November 19, 2015
We like to believe that we're safer when dealing with larger organizations. We also like to belief that folks who are more intelligent than us use big words that we don't necessarily understand. Perhaps relying upon those beliefs, Wall Street has got the bigger-is-better and if-you-don't-understand-our-explanations-trust-us strategies down to a science. In a recent federal securities settlement, we are confronted by a multi-billion dollar investment advisor that used a subadviser to manage some mutual funds. Enmeshed in all those big bucks and layers of management was a "sector rotation strategy" based on that ever-popular but somewhat obtuse term: algorithm.
If you were one of the unlucky investors whose mutual fund was involved in using the sector rotation strategy, your head may have spun in response to the explanation of that approach but it doesn't appear that your investment necessarily increased in value. Turns out that a lot of the purported back-testing and the historical data used to present the success of the strategy was a tad inflated and more than a bit unreliable. All of which made for some angry investors, which may have prompted queries from regulators, which, perhaps, disclosed that Virtus, the funds' manager, had not exactly done its best to confirm the representations and practices of the subadviser.
Case In Point
As set forth in the "Summary" section of the OIP, we have the following background:
1. This matter arises from misstatements made by registered investment adviser
Virtus to certain of its mutual fund clients, to those funds' shareholders, and to clients in
separately managed accounts concerning its subadviser F-Squared Investments, Inc.'s ("FSquared")
materially inflated, and hypothetical and back-tested, performance track record.
2. AlphaSector is a sector rotation strategy based on an algorithm that yields a
"signal" indicating whether to buy or sell nine industry exchange-traded funds ("ETFs") that
together made up the industries in the S&P 500 Index. Between September 2009 and May 2015,
Virtus advised six mutual funds and certain separately managed accounts ("SMAs") that used
AlphaSector (collectively, the "Virtus AlphaSector Funds"). The Virtus AlphaSector Funds
grew quickly, with assets under management increasing from $191 million at the end of 2009 to
approximately $11.5 billion by 2013.
3. From May 2009 to September 2013, in certain client presentations, marketing
materials, filings with the Commission, and other communications, Virtus falsely stated that:
(a) the AlphaSector strategy had a history that dated back to April 2001 and had been in use since
then; and (b) the track record had significantly outperformed the S&P 500 Index from April 2001
to September 2008. In fact, no F-Squared or other client assets had tracked the strategy from
April 2001 through September 2008. In addition, F-Squared miscalculated the historical
performance of AlphaSector from April 2001 to September 2008 by incorrectly implementing
signals in advance of when such signals actually could have occurred. As a result of this
inaccurate compilation of historical data, Virtus advertised the AlphaSector strategy by using
hypothetical and back-tested historical performance that was substantially inflated over what
performance would have been if F-Squared had applied the signals accurately.
4. Virtus also failed to adopt and implement written compliance policies and
procedures reasonably designed to prevent violations of the Advisers Act and the rules
thereunder, as required by Section 206(4) of the Advisers Act and Rule 206(4)-7. Specifically,
Virtus's compliance policies and procedures with respect to performance advertising and the
retention of books and records supporting the performance or rate of return of managed accounts
in performance advertisements addressed Virtus's obligations with respect to advertising the
performance of Virtus's clients' accounts but not the performance obtained by other advisers or
sub-advisers in performance advertisements directly or indirectly circulated or distributed by
Virtus. Given its manager of managers business model, Virtus failed to adopt and implement
policies and procedures regarding: (a) the accuracy of third-party produced performance
information and third-party marketing materials; and (b) the reporting and assessment of
concerns about the accuracy of statements in Virtus's marketing materials and other disclosures. As a result, Virtus failed to adopt and implement reasonably designed written policies and
procedures regarding the retention of books and records necessary to support the basis for
performance information in advertisements directly or indirectly circulated or distributed by
5. In addition, Virtus violated Section 206(4) of the Advisers Act and Rule 206(4)-
1(a)(5) thereunder by publishing, circulating, and distributing advertisements that contained
untrue statements of material fact. Virtus likewise failed to make and keep true, accurate and
current records or documents necessary to form the basis for or demonstrate the calculation of
the performance or rate of returns that it circulated and distributed, as required by Section 204 of
the Advisers Act and Rule 204-2(a)(16) thereunder.
Pages 2 - 3 of the OIP
Rotating Dollars From Virtus to the SEC
In anticipation of the OIP, without admitting or denying the findings, Respondent Virtus Investment Advisers, Inc.submitted an Offer of Settlement, which the SEC accepted. In partial consideration of Respondent's having retained an Independent Compliance Consultant in April 2015, the SEC Censured Respondent and ordered the company to Cease-And-Desist from further Advisor Act and Investment Company Act violations and to pay a $13.4 million disgorgement with $1.1 million prejudgment interest. Additionally, Respondent Virtus was ordered to pay a $2 million civil monetary penalty.
Bill Singer's Comment
All serious industry participants and investors should set aside the time to read the OIP, which presents the regulatory matter with admirable content and context.
The OIP presents us with the circumstance that those who were dealing with Virtus felt comfortable in accepting that representations about the AlphaStrategy. After all, there was a defined strategy that the subadviser was using and, you know, of course . . . of course! . . Virtus wouldn't just utilize any subadviser or its strategy with vetting the underlying approach. You rely upon that integrity. You don't expect that the funds' manager merely rubber stamps its subadvisers. Oh my, what a nasty surprise!
Next, you have to turn your focus on Virtus and ask just what the hell this company was doing when it didn't do the necessary due diligence to confirm that what it had been told by F-Squared about the AlphaStrategy was correct. Had Virtus grown to such an unwieldy size that the company thought it was okay to sort of franchise-out its obligations to those buying funds bearing its name? Frankly, this takes on the unsettling feeling that Virtus had installed Cruise Controls in its vehicles but failed to notice that the "60 mph" setting was ramping the car's speed up to "160 mph;" and what was supposed to engage the automatic speed control was actually activating the emergency brake -- when you put it that way, it takes on more urgency, no? Was this a corporate failure prompted by laziness or convenience?
Compliments to the SEC on a compelling settlement.
November 17, 2015: Veteran industry attorney and BrokeAndBroker.com Blog publisher Bill Singer talks with Brittany Weiner, attorney with Imbesi Law PC, about former Wells Fargo broker Donna Sabb, and a family feud that spilled over into FINRA arbitration, Sabb was sued by her nieces and a nephew over "misappropriation" in accounts that Sabb established and funded. Presently, Weiner is seeking an expungement of the complaint from her records. WATCH