RIA Compliance Blog
On December 22, 2014, the SEC announced a settlement with F-Squared Investments (“F-Squared”) in which F-Squared will pay a civil penalty and disgorgement for violations of the anti-fraud provisions of the Investment Advisers Act by advertising falsely inflated performance numbers of its most successful exchange traded fund (“ETF”) investment strategy. Under the terms of the settlement, F-Squared, the largest U.S. marketer of index products using ETFs, agreed to disgorge $30 million and pay a $5 million penalty.
In October 2008, F-squared, along with its co-founder and former CEO, developed an investment strategy called AlphaSector. AlphaSector used data received from an algorithm to decide whether or not to buy or sell nine industry-focused ETFs. The algorithm was developed by an intern at a private wealth advisory firm, who told F-Squared’s CEO that it had been used before to manage the private wealth advisor’s client assets. The intern sent F-Squared’s CEO three separate data sets of hypothetical, back-tested weekly trends for each of the ETFs. This data was then used by an F-Squared employee to calculate hypothetical back-tested results for AlphaSector from April 2001 to September 2008.
It turned out, however, that the private wealth advisory firm never used the investment strategy for which F-Squared used in AlphaSector. Most of the trades conducted by the private wealth advisory firm were non-uniform and specific to each clients needs. Some ETFs that formed the basis of AlphaSector were rarely traded, while other ETF’s that formed the basis of AlphaSector were not traded at all. The private wealth advisory firm’s trend data was not consistent, to the extent their ETF trading was ever used to make trend data, with any of the trend data that F-Squared used in its advertisements regarding AlphaSector’s performance.
At multiple times, F-Squared and its CEO requested audited track records from the private wealth advisor’s accounts to substantiate the claims it made to F-Squared. Although F-Squared never received audited records in response to their requests, F-Squared and its CEO continued to advertise the hypothetical historical seven-year track record as “not back-tested,” and dated the investment strategy’s management of actual client assets back to April 2001.
Moreover, the historical track record that F-Squared advertised was inaccurately compiled, resulting in a 350% increase from the actual investment’s value had the hypothetical historical data been back-tested accurately. This error originated when the ETFs trade signals determining when to buy and sell were implemented one week too early. These claims about the investment strategy’s success were also contained in F-Squared’s Form ADV filings until September 2013.
The SEC also found deceptive or fraudulent conduct in that AlphaSector’s historical track record was derived by assuming that sell signals were sent before price drops occurred and buy before price increases occurred. The error was brought to the attention of F-Squared’s CEO in September of 2008, but F-Squared continued to advertise AlphaSector’s inflated performance.
The SEC determined that F-Squared violated certain fraud sections of the Advisers Act specifically related to advertising, registration materials, and failing to implement policies and procedures reasonably designed to prevent violations of the Advisers Act. F-Squared stated that it would continue the use the services of its new independent compliance consultant for another nine months. The SEC has also filed a separate complaint against the co-founder and (now former) CEO of F-Squared.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds and issuers of securities, among others. Our attorneys can help assist financial service providers in complying with the complex issues that arise in the course of their businesses, including compliance with federal and state laws and rules.