Advisers take stock as ETF portfolio manager F-Squared faces legal action

The largest manager of exchange-traded-fund portfolios, F-Squared Investments Inc., on Thursday moved to reassure clients after disclosing that regulators may take legal action against the firm for misrepresenting past returns, a violation of federal law.

The firm said in a regulatory filing last month that it had been notified by the Securities and Exchange Commission of its preliminary intent to recommend law enforcement action against the firm in an Aug. 13 Wells notice.

Increasing regulatory scrutiny of the performance claims of F-Squared brought a new round of unwarranted notoriety to a group of mostly newborn money managers that manage ETFs in separate accounts and have grown 27.5% in the 12 months ended June 30, according to Morningstar Inc.

The full impact of the investigation is unclear. Some brokerage firms, including Wells Fargo Advisors, have sent up warning flags to advisers about the firm in recent months. Others, like RBC Wealth Management and Raymond James Financial Inc., have required advisers to reign in client exposures to F-Squared, according to three people with knowledge of those firms’ efforts. (Spokespeople for those brokerages declined to comment.)

“The key for any adviser is that there’s a process in place to monitor money managers,” said David C. Gratke of Gratke Wealth in Beaverton, Ore., who has recommended F-Squared strategies to clients. “I would rather just see the whole process take its course and then say, ‘Now we have all the known information.’”

Asked if he would keep his clients invested in F-Squared, one Raymond James adviser who uses the strategies answered simply: “I don’t know.”

“We don’t have any concerns,” said a top executive in charge of one major investment platform for advisers on which F-Squared models are available. “They do what they do and none of that has changed, and they garner a fair amount of assets from advisers.”

The issue is clearly delicate. More than a dozen advisers with current or past affiliations with F-Squared declined to comment for this article, as did a number of executives from broker-dealers and other investment platforms used by advisers. Most who did speak cited the sensitive relationships with clients and the potential for litigation among reasons for asking not to be named.

“We are a different firm today and are poised for continued growth going forward,” said Howard Present, F-Squared’s chief executive, in a letter to clients dated Thursday, a copy of which was obtained by InvestmentNews. “We have been transparent about the SEC investigation. We do not intend to debate or discuss any specific elements of the investigation in the press.”

A spokesman declined to make Mr. Present available for comment for this article.

Their black-box, quantitative investment strategies are complex, but F-Squared’s elevator pitch is simple. The firm builds portfolios with ETFs, an investment product with cost and other efficiencies that have in recent years captured the imagination of investors from day traders to financial advisers and institutions such as pensions and foundations.

And F-Squared’s promise of a high degree of protection when stocks dive — without missing the market’s upside — resonated after the average U.S. large-cap growth mutual fund lost more than 40% of its value in 2008.

The firm has raised billions in assets and managed $25.6 billion at the end of June, up 80% from about $14.3 billion in the 12 months ended June 30, 2013, according to Morningstar.

But while F-Squared’s publicity rested on its strong track record, the firm itself now disavows some of the performance it reported on its own strategies, which it now says were “clearly overstated.”

The firm has said that, in some cases, its methodology for calculating indexes was incorrect and that some quoted returns did not reflect, as advertised, the performance of real assets under management.
The firm’s strategies include several of the top performing over three and five year periods, such as its Premium AlphaSector Index, the basis of its largest strategy by assets, with a five-year gain of 19.47% as of June 30, according to Morningstar. (Morningstar also builds ETF portfolios and is a competitor to F-Squared.)

That strategy is offered at 60 basis points, and sometimes less, while investors in discounted institutional share classes of large-cap core mutual funds paid nearly 69 basis points in 2013, according to the research firm Lipper. (A basis point is equal to 0.01%.)

F-Squared also manages a suite of five mutual funds for Virtus Investment Partners Inc.
In his letter, Mr. Present said F-Squared had enjoyed positive flows for 25 months despite the investigation, and that assets with RBC, Raymond James and Wells Fargo have also grown.

Mr. Present said his firm has seen $6.6 billion in estimated inflows since the SEC investigation was launched last October. Indeed, Morningstar data show that 15 F-Squared strategies place in the top 25 fastest growing in the ETF strategist space over the year ending June 30.

News of the SEC’s Wells notice was first reported Wednesday by the Wall Street Journal. F-Squared said it intends to cooperate with the investigation.

Related Topics: Securities and Exchange Commission