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SEC leaves little doubt that Virtus knew to be suspicious of what it was selling yet kept those concerns from wholesalers

After concerns were raised Virtus grabbed for earplugs -- a move that made economic sense in retrospect

Tuesday, November 24, 2015 – 7:08 PM by Sanders Wommack
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Julie Riewe: By failing to take steps to verify F-Squared's claims, Virtus solicited investors using materially false and misleading AlphaSector performance data.

Virtus executives knew plenty — and earlier on than they let on.

The SEC has settled with Virtus Investment Partners over allegations it misled investors about the historical track records of its once red-hot AlphaSector line of mutual funds. Without admitting or denying the Securities and Exchange Commission’s findings, the Hartford, Conn. mutual fund firm “consented to the entry of the order” finding it had violated three sections and four rules of the Investment Advisors Act of 1940.

But the commission’s final disposition did not exonerate Virtus — even if the $16.5 million penalty suggests its actions were more misdemeanor than felony. Now, for the first time, it’s part of the record that VIrtus was tipped off to the cooked-up quality of AlphaSector’s inflated returns months before the company took action. The moment was described by the SEC in its order, dated Nov. 16.

Failure to recreate

“In May 2013, principals for the firm that provided F-Squared with the signals for AlphaSector (the “Data Provider”) informed Virtus that they believed the AlphaSector index’s track record may have been miscalculated. The Data Provider’s principals informed Virtus that it had attempted to recreate the advertised track record covering the 2001 through 2008 period, but could not. Virtus took no steps to follow up on the concerns raised by the Data Provider’s principals.”

The SEC also found many other signs that suggest Virtus leaders knew that F-Squared’s strategies were created in the financial advisory test tube known as backtesting—not “live” as Virtus claimed to clients.

Virtus the SEC says, initially “expressed skepticism about AlphaSector’s so-called “live” track record,” when it was approached by F-Squared in early 2009, but it took no steps to verify Present’s claim that F-Squared’s signals had been used since 2001 by a private wealth advisor. See: Allegations in Virtus class action relate to the fund company using a track record improperly calculated by its subadvisor.

It chose to see no evil.

Then just a few months later, in November 2009, FINRA flatly told Virtus execs that the AlphaSector indexes were derived through backtesting. The regulatory agency also added, presciently, that “we are concerned that the process could be manipulated to obtain desired outcomes.” Virtus bowed to FINRA’s concerns and noted in fund prospectuses that the AlphaSector Index was first calculated in October 2008, but its inception date was still April 1, 2001. See: Virtus bites bullets with F-Squared firing, Dorsey Wright hiring and an admission that it’ll likely pay a $5-million-plus SEC settlement.

The SEC did not include mention that Virtus’s glossy marketing materials disclose the AlphaSector’s April 2001 inception date but omit the October 2008 calculation date.

Virtus vs. Virtus wholesalers

According to the SEC order, something — and here the SEC is apparently blaming inadequate compliance protocols — kept knowledge of F-Squared’s backtesting-derived performance away from those who were successfully selling those stellar returns: it’s sales team.

The SEC says an intra-Virtus controversy erupted at the end of 2011 after some wholesalers were told by “market participants” what Virtus already knew: That F-Squared’s indexes were backtested. Virtus’s salesforce questioned Howard Present again, and according to the SEC order, “Present did not provide answers to many of the questions, but Virtus did not follow up or obtain the requested information or change how it used and marketed AlphaSector.” See: In reply to SEC, Howard Present blames bad advice for any alleged wrongdoing.

The SEC’s order says that the company continued to order its wholesalers to tell clients the strategy’s historical performances were “live.” According to the SEC’s order, wholesalers were given “talking points “ that asserted “[AlphaSector] Index returns are not back tested as the track record is based on the actual model signals at the time they occurred since 2001,” and that the index’s returns had been “live” or “running live assets.”

This occurred even though a senior leader — unnamed in the report — at the company thought this wasn’t true:

“ Virtus’s Product Management group understood that the AlphaSector Premium and AlphaSector Rotation indexes had no assets and never traded” the SEC order reads. “The Virtus product manager responsible for AlphaSector also believed that the algorithm that drove the price momentum model underlying the AlphaSector strategy had been used since 2001, but on a different portfolio construction, including possibly different securities and trading rules. This product manager understood the AlphaSector strategy’s then-current portfolio construction was not established by Present until 2008, meaning that no 'live’ assets could have been traded using the AlphaSector strategy prior to 2008 using the portfolio construction employed by the Virtus AlphaSector Funds. Virtus did not adequately communicate this understanding to Virtus’s wholesalers.”

