The SEC alleges that the former F-Squared CEO engaged in a massive cover-up with lies, and the fabrication related to faulty backtesting

January 6, 2015 — 6:20 PM UTC by Sanders Wommack


Brooke’s Note: I recall an acquaintance from college who perused his bank statement one day and saw that $700 had been magically deposited into his account. He responded by going to the bank, withdrawing the funds and closing the account. I recall we all sort of scratched our heads and wondered what exactly we would have done under similar circumstances. Every dollar was precious in those days to us students and it seemed reasonable to believe that the bank would be the one to eventually swallow the mistake. Based on SEC documents, it seems that Howard Present may have been faced with a moral dilemma of roughly moral equivalence. He had a great track record dropped in his lap and at a time when he and his company really seemed to need a boost. And by accepting these ill-gotten returns (knowingly the SEC says) there weren’t going to be any easy-to-identify victims. The big “they” would pay. Indeed, Present’s lawyers issued a statement that says: “There is no allegation in the SEC’s complaint that investors lost money.” So it seems a little morally confusing. But the SEC is not confused at all and it isn’t treating Present like a naive college student overcome by wishful thinking.

Former F-Squared Investments Inc. chief executive Howard Present knew he was wildly deceiving investors about his company’s returns and engaged in a comprehensive cover-up that spanned years, according to a 48-page complaint from the Securities and Exchange Commission.

That complaint, issued on Dec. 22, along with an order against the Wellesley, Mass.-based manager of exchange traded funds, states that Present lied to clients about the historical performance of its AlphaSector Premium Index product from almost the very beginning. To initially sell the product, F-Squared relied on backtested returns that were inflated by more than 350% because of a miscalculation. When the situation was brought to Present’s attention, he turned a blind eye of convenience to the problem, the SEC alleges.

The reported stellar returns acted as a tonic for a company trying to make its way among a world of competitors following the direction of the down market. Indeed, over the course of six years, as F-Squared grew from nothing to become the largest model ETF portfolio provider with over $28 billion in assets, Present ignored warnings from an analyst at the firm, a mock auditor, and the firm’s chief compliance officer. When he was confronted by F-Squared’s business partners with the sum of the firm’s dissembling and was asked to correct the record, Present essentially told his accusers to forget the whole thing.

Present eventually attempted to cover up the matter when the SEC began to investigate, and only gradually admitted to his misdeeds. See: Following serious questions about how it calculated returns, F-Squared hires a new CEO after the old one leaves.

As a result of the SEC investigation, F-Squared and Present admitted the wrongs and agreed to fork over $30 million in profits and a $5 million fine.

No harm…

The SEC is not finished with Present and the investigation into his conduct is ongoing. Nevertheless, his departure from F-Squared in November was amicable; in fact, Present was given an $8.5 million compensation package upon his resignation.

That generous severance package may come in handy for paying legal fees. Lawyers at Washington D.C.-based Williams & Connolly LLP, which represents Present, released a statement saying, “Howard Present acted with integrity in building F-Squared Investments. There is no allegation in the SEC’s complaint that investors lost money. There is no allegation questioning the company’s investment performance over the past six years. Instead, the complaint focuses on the firm’s marketing and advertising relating to performance data for 2001 through September 2008. We will demonstrate in court that Mr. Present acted appropriately and that the SEC’s allegations are misdirected and meritless.”

The lawyers did not respond to e-mails asking for further comment.

The revelations about F-Squared have caused at least one firm, Concord, Calif.-based AssetMark Inc., to begin to make changes.

“After carefully reviewing the details of the settlement, we decided to remove the F-Squared strategy from our platform. As of December 22, 2014, we closed the strategy to new accounts. We are working with advisors on transition plans for existing assets,” an AssetMark spokesperson wrote in an e-mail.

Algorithm prodigy

Howard Present's legal defense is that the actual returns of his funds were represented legally for the past six years.
Howard Present’s legal defense is that
the actual returns of his funds
were represented legally for the past
six years.

F-Squared was founded in May 2006 but struggled to find clients for its AlphaCycle ETFs. In the first six months of 2008 it earned just $189 in revenue and recorded losses of $609,000, according to the SEC’s summary of its investigation. The firm was struggling to meet payroll, the SEC claims.

In June 2008, Present, who co-founded and owned 26% of the firm, met with David Morton, a wealth advisor from the Boston area, to pitch AlphaCycle. Instead, Morton pitched Present a sector-rotation investment model based on a market-beating algorithm. The algorithm was created, Morton explained, by his then 20-year-old intern, Corey Hoffstein.

Impressed with Hoffstein’s work, Present worked to translate the licensed buy/sell signals from the algorithm into a model ETF portfolio over July and August with an assistant. In the process, Present designed the investment rules for what would eventually become F-Squared’s AlphaSector Rotation Strategy while the assistant worked on its backtesting.

At first, Present may have thought he had unearthed a legitimate gold mine. The backtests showed spectacular gains for Hoffstein’s translated signals. Various portfolios constructions by the assistant showed gains of 238.62%, 223.87%, and 224.59% between December 2000 and May 2008, a period during which the S&P 500 earned just over 21%.

