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Observers say the Hartford, Conn.-based mutual fund company turned a blind eye to a fictitious track record but the SEC saw fit to mete out a not-so-big fine
November 4, 2015 — 7:13 PM UTC by Sanders Wommack
Brooke’s Note: Early in our reporting efforts on this case, a source said it appeared that Virtus might be guilty of “willful blindness” by conveniently marketing boffo returns of its subadvisor that were subsequently shown to have been essentially fabricated. You could feel sympathy for the Virtus CEO. It doesn’t seem at all likely he knew from the get-go. But it’s also unlikely that he didn’t eventually become aware of the origins of the track record he was selling. At that point he had a decision to make about the funds that represented so much of the value of his company. He chose to essentially think wishfully — and hope the SEC saw things from his standpoint. It turned out to be an excellent decision for his shareholders. What is perplexing is just how the SEC came to frame Virtus’s behavior as a relative misdemeanor. In football terms, the referee is sending a signal to let the players play.
After what Wall Street clearly sees as Houdini-like move by Virtus Investment Partners in escaping massive fines and other potential industry sanctions, the mutual fund firm’s shares soared, soared then soared again.
Following Friday’s announcement by Virtus that it had reached a $16.5 million settlement with SEC staff, its stock price leapt 14.5%, climbed another 5% Monday, and gained another 4.5% Tuesday. Three days of trading have added more than $230 million to the company’s market capitalization.
Better yet for Virtus, the net tab for playing along with the presentation of disgraced subadvisor F-Squared’s fictitious track record will be only $11 million after the tax benefit — a pittance compared to the hundreds of millions in fee income derived from the funds that F-Squared managed.
The firm’s stock spikes occurred despite Virtus reporting disappointing third-quarter results last Thursday with earnings of $1.76 per share against estimates of $2 and revenues of $92.38 million versus estimates of $92.81 million.
The deal is not fully executed, according to CEO George Aylward on the company’s Friday morning conference call with analysts. The SEC’s press department declined to make any comment on its supposed agreement with Virtus Investment Partners.
Subject to review
“The agreement is subject to review and approval by the Commission and therefore we cannot provide any additional information or answer any questions,” Aylward said.
But Wall Street was unfazed by any “review’ and on Monday, Sandler O’Neill & Partners upgraded Virtus from “sell” to “hold,” citing fading regulatory risk, according to Barron’s.. (Sandler O’Neill’s analyst in charge of coverage, Michael Kim, did not respond to a request of comment.)
Virtus has been under scrutiny since May 2014 when The Wall Street Journal reported that the SEC was investigating the way its asset manager, Wellesley, Mass.-based F-Squared, stated historical performance of the company’s ETF strategies.
The AlphaSector mutual funds bad comparatively high management fees for Virtus funds. Although Virtus payed F-Squared roughly half of these fees, it reaped about $260 million from the AlphaSector funds between 2009 to September 2014, with the majority of this revenue generated recently. For the firm’s fiscal year ending Sept. 30, 2014, Virtus split $137.5 million with F-Squared in AlphaSector management fees. The fund company has presumably made tens of millions more in the last 13 months.
Virtus’s wholesaling subsidiary, Hartford, Conn.-based VP Distributors LLP, also profited. The company retained $6.3 million in AlphaSector sales commissions between September 2010 and September 2014.
Virtus fired F-Squared as a subadvisor in May 2015 and replaced it with Richmond, Va.-based Dorsey Wright & Associates. 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 five former AlphaSector funds (now the Virtus “Trend” funds) saw net outflows of $900 million in the third quarter of 2015 and currently hold $3.24 billion in assets, down from $5.68 billion on May 11 and $12.5 billion one year ago.
Class actions still in play
Though Virtus may now be square with the SEC, it is still defending itself in two private lawsuits related to the issues the SEC investigated.