More to the story

The SEC’s order did not address the claim, confirmed by multiple sources to RIABiz, that this product manager did in fact communicate this understanding to Virtus wholesalers at a December 2012 conference in Boca Raton, Florida. This occurred about ten months before Virtus changed any of its marketing materials. See: Where Virtus stands after F-Squared seemingly led it astray, to mutual benefit.

And the SEC’s order appears to be written in a way lets Virtus come away looking better than it should. As excerpted earlier, the SEC’s complete description of the moment Virtus was tipped off about AlphaSector’s accuracy reads as follows:

This paragraph implies that the report from the data provider (Newfound Research) to Virtus was unsolicited, required further “follow up” to be verified and acted on, and that Virtus could have plausibly remained in ignorance.

But this implication strains belief when read against the SEC’s December 2014 description of the exact same moment. The SEC said then in its order against F-Squared that Newfound and Virtus were working together in early 2013 on a potential new joint venture:

“In the course of their discussions, the Fund Company asked why the Data Provider’s proposed strategy substantially underperformed AlphaSector in 2008. On May 28, a Data Provider employee ran a backtest using the data for 2008 that had been sent to F-Squared. he found a large difference between the performance he calculated and AlphaSector’s 2008 performance as advertised by F-Squared. On May 29, the former Intern himself ran several backtests of the data sent to F-Squared, and his results were also quite different from AlphaSector’s advertised performance. On May 30, the former Intern tried again. This time he found that, by applying the buy/sell signals one week before they should have been applied, he could generate results that were close to AlphaSector’s reported performance. In other words, he discovered the calculation error that had substantially inflated AlphaSector’s purported pre-September 2008 track record.”

Really big sign

What the SEC leave out is that it was principals at Virtus, not Newfound, who initially raised concerns about F-Squared’s performance. And, contrary to the most recent SEC order, Virtus apparently did “follow up” on these concerns by asking Newfound to investigate them. See: Allegations in Virtus class action relate to the fund company using a track record improperly calculated by its subadvisor.

The SEC also claimed in December that Newfound was able to recreate F-Squared’s advertised track record by inaccurately backtesting the signals in the same way as Howard Present. Although Newfound couldn’t know for certain, this was a very, very large sign that the historical track records of the AlphaSector indexes had been backtested incorrectly and were extremely inflated.

Neglect pays?

Virtus profited handsomely from the public’s perception that real investors experienced AlphaSector returns as advertised. Virtus’s pulled over $12 billion into funds paying very high fees and had earned over $130 million in management fees by September 2014. See: Catching shareholders short, SEC lets Virtus skate with $16.5 million tax-deductible settlement after alleged 'willful blindness’

But the language of the order casts Virtus’s actions as the consequences of poor compliance procedures. The SEC’s order against Virtus is broken into five sections outlining evidence of it’s misdeeds. These sections are “Virtus’s Marketing Efforts Contained Misleading Statements,” “Virtus Failed to Respond to Concerns about AlphaSector and F-Squared,” “Virtus Failed to Respond to Allegations Concerning The Accuracy of The AlphaSector Index Track Record,” “Virtus Failed to Adopt and Implement Adequate Policies and Procedures,” and “Virtus Failed to Maintain Adequate Books and Records.”

Quotes from SEC brass in the order’s press release succinctly sum up the toothlessness of the government’s case.

“Virtus accepted F-Squared’s historical performance misrepresentations at face value and ignored red flags that called these statements into question….If an investment adviser chooses to advertise, it is responsible for the content and accuracy of its ads,” wrote Andrew Ceresney, the SEC director of the enforcement division.

Julie Riewe, Co-chief of the enforcement division’s asset management unit, added: “By failing to take steps to verify F-Squared’s claims, Virtus solicited investors using materially false and misleading AlphaSector performance data.”

More to come…

This SEC’s action closes the book on Virtus’s punishment. But as in its F-Squared settlement press release, the SEC signed off by warning that more enforcement actions may be coming. “The SEC,” the release noted, “continues to investigate the conduct of other advisers that potentially misled investors and others with advertisements containing F-Squared’s false historical performance data.”

Next on the firing line may be those brokerages who steered billions into F-Squared’s products without doing proper due diligence on the firm. In June, Chicago-based securities law firm Stollmann Law Offices filed a FINRA arbitration claim against Wells Fargo Advisors for its F-Squared sales practices. See: Big brokers take action on F-Squared funds and Virtus shares reel as SEC actions sink in.



December 15, 2017 — 8:03 PM
Jeff Cerutti and John McCormack should both be investigated by the SEC. SEC should piece together when they knew of this fraud, how they continued to push all of the Regional Directors at Virtus to knowingly sell a fake track record, and the SEC should look at those 2 for stock gains if they sold based on insider information which could be insider trading

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