Invented rules

Better yet, Present knew how to convert such returns into business success. Present was managing director and head of product development at Putnam Investments between 1996 and 2002, and later at Evergreen Investments between 2002 and 2004 (Evergreen was Wachovia’s investment management arm. it was folded into Wells Fargo Advantage Funds and was subsequently phased out in 2010.) At both firms, Present was involved in creating the firm’s advertising materials. See: What I learned at Putnam Investments’ analyst meeting from the real Capt. Phillips.

Present began to send sales e-mails to potential clients broadcasting the apparent efficacy of his firm’s investing formula. Those e-mails contained the first of many, many statements the SEC is now suing him for. Despite inventing the investment rules for the model ETF portfolio himself only weeks before, Present claimed in an Aug. 8 e-mail to potential clients that “the product has been run on a live basis since 12/2000, and currently has over $90M managed against a current version of it.”

Mixed signals?

Meanwhile, Hoffstein and Morton had founded Boston-based Newfound Research to sell the signals to F-Squared and appointed a technology lawyer, Tom Rosedale, as chief executive.

Present and F-Squared “claimed that they were duped” by Newfound Research according to Fortune magazine. But the SEC documents note that 18 days after Present told potential clients the strategy had been managed live since 2000, he finally got around to asking for the exact inception date of the sector-rotation strategy.

Morton responded in an e-mail, the subject line and body of which read, simply, “2003.”

The SEC says Present never saw more documentation that Morton or Newfound’s two other principals were managing money using a similar strategy. Even if he had, Present made major changes to Newfound’s signals as he created the AlphaSector product line.

F-Squared was ready to launch its actual “live” product on Sept.18, 2008, and issued a press release and marketing materials that compounded Present’s initial lies about the strategy’s history. Writing much of the ad copy himself, Present claimed in a marketing presentation sent to potential clients that the strategy was used to manage $100 million by a $3.9 billion wealth management firm, and that the “specific buy and sell decisions reflected in the historical track record were those actually used to manage Private Client assets.” These are all statements the SEC claims are “materially false and misleading.”

Three days after the big launch of AlphaSector Rotation Strategy, Present received a shock. F-Squared had just received its first live buy/sell signals from Newfound Research, and the assistant who had performed all the backtesting couldn’t reconcile the index’s performance with the new signals. This analyst noticed the new signals could only be correctly implemented if he scrapped his old methodology, and applied the signals one week later than he had previously been doing.

As it turns out, because of the unintuitive way the signals were given to F-Squared, the analyst had accidentally applied every buy/sell signal one week earlier than he should have for all of the backtested weeks. And since Hoffstein’s algorithm was largely momentum-based, this meant that F-Squared’s backtested portfolio had bought ETFs right before these funds went up and sold them right before they went down.

Blind eye

The AlphaSector portfolio’s returns looked too good to be true because they were. Had the signals been correctly applied, F-Squared might have been able to boast a 38% return over eight years against just a 28% return for the S&P 500.

Instead, F-Squared claimed the AlphaSector Rotation Strategy, an ETF portfolio rebalanced just once a month, had a 135% return between 2001 and 2008. See: This $9-billion Philly RIA is launching an ETF company financed by Chinese private equity.

After months of work coordinating with Newfound Research, various stock exchanges, and potential clients led to a successful product launch, at least two people at F-squared learned the entire AlphaSector story was a lie less than one week after launching the product and sending out triumphant press releases to the media and investors.

The SEC does not go into detail about how Present learned of the backtesting error. The complaint against Present says, “Soon after, the analyst had a meeting with Present in which he tried to explain this possible error about when to implement the signals used to calculate AlphaSector’s historical performance. Present did not investigate further. He did nothing to ascertain whether the extremely positive track record that he was already advertising for AlphaSector had been calculated in error.” See: 6 ways to advertise your investment performance and not run afoul of regulators’ wrath.

No looking back

Instead of shutting down the strategy when he learned about the mistaken backtesting, Present and F-Squared forged ahead. The firm continued to tout the exaggerated returns, and the SEC says Present continued to make untrue statements about other aspects of the AlphaSector strategy.

A small sample of the extensive list of instances of deception the SEC uncovered shows Present lying to clients, potential clients, journalists and regulators. Present wrote to FINRA and Virtus Investment Partners in October 2009 that, “the investment philosophy, portfolio construction methodology, and actual investment securities were established, and remained largely unchanged over the past eight and one-half years. The Index therefore explicitly does not reflect backtested data, but instead represents live, historical data.”

On Sept. 28, 2011, Present appeared on CNBC’s Closing Bell and said that F-Squared had been managing the AlphaSector strategy for 10 years. And in a March 2011 e-mail to a client, Present goes into the strategy’s non-existent historical evolution in great detail.

Chart from F-Squared's August 2013 marketing materials touting the fictitious returns
Chart from F-Squared’s August 2013 marketing
materials touting the fictitious returns

“In late 2003 the rolling window [of the investment engine] was shortened modestly in reaction to the observed slow response time to the market recovery in 2003. In 2004 an initiative was launched to create a more fundamentally sound enhancement to the issue. The effort took several years, but in 2007 the new version was implemented (which is virtually identical to the model in place today), including the use of the dynamic volatility window.”

