Tuesday, December 23, 2014

Proving our Gullibility: An Investment Product That Doesn’t Stand up to Scrutiny

Proving our Gullibility: An Investment Product That Doesn’t Stand up to Scrutiny

I’m beginning this blog with one of the most compelling investment marketing pages, I’ve ever seen.  It comes from an investment presentation made in 2013 by a firm called F-Squared.  It contains numbers that would induce institutional and retail investors alike to invest with the manager.  Even if you are a financial novice, you will be amazed by the numerical comparisons that appear on the right side of this page. 

Who wouldn’t be attracted to a money manager who had achieved a cumulative return of 368.2% versus 76% for the S&P 500 since 2001?   The manager has soundly beaten the market in every time period.  Astoundingly, these returns were achieved with 50% of the volatility of the stock market.  The standard deviation for this wonderful product was 10.4%, while the market’s volatility was 15.5%.   Notice the numbers in red, which show the maximum decline from high to low of the AlphaSector Premium Index versus the S&P 500.  While the S&P 500 suffered a maximum drop (known as drawdown) of 51%, this product only dropped 13.5%.  Sign me up.

There’s one small problem.  This presentation is Exhibit 1 of an Administrative Order filed by the Securities and Exchange Commission against F-Squared.[1]  The numbers from 2001-2008, which accounted for the bulk of the superior performance, were made up and the manager knew it.  Nonetheless, $28.5 billion of investor capital flowed into funds using F-Squared’s investment model.    The firm has agreed to pay a $35 million fine and has admitted that the data supporting this product was false.

In marketing the product, F-Squared’s founder and former CIO claimed that he’d found a proprietary algorithm that could predict which sectors of the market would perform well and which wouldn’t.  He developed a sector rotation product that would purchase attractive industries using exchange-traded funds and sell those industries that were less attractive.  It turns out that the back-test for the algorithm was flawed, but the CIO didn’t care.  Moreover, he pretended that the back test was actual investment performance.  In other words, when prospective investors received his marketing pitch, they were led to believe that the numbers were accurate and that they represented actual investments. When the SEC corrected the data, the investment performance became rather ordinary.  F-Squared’s marketing exhibit wouldn’t have been particularly compelling using real data.

I think this case says more about us than it says about F-Squared or its former CIO.  As investors we tend to be extremely gullible.  Give us a couple of compelling charts and precise looking numbers, and we’ll reach for our checkbooks.  In my investment career, I’ve learned that when numbers appear to be extremely attractive, its time to be extremely skeptical.

[1] http://www.sec.gov/litigation/admin/2014/ia-3988.pdf

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