SEC Continues Increased Focus on RIA Performance Advertising

The F-Squared Investments matter continues to have far-reaching consequences for those investment advisers who used F-Squared’s falsely inflated and improperly labeled backtested performance results in advertisements. As discussed previously, in November of 2015 Virtus Investment Advisers was fined $16.5 million for including the false and misleading performance results in its own advertisements and filings with the Securities Exchange Commission (“SEC”). More recently, the SEC charged Cantella & Co. (“Cantella”), a Boston-based investment adviser that licensed F-Squared’s Alpha Sector strategy, with securities violations for employing F-Squared’s false track record in its marketing materials.

F-Squared is an investment adviser that creates and markets index products using exchange-traded funds (“ETFs”). It sub-licenses these indexes to various unaffiliated investment advisers who manage assets pursuant to those indexes. In 2014 F-Squared admitted in a settled SEC administrative proceeding that it had materially misrepresented the performance results of its largest ETF strategy, AlphaSector, by labeling these results as actual results from a seven-year period when they were in fact hypothetical results derived through backtesting. In addition, F-Squared claimed that the strategy had outperformed the S&P 500 Index from 2001 to 2008 when in fact the hypothetical data contained a calculation error that falsely inflated results by 350 percent. F-Squared agreed to pay disgorgement of $30 million and a penalty of $5 million to settle the claim.

Cantella allegedly began its relationship with F-Squared in 2012 when it decided to enter into a model manager agreement with F-Squared and establish an investment product based on F-Squared’s AlphaSector strategy. F-Squared falsely described their AlphaSector strategy to Cantella, stating that it was used to manage client assets from 2001 to 2008 and had a “live” track record, as well as stating that the strategy had outperformed the S&P 500 Index during that period. Cantella allegedly used portions of F-Squared’s advertisements in its own advertisements, including these false claims.

According to the SEC, Cantella took insufficient steps to confirm the accuracy of F-Squared’s representations before using its false and overstated claims in its advertisements, and knew or should have known that it did not have a reasonable basis to believe that the claims were accurate. The SEC based this allegation on the fact that the purported performance results were exceptional given that they significantly outperformed the S&P 500 Index in the stated time period. In addition, the performance results purported to portray actual results, despite the fact that the AlphaSector strategy was not launched until 2008. Lastly, the Morningstar report provided by F-Squared to Cantella stated that the information had been obtained from third party sources and had not been independently verified by Morningstar.

Cantella included a general disclaimer that the performance results were provided by third-parties and that Cantella did not guarantee the accuracy of the results. The SEC alleged that this disclaimer was inadequate, stating that Cantella should not have relied solely on the documents prepared and provided by F-Squared without any other substantiation. Overall, the SEC alleged that Cantella did not take sufficient steps to confirm the accuracy of F-Squared’s performance results or obtain sufficient documentation to substantiate F-Squared’s claims before including this information in its own advertising materials.

Cantella was alleged to have violated Section 206(4) of the Advisers Act and Rule 206(4)- 1(a)(5) thereunder by making untrue statements of material fact in its advertisements. Cantella also allegedly did not keep sufficient books and records of the performance results as required by Section 204(a) of the Advisers Act and Rule 204-2(a)(16) thereunder. In order to settle these claims, Cantella agreed to pay a civil penalty of $100,000.

The Virtus and Cantella case seem to imply a stricter standard of review by the SEC in regards to performance data results. Firms will generally be held responsible for sub-adviser performance results used in marketing, and must independently verify all claims before distributing such materials to its clients and prospective clients. Furthermore, the SEC recently announced penalties against 13 more investment advisory firms that used F-Squared’s false and misleading performance results in advertising.

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