F-Squared, of course, was only founded in May 2006, and Present was working at Evergreen Partners from 2002 to 2004. The algorithm which AlphaSector strategies are based on wasn’t created until 2007 and not finalized until the second half of 2008.

Cracks appear

Business boomed as Present and F-Squared continued to mislead the investing public. Total assets under management at F-Squared grew from $250 million at the end of 2009 to more than $6 billion at the end of 2011. The firm’s success went on afterburners after it signed a subadvisory agreement with Virtus Investment Partners in September 2009. F-Squared currently manages $10 billion across five Virtus funds. As of September 2014, F-Squared had more than $28 billion in assets under management.

In June of 2012, an attorney performing a mock audit for F-Squared recommended that the firm get documentation to verify its investment returns for the years before its incorporation.

Goaded by the firm’s then chief compliance officer, Present e-mailed Newfound Research asking for a letter stating that the “historical performance indexes such as we show in our materials, reflects that accurate output of the investment engine in use for the strategy over time.”

Newfound chief executive Rosedale responded the same day with a curt e-mail.

“[Corey Hoffstein] is 24 years old and he worked on the underlying technology in 2007 and 2008 (when he was 20 and 21 years old)—he didn’t work on this when he was 14 in 2001…[Hoffstein] started working on this in 2007 and [Newfound Research] didn’t exist until August 2008.”

The SEC says Rosedale offered to write a letter saying data from the fall of 2008 onward was live while everything before was backtested. Present, the complaint notes, did not accept the offer.

F-Squared decided to replace Newfound Research’s ETF signals with its own proprietary signals in May 2013, and thus eliminate the 20 basis point fee it was paying to Newfound. That same month Newfound Research and Virtus began discussions about forming a new venture (Virtus and Newfound had founded an investment management company, Newfound Investments, together in October 2012). During these talks, Virtus executives asked Newfound why it had so dramatically underperformed F-Squared’s reported returns between 2001 and 2008 when the underlying signals were the same.


Newfound was equally perplexed, so the next day, May 28, 2013, a Newfound employee ran a backtest of the data originally sent to F-Squared in 2008 and found major differences between F-Squared’s stated results and the results that would have been expected. The day after, Hoffstein himself ran the same test and got the same results. On May 30, Hoffstein discovered that if he applied the signals a week earlier, as F-Squared had, he could replicate the firm’s stated returns very closely.

At a meeting with Howard Present on July 1, 2013, Hoffstein and Rosedale explained what they had found, reminded him of the history of their product, and asked if he was going to correct the record. The SEC says, “Present essentially told them to drop the subject.”

Four weeks later, the SEC began a routine examination of F-Squared. When the regulator inevitably asked for documentation verifying the firm’s historical returns since April 200, Present scrambled. The SEC says he left a voicemail for Morton — who had since left Newfound Research — saying:

“I have a regulator in my office and they are looking at the contracts between us and Newfound Research, and some of the deliverables that were associated with that. There are some confidentiality issues that I’m about to have to breach and I’m going to give you a heads up. I am going to talk to you about what’s being provided and see if we can forestall because I don’t want them to walk out of my office and over to yours. Um, that doesn’t help either of us.”

According to the SEC complaint against Present, the next day he provided his chief compliance officer with an Excel spreadsheet to give to the SEC which he said “verified” the year-end totals of client assets in the AlphaSector strategy between 2001 and 2009. This, the SEC says, was clearly a false statement; and it appears from the evidence that Present may have created the Excel spreadsheet himself.


Auditors weren’t fooled by Present’s spreadsheet. Present took a first step to correct the record in late September, when he told staff that the firm would henceforth define all returns before September 2008 as backtested. As the SEC notes, in paragraph 84 of its complaint against Present, his letter was far from a forthright admission of error.

As the SEC investigation continued, Present slowly disclosed more information. In an October 2013 letter to clients, Present admitted the SEC had “raised some questions regarding the marketing and supporting materials,” according to Barron’s.. By May, F-Squared was writing to clients again to tell them that his firm’s strategies hadn’t been linked to live money between April 2001 and October 2008 after all, and that AlphaSector returns were “clearly overstated” over the period.

In August, F-Squared received a Wells Notice from the SEC implying that an action was imminent, and in November Howard Present finally left the company. See: Following serious questions about how it calculated returns, F-Squared hires a new CEO after the old one leaves.

Now that it has settled with F-Squared, the SEC has turned its full attention to Howard Present. The SEC is seeking the disgorgement of “ill-gotten gains,” an “appropriate civil penalty,” and “such other and further relief the Court deems just and proper” from the former CEO.

Share your thoughts and opinions with the author or other readers.


Big Frank said:

January 6, 2015 — 9:35 PM UTC

Some nice writing there.


Ricky Ross said:

July 1, 2015 — 1:05 AM UTC

F-Squared Lied & paid 10s of millions of dollars to the SEC. I was lucky. Out of my $100,000 investment, I lost only $400.
Wells Fargo Advisors was pushing their fraud & that’s how I got in on it. Screw them both.

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