AlphaSector mutual fund owners filed a class-action lawsuit, Mark Youngers v. Virtus Investment Partners, Inc. et al, against the company for failing to provide complete and accurate disclosure and for breaching fiduciary duties. The suit being litigated by Jonathan Stern of the Rosen Law Firm of New York, and has not to respond to a request for comment.
Virtus shareholders have brought their own suit against the company, In re Virtus Investment Partners, Inc. Securities Litigation. Lawyers at New York-based Bernstein Litowitz Berger & Grossmann argue that Virtus engaged in a cover-up of marketing materials after the company learned about the SEC investigation of F-Squared.
Under the leadership of former CEO Howard Present, F-Squared inaccurately performed backtests to develop what became the company’s AlphaSector line of indexes. The backtests produced wildly inflated returns for a period between April 2001 and September 2008. When an analyst at the company discovered the misinformation and brought it to Present’s attention, the SEC says he failed to investigate further. See: How Howard Present parlayed an intern’s algorithm into a small fortune — and when the SEC says he knew of a mega-disconnect
With an incredibly successful, albeit fictitious, track record, F-Squared was able to attract $28.5 billion in AUM over just six years.
Much of F-Squared’s success was due to its partnership with Virtus. The mutual fund company hired F-Squared to subadvise two funds in late 2009 and quickly found that F-Squared’s track record sold itself. Virtus soon added three more AlphaSector mutual funds to its lineup and by the third quarter of 2014 these five funds held around $12.5 billion in AUM.
A routine inspection by the SEC in July 2013 discovered F-Squared’s fraud. In December 2014, the company announced it would pay $35 million to the SEC to settle charges of securities fraud. Present declined to settle and is fighting the SEC in court. Currently in discovery, the case’s first depositions are scheduled to begin this week. See: In reply to SEC, Howard Present blames bad advice for any alleged wrongdoing
Slow to react
It seems that Virtus wasn’t entirely clueless about AlphaSector’s fictitious track record; in February, RIABiz reported that senior leaders at Virtus knew as early as December 2012 that Present hadn’t been truthful about the AlphaSector indexes. According to several witnesses, Virtus management told its wholesalers that F-Squared’s strategies were backtested and did not represent live track records at a conference in Boca Raton, Fla.
Nevertheless, Virtus did not change its marketing materials for the AlphaSector mutual funds until fall 2013 after the company learned F-Squared was being investigated by the SEC. See: Where Virtus stands after F-Squared seemingly led it astray, to mutual benefit
In March, the SEC denied a Freedom of Information Act filed by RIABiz asking for documents related to an ongoing SEC investigation into Virtus Investment Partners, a decision that suggested that the agency was investigating Virtus. See: SEC denies Freedom of Information request by RIABiz related to Virtus funds as Ameriprise and TD Ameritrade become latest biggies to cut ties
Sold for $1 million
If Virtus has turned a corner, its longtime subadvisor was not so lucky.
In the wake of scandal, AUM flew out the door at F-Squared even faster than they had arrived. Dismal performance by F-Squared’s indexes added to the pain. Between Oct. 24, 2014 and the termination of F-Squared’s subadvisory contract in May 2015, investors in the flagship Virtus Premium AlphaSector fund lost 4.5% as the S&P 500 gained more than 9%.
F-Squared filed for bankruptcy on July 8 and was purchased by Broadmeadow Capital in September. See: Bean Town Brahmins — ex-Windhaven execs — may pay as much as $100 million for F-Squared remains
Ever since the scandal struck, F-Squared had argued that clients had always received exactly the kind of risk-averse performance they had expected. But the company’s strategies were a fraction of their former size by the time investment contracts were transferred to Broadmeadow.
Broadmeadow says it acquired just $85 million in discretionary assets and $200 million in non-discretionary assets from F-Squared, meaning exactly one out of every one-hundred dollars remained in F-Squared products at the time of sale.
These diminished asset levels freed Broadmeadow from owing any “earn-out” payments on the transfered investment contracts—potentially the most lucrative part of the deal. It also allowed Broadmeadow to negotiate down its upfront payment, now its only payment, from $5 million to just $1 million.
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