SEC scrutinizing more sellers of F-Squared portfolios based on bad performance

August 31, 2016

By Richard Satran, Regulatory Intelligence

(Thomson Reuters Regulatory Intelligence) – After charging 13 firms for using discredited marketing claims from the now-defunct investment adviser F-Squared, the Securities and Exchange Commission said it is looking more broadly at other companies that used a portfolio strategy for exchange-traded funds (ETFs) whose claims of market-beating results were based on false data.

The case is the latest action by the SEC in the fastest-growing enforcement category of faulty or incomplete disclosures, signalling the need for compliance to make certain performance data is verified and documented.The agency has made fund disclosures a top examination priority this year.
“The Asset Management Unit continues to investigate and pursue similar enforcement actions against other advisers that potentially misled investors and others with advertisements containing F-Squared’s false historical performance data,” said Anthony S. Kelly, co-chief of the SEC Enforcement Division’s Asset Management Unit.

While the SEC named 13 firms that marketed the discredited F-Squared “AlphaSector” system, many others could face questions. The SEC said in an earlier enforcement action against F-Squared that more than 70 investment firms used the tool at its peak.

The use of portfolio-selection tools has gained popularity as large and small firms have pushed financial advisers to concentrate on client relationships and asset acquisition instead of spending time on stock and fund picking, and to rely more on investment specialists and portfolio managers’ allocation models.

Portfolio selection tools widely used

The F-Squared AlphaSector selection tool initially was launched in the aftermath of the 2008 crash with features aimed at giving sell signals when sectors appeared vulnerable. It became one of the first companies to create a business model by licensing its selection tools. Its performance disclosures showed an enviable record at beating the market with AlphaSector.

But the SEC investigation found the company relied on back-testing and “mock audits” that appeared designed more to bolster marketing efforts than to assess its reliability. Despite claims its performance measures were generated in “live” situations, the company had not derived its results by from independently-verified results.

In addition to performance claims, some of the tools were marketed with special features suited to market trends. F-Squared became one of the hottest investment advisories and the largest licenser of “tactical” ETF allocation tools. It pitched its tool as having safeguards against market downturns, an attractive feature in the aftermath of the crash.

It became highly profitable as investors poured $30 billion into F-Squared assets. But investment firms swiftly began pulling clients’ funds out of the F-Squared funds in 2014 when word spread of an SEC probe into F-Squared. It declared bankruptcy last year and its assets have been auctioned off by receivers.

Algorithm based on college intern’s work

The SEC last week singled out 13 firms that licensed AlphaSector, which the firm admitted used the same misleading data without independent verification. SEC investigators subsequently found that the original “algorithm” used to allocate billions of dollars in assets was based on a simple list of moving averages and other features created by an unnamed college intern at the firm.

“In reality, the algorithm was not even in existence during the seven years of purported performance success,” the SEC reported two years ago when it settled the case with a $35 million fine and an admission of wrongdoing from the firm.

Other firms licensed the AlphaSector and used all or part of the portfolio features and highlighted them in sales efforts over a six-year period.

“These advisers negligently passed many of F-Squared’s claims onto their own clients, who were consequently relying upon false and misleading information when making investment decisions,” said Andrew J. Ceresney, director of the SEC Enforcement Division.

Takeaway: Firms must show documentation of performance claims

The SEC case shows that firms can face enforcement actions over misleading advertising, even when they did not originate the content. In the F-Squared case, many top firms were selling the product and it was frequently cited in press reports as a hot investment tool. The SEC requires that each firm have its own documentation of performance claims on hand to back up marketing claims regardless of how widely the tools have been adopted by the industry.

The SEC F-Squared case also points to a red flag for firms whose brokers go off-script and omit the disclaimers on performance verification in one-on-one meetings and emails. A number of the firms cited last week were cited for this lapse.

“When an investment adviser echoes another firm’s performance claims in its own advertisements, it must verify the information first rather than merely accept it as fact,” said Ceresney.

The agency said in its examination priorities for 2016 that it will look for compliance measures that go beyond printed performance claims for ETF “sales strategies, trading practices, and disclosures involving ETFs.”

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Aug. 29. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

(Richard Satran is a financial journalist covering daily and emerging issues for Thomson Reuters Regulatory Intelligence.)

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