Asset management firm laid off 25% of its staff last week
In 2013, F-Squared Investments Inc. was on a hot streak. The asset management firm had won responsibility for more than $20 billion of investor money, most of it over the prior five years. The firm's killer app was an algorithm developed by a then-college student that told investment managers when to buy or sell a small set of ETFs.
But a routine examination by the Securities and Exchange Commission that year would lead to charges in 2014 that turned the company upside down and from which it is still reeling. Just last week, it laid off 40 workers — 25% of its staff — as it continues to try to stanch the flow of assets out of the company and fights for its reputation.
What the SEC discovered was that F-Squared misled investors by claiming its performance history was based on an actual trading record that went back to 2001, when in fact, it only had back-tested its vaunted algorithm. Last December, it agreed to pay $35 million to settle the SEC charges.
While the company has been trying to move on, its former chief executive, Howard B. Present, has not. He left F-Squared a month before it settled with the SEC and is fighting civil charges brought against him by the regulator. The two sides are expected to square off in Boston federal court proceedings as early as this month.
The lawsuit against Mr. Present will put a fresh spotlight on the investing industry's safeguards against fraud. As advisers and platform minders
attempt to look beyond the sales pitch of fund managers, they depend on a complex web of regulators, auditors, outside custodians and others to verify information about those pitching products. In this case, none peered far enough beyond the spectacular claims of a firm that said it could avoid the downside of markets.
“The people that buy the products have been entirely too gullible,” said Tom Brakke, a consultant on investment due diligence. “Imagine yourself at a wirehouse 18 months ago, and you've got an incredible volume of new liquid alternative funds coming to market, you've got advisers that are demanding them — how much do you have in terms of resources?”
LICENSED ALGORITHM
“I still think there are questions about the whole thing,” said a broker at Wells Fargo Advisors, the $1.4 trillion brokerage, which put F-Squared's strategies on a watch list.
“If somebody's going to fabricate a story, they can sell it to anybody,” he said. “It just makes you mad.”
F-Squared was, in part, the brainchild of Mr. Present, a former Putnam Investments executive, who helped start the company in 2006. After two years marketing a small investment strategy, F-Squared licensed the algorithm upon which it would build its success. It began promoting its AlphaSector strategy in October 2008, the same month the S&P 500 index lost 17% of its value.
Given the state of the market, its story was appealing. “A financial advisory firm is betting that investors who use a quantitative formula — rather than emotion and panic — to move in and out of stocks will get through Wall Street's roller coaster ride with their pocketbooks largely intact,” an InvestmentNews article about F-Squared said at the time.
But it wasn't just its winning strategy that put F-Squared on the map; it was its relationship with Virtus Investment Partners Inc.
In the federal-court complaint against Mr. Present, lawyers for the SEC imply the firm was on its last legs when it won a contract to manage, or sub-advise, mutual funds for Virtus. In the year ended June 30, 2009, AlphaSector produced just $23,102 in fees for F-Squared, and the company posted a $1.7 million loss, the SEC said.
“[Mr.] Present had wooed the fund company for months, making many false and misleading statements along the way,” the SEC said.
Virtus lent credibility to the firm. The money manager's executives are on a first-name basis with top brokerage houses, making it the linchpin to F-Squared's adoption by the largest adviser-serving firms, according to two people familiar with Virtus' broker-dealer relationships.
“The Virtus team and wholesalers, they are a wonderful organization, I have to say,” said one person familiar with the fund-manager relationships of a top broker-dealer. “It's been a black eye on them for sure.”
F-Squared's assets would grow more than 24 times over the following two years, to $6 billion, the SEC said.
None of the seven lawyers listed as representing Mr. Present — including partners from the white-shoe law firm Williams & Connolly — returned emails requesting comment. Virtus declined to comment.
A PASSING GRADE
Still wounded today, F-Squared is trying to repair the damage. Ironically, its exchange-traded fund strategy has proved to work largely as advertised.
F-Squared's flagship Premium AlphaSector Index rose 17.6% over the three years ended Dec. 31. That's less than the nearly 18.7% posted by its category, but F-Squared achieved those results without exposing in¬vestors to wild swings in the market as measured by standard deviation, according to Morningstar Inc.
A number of due-diligence professionals who had looked at F-Squared's strategy verified that it worked and gave the company a passing grade.
“They worked exactly like we thought they would,” one of them said, noting the model's successful performance in periods of volatility. “But what does it mean to the bigger picture of what we do, that's a different story.”
Anticipating the SEC's charges, investors pulled billions from F-Squared strategies last year, and several broker-dealers continue to prevent advisers from adding new money to the strategies.
In an interview, F-Squared CEO Laura P. Dagan, named to the post last November, said the firm is refocusing its efforts on compliance and its core product line. The firm she took over was too siloed and had “redundancies,” she said.
“I've been on a listening tour with our clients, trying to hear their needs, and we've also done a deep dive internally,” Ms. Dagan said. “I want broker-dealers and advisers, especially those disappointed in what happened as we went through the settlement with the SEC, to know that we have not just learned lessons but we're acting on them.”
Ms. Dagan said she is not distracted by “legacy” issues. She said the legal proceedings involving Mr. Present are separate from the firm.
Not all industry observers think F-Squared should be let off the hook.
Some firms that conducted due diligence on F-Squared said it positioned its products too aggressively.
“The problem I've always had was, it's like Lance Armstrong, where not only were they cheating but they were obnoxious about how great their performance was,” said one industry executive. “I don't see how anyone could call themselves a fiduciary and allocate to Virtus or F-Squared [today].”
