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F-Squared Admits Wrongdoing in Pact
From the Wall Street Journal of Tue, 23 Dec 2014 00:18:57 EST

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.

Mr. Present’s lawyers said in a statement they intend to show in court that he did nothing wrong and the SEC’s allegations “are misdirected and meritless.”

“There is no allegation in the SEC’s complaint that investors lost money. There is no allegation questioning the company’s investment performance over the past six years,” the lawyers said. “Instead, the complaint focuses on the firm’s marketing and advertising relating to performance data for 2001 through September 2008.”

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%.

“We are pleased to put this matter behind us so that we can focus on our clients and continue to invest to ensure that our compliance, research, analytics and operational teams are best-in-class,” said F-Squared Chief Executive Laura Dagan in a statement Monday. Ms. Dagan succeeded Mr. Present last month.

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.

Mr. Present referenced this hypothetical performance in a presentation sent to potential clients in August 2008, but at that time he said in an email that the “product has been run on a live basis since 12/2000 and currently have over $90M managed against a version of it,” according to the SEC. Throughout the late summer of 2008, Mr. Present went back and forth with the intern and an analyst to change the algorithm and compile track records for the model portfolio, the SEC said.

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. Mr. Present wrote that the results were real and “not backtested in any manner,” according to the SEC

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. A spokesman for Virtus didn’t immediately return calls seeking comment.

Since news broke of the SEC’s probe, some brokerages have distanced themselves from F-Squared and Virtus.

—Chelsey Dulaney
contributed to this article.

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