F-Squared Investments Inc., which builds investment
portfolios out of exchange-traded funds, admitted it misled clients about its
track record and agreed to pay $35 million in a settlement with regulators. The
Securities and Exchange Commission filed separate civil charges against former
Chief Executive Howard Present, accusing him of making false and misleading
statements to investors. Mr. Present stepped down as head of the firm last
month.
The settlement follows a more than yearlong investigation by
the SEC into how F-Squared presented its performance to clients. In reaching
the deal, F-Squared admitted that it used hypothetical data to overstate the
track record of its flagship index for seven years through 2008, including
market-beating returns during the financial crisis. F-Squared also admitted
that the formula used to create the hypothetical data inflated results by about
350%.
The settlement comes at a time when SEC Chairman Mary
Jo White has made a priority of requiring admissions of wrongdoing to
settle SEC allegations. There have been 15 such pacts, including the F-Squared
admission, according to the SEC.
F-Squared is the biggest company among a group of money
managers that build portfolios out of exchange-traded funds, overseeing $25
billion in such assets at the end of September, according to data reported to
research firm Morningstar Inc. ETFs are mutual funds whose shares trade on an
exchange and usually are designed to track an index or benchmark.
In the wake of the financial crisis, investors have poured
money into these ETF portfolios, especially those that make frequent shifts in
and out of ETFs with the aim of timing the market. Assets in these ETF
portfolios totaled $96 billion at the end of the third quarter, up from $14
billion five years ago, according to Morningstar.
From the creation of AlphaSector in 2008, the firm’s
flagship ETF portfolio, Mr. Present misled potential clients, the SEC alleges.
F-Squared advertised that the strategy behind AlphaSector had been in use since
2001, even though Mr. Present knew the algorithm wasn’t completed until 2008,
the SEC said.
According to the SEC complaint, an F-Squared analyst working
with Mr. Present used the algorithm, which was built by a 20-year-old college
intern at the wealth-advisory firm, along with Mr. Present’s portfolio
construction rules to calculate the hypothetical performance of a model
portfolio going back nearly eight years.
When F-Squared issued a statement announcing AlphaSector’s
launch on Sept. 18, 2008, it claimed AlphaSector had been the basis for real
investments on behalf of real clients since 2001, according to the SEC. This type of misleading language remained on
some of F-Squared’s promotional materials and in presentations to potential
clients for years, repeated even when Mr. Present knew they were falsehoods or
was reckless in not knowing, the SEC alleges.
In September 2009, Mr. Present emailed a fund company with
sample answers to questions the company’s sales agents may be asked by
potential clients, the SEC said. One such question specifically addressed
whether AlphaSector’s track record was hypothetical or real. Since AlphaSector’s launch, F-Squared has
become popular among investors, and F-Squared’s strategies underpin a handful
of popular mutual funds sold by Virtus Investment Partners Inc.
That popularity paid off for Mr. Present. According to the
SEC, from 2008 to 2014 he received more than $8.1 million in wages and profit
distributions, and upon his departure from the company he was awarded a 12-year
package valued at about $8.5 million. Since news broke of the SEC’s probe, some
brokerages have distanced themselves from F-Squared and Virtus, including
setting limits on how much new business brokers can conduct with F-Squared.
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