Having spent a few days in Las Vegas over the holidays, one is reminded of the lure of legerdemain. A few bells go off, some flashing lights and a win here and there can tempt even the most staid rationalist into believing that magic can happen. If you have seen "Chicago," you may recall Billy Flynn's musical urging to "Give 'em the old razzle dazzle...Give 'em the old hocus pocus, Bead and feather 'em, How can they see with sequins in their eyes?"

On Broadway or at a casino, entertainment is the name of the game. Investing is another matter altogether. By its nature and in contrast to trading, investing is typically thought of as an ongoing process with a long-term goal of satisfying one or more objectives. A disciplined and diligent investor will (hopefully) eschew gimmickry in favor of doing one's homework, ask questions and make sure that the answers make sense. Examining performance numbers is an important part of the exercise. Past is not necessarily prologue. Projecting future risk-adjusted returns is mission-critical. When a fund is new and has a relatively short track record, that work of assessing potential gains or losses can be challenging but certainly not impossible.

When numbers provided by an asset manager reflect smoke and mirrors, trouble is likely to follow. For one Massachusetts-based organization, its predicament took the form of an investigation and subsequent censure decision and fine. According to its December 22, 2014 order in the matter of F-Squared Investments, Inc., the U.S. Securities and Exchange Commission ("SEC") accepted a $35 million settlement regarding "recklessness" in how this registered investment advisor ("RIA") advertised returns. 

One grievance relates to its use of back testing to manufacture a track record of an equity product. Ignoring a "material performance calculation error" is another upset, with "virtually all of AlphaSector's claimed outperformance relative to the S&P 500 Index (SPX) for the pre-October 2008 period [being] attributable to this erroneous calculation."

Yet another complaint, registered by the SEC, is that "After 2008, Present and F-Squared continued to advertise AlphaSector's hypothetical and back-tested and substantially improved track record." (A November 14, 2014 F-Squared press release informs that co-founder Howard Present has stepped down as CEO.) Besides complaints about "inaccurate" advertisements and Form ADV filings, the SEC document does credit F-Squared with engaging an Independent Compliance Consultant and agreeing to abide by recommendations made by this outside party.

Given its more than $20 billion in assets under management, the woes of F-Squared have an impact that is hard to ignore. In an article published by ETF.com, writer Olly Ludwig describes fears of investors who, once burned, may suspect numbers reported by other firms. Being circumspect of course is not a bad thing. To the contrary, doing a deep dive as to how returns are calculated is a good thing. Interested readers can download "Financial Model Mistakes Can Cost Millions of Dollars" by Susan Mangiero (Expert Witnesses, American Bar Association, Section of Litigation Expert Witnesses Committee, Spring/Summer 2011).

In my experience as a forensic economist and someone who has taught investment performance reporting workshops, it is folly to bounce numbers around as if they were created equal. Whether civil, criminal or regulatory in nature, these matters almost always require an in-depth analysis of returns to understand exactly what they represent (and by extension, what information is missing). I know that some banty about stated percent return comparisons over time and across asset managers as if doing so validates numbers as equal. Smart retail and institutional investors will carry out other calculations in an effort to benchmark on a comparable "risk adjusted" basis.

Addressing the subject of risk/return comparisons is outside the scope of one blog post. If you want to learn more about this process or need an independent third party to assist with compliance or litigation, drop me a line at contact@fiduciaryleadership.com.