature of some of the adviser’s quantitative ratings were not clear enough;
- The SEC implied that the adviser’s motivation for providing back-tested performance from 1995 to 2000 was because that time period was part of a boom cycle which made the returns look better; and
- MFS made statements that made it seem as if its quantitative strategy had been in place since 1995, when in fact it was not in place until after 2000.
One takeaway for advisers from the settlement is that MFS, prior to completion of the settlement, hired a compliance consultant to, among other things, conduct a comprehensive review of its written compliance policies and procedures involving advertisements involving investment models, research ratings or strategies. “While such consultants often add a considerable expense for advisers to bear,” Birnbaum said, “the SEC, by noting the adviser’s retention of a consultant in the settlement order, appears to have given MFS some measure of credit for retaining the consultant.”
MFS, through a spokesperson, said that the advisory firm “has entered into a settlement with the U.S. Securities and Exchange Commission regarding misstatements in disclosures in certain marketing materials provided to institutional audiences for its blended research strategies. MFS, which neither admits nor denies the allegations, has cooperated fully with the SEC. As described in the SEC order, MFS voluntarily discontinued the use of the materials in question in late 2015 (prior to the SEC’s investigation), consistently labeled them ‘hypothetical,’ restricted their use to institutional audiences, and generally provided them along with actual standardized returns of its blended research products.”
“Importantly,” the spokesperson continued, “the SEC made no finding of any intentional wrongdoing or financial loss to our clients. Indeed, the SEC made no findings questioning the construction or performance of our blended research strategies. MFS retained a third-party compliance consultant to assist MFS in enhancing our compliance program to help ensure we continue to market all of our strategies appropriately.”
The research strategies
MFS, which was historically a fundamental-based investment manager, in 2000 established a quantitative-based research department, according to the settlement order, and then began to develop what the adviser later referred to as its “blended research” strategies. What this meant was that the adviser would combine fundamental and quantitative ratings to arrive at a “blended stock score, and by using a portfolio optimization process that considers the blended scores along with risk and other portfolio constraints.”
The adviser developed different versions of this blended strategy, including for U.S. equities and for global equities, the SEC said. By the end of May of this year, the agency said, MFS had approximately $21 billion in AUM invested in blended research strategies.
Here’s how the SEC described how MFS’s “research proof,” which it said was developed in 2003, worked: The firm divided annualized returns since February 1995 for six hypothetical baskets of stocks:
- All stocks rated “buy” by MFS’s fundamental research,
- All stocks rated “buy” by the adviser’s quantitative research,
- All stocks rated “buy” by both MFS’s fundamental and quantitative research (a category that the firm referred to as the “fundamental-quant intersection,”
- All stocks rated “sell” by the MFS’s fundamental research,
- All stocks rated “sell” by the adviser’s quantitative research, and
- All stocks rated “sell” at the fundamental-quant intersection.
From 2006 until the end of 2015, MFS used its research proof analysis, which it updated quarterly, to create data (and later in that period a bar chart) that was included in certain MFS advertisements, according to the settlement order. “The chart consistently showed that the hypothetical portfolios of ‘buy’ stock at the fundamental-quant intersection performed better than either the hypothetical portfolio stocks rated ‘buy’ by MFS’s quantitative model or the hypothetical portfolio of stocks rated ‘buy’ by MFS’s fundamental research.”
“Using the chart, MFS advertised a ‘[c]lear alpha benefit from combining MFS fundamental and quantitative research,’” the SEC said.
It then marketed the bar chart in three different types of written marketing materials directed to institutional investors and financial intermediaries (including other investment advisers, broker-dealers and insurance companies), as well as consultants, according to the agency. The three different types of marketing materials that the firm allegedly used were a standard slide deck, a chart issued in response to requests for proposal, and a white paper.
The problem with back-testing
Back-testing, as the SEC noted in the settlement order, involves the retroactive application of an investment strategy to a historical set of data. “Back-tested performance carries the risk that the performance depicted is not due to successful predictive modeling,” it said.
In this case, the chart that MFS included in its advertisements, while providing fundamental ratings generated in real time, did not always do so on the quantitative side, according to the settlement order. “Specifically, the quantitative ratings for the period 1995 to 2000 for all stocks and for the period 2000 to 2003 for some stocks were the results of the retroactive application of MFS’s quantitative model. . . . Although the research proof chart was consistently labeled ‘hypothetical,’ none of MFS’s advertisements disclosed that the research proof chart was based in part on back-tested quantitative ratings.”
“Using the back-tested period in the research proof made the annualized cumulative returns from the hypothetical fundamental-quant intersection significantly better relative to the comparable returns from the quant model alone,” the agency said. “If MFS had instead relied only on actual and not back-tested quantitative ratings, by showing hypothetical annualized returns back to only 2000 or 2003, then the hypothetical blended portfolio of buy-rated stocks would have outperformed the hypothetical quantitative-only portfolio to a much smaller extent.”
The advisory firm apparently took this point to heart. After 2003, according to the settlement order, MFS updated the research proof chart each quarter using quantitative ratings derived in real time from its current quantitative models and current market data.
In 2015, however, MFS compliance personnel decided to remove the research proof chart from its advertisements, the SEC said.