The Securities and Exchange Commission recently issued an Order Instituting Administrative and Cease-and-Desist Proceedings against Massachusetts Financial Services Company (“MFS”), an SEC-registered investment adviser. According to the SEC’s Order, MFS advertised hypothetical returns pertaining to its blended research stock ratings without informing clients that a number of the hypothetical portfolios’ superior returns were based on back-tested models. Without admitting or denying the allegations in the SEC’s Order, MFS submitted an offer of settlement to resolve the matter.
According to the SEC’s Order, MFS has employed a quantitative-based research department since 2000. In 2000, the department developed what MFS calls “blended research” strategies, which involve “combining fundamental and quantitative ratings to arrive at a blended stock score, and by using a portfolio optimization process that considers the blended scores along with risk and other portfolio constraints.” As of May of this year, MFS had approximately $21 million in assets under management invested in blended research strategies.
The SEC’s Order alleges that from 2006 through 2015, MFS created research proofs based on the blended research analysis. The data and a bar chart describing the analysis were featured in MFS advertisements. MFS subsequently used the bar chart in three different kinds of marketing materials: in a standard slide deck from 2006 through 2015, in responses to formal requests from clients starting in 2012, and in a white paper that discussed MFS’s blended research strategies. These materials were marketed exclusively to institutional clients, prospective institutional clients, financial intermediaries, and investment consultants.
The SEC alleged that the research proof chart featured in these advertisements included some quantitative ratings that MFS established through back-testing. Of course, the use of back-tested data is risky because there is a possibility that the performance portrayed is not attributable to successful predictive modeling. Although the returns were labeled “hypothetical,” MFS did not disclose in any of its advertising that the research proof chart included in that advertising was partly based on back-tested quantitative ratings, thereby violating the Investment Advisers Act of 1940.
The SEC’s Order notes that the use of back-tested data significantly improved the returns of the models because the period 1995 through 1999 was the period with the best results from the hypothetical combined “fundamental quantitative” set of returns.
The SEC’s Order also alleges that MFS made a number of misleading statements regarding the research proof chart it featured in its advertising. MFS allegedly represented that the research proof chart was based on MFS’s quantitative ratings dating from the mid-1990s when in fact MFS did not produce any quantitative ratings until 2000.
The SEC’s Order compels MFS to refrain from further violations of the Advisers Act. MFS also agreed to pay a civil money penalty of $1.9 million.
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