F-Squared Investments, the largest provider of exchange traded funds managed portfolios, will pay $35 million and admit wrongdoing to settle charges it defrauded investors with false advertising about historical returns for the firm’s flagship ETF strategy, the Securities and Exchange Commission said Monday.
“The SEC separately charged the firm’s co-founder and former CEO Howard Present with making false and misleading statements to investors as the public face of F-Squared,” said the Commission in a statement.
Present left the firm in November and was replaced by Laura Dagan. F-Squared had $28 billion in assets under management at the end of the third quarter, according to a statement issued by the firm, meaning the firm controls over a quarter of the capital allocated to ETF managed portfolios. [Changes at the Top at F-Squared]
“According to the SEC’s order instituting a settled administrative proceeding against Massachusetts-based F-Squared, which is the largest marketer of index products using exchange-traded funds (ETFs), the firm began receiving signals from a third-party data provider in September 2008 indicating when to buy or sell an investment. The signals were based on an algorithm, and F-Squared and Present used the signals to create a model portfolio of sector ETFs that could be rebalanced periodically as the signals changed. They named the new product ‘AlphaSector’ and launched the first index a month later. AlphaSector’s indexes quickly became the firm’s largest revenue source, and F-Squared went from losing money to becoming a highly profitable investment manager,” said the SEC in the statement.
Strategies offered by ETF manage portfolios allow a new breed of so-called ETF strategists to customize tactical short-term or strategic long-term portfolios for advisors and investors in a changing market.
Specifically, ETF managed portfolios are investment strategies that hold more than 50% of assets invested in ETFs. A group of ETF Strategists package portfolios of ETFs into investment strategies to meet a wide range of investor demands, providing stand-alone investment strategies or a one-stop complete offering. Many portfolios can be adjusted to adapt to changing market conditions and most employ a rules-based process based on technical or quantitative factors.
According to Morningstar, there were 667 such strategies from 145 firms with $102 billion in assets under management as of June 2014, with existing managers still expanding on their current product offerings.
F-Squared has included strategic beta ETFs in its portfolios, such as the First Trust AlphaDEX ETFs, which select holdings based on growth factors like 3-, 6- and 12-month price appreciation, sales to price and one year sales growth, along with value factors like book value to price, cash flow to price and return on assets. [ETF Managed Portfolios on the Rise]
The SEC also alleges that “the F-Squared analyst who calculated the backtested AlphaSector performance inadvertently applied the buy/sell signals to the week preceding any ETF price change that the signals were based on. The mistake carried the model portfolio’s backtested buy and sell decisions back in time one week, enabling the model to buy an ETF just before the price rose and sell an ETF just before the price fell.”
“We allege that not only did F-Squared and Present attract clients to this investment strategy by touting a track record they presented as real when it was merely hypothetical, but the hypothetical calculations also were substantially inflated,” said Julie M. Riewe, co-chief of the Enforcement Division’s Asset Management Unit, in the statement.