2016 So Far and the Levy Decision

I recently posted an article on my blogs about the fact that not everyone is losing money in 2016. I had several people respond negatively, some rudely so, suggesting that I did not understand the cyclical nature of the stock market. Not only do I understand the cyclical nature of the market, I also understand the legal decisions that have dealt with the cyclical nature of the stock market and have addressed the legal obligations of investment advisers and other investment fiduciaries in light of said cyclical nature.

Recently we have seen a number of mutual funds begin to offer so-called low volatility mutual funds for investors who have become skittish due the increased volatility in the U.S. stock markets. These low volatility funds basically overweight less volatile sectors in the stock market in hopes of reducing the fund’s overall volatility. In exchange for reduced volatility, investors need to understand that they are potentially giving up some upside return that is often provided by historically more volatile sectors, such as technology, in bull markets.

One such fund, the S&P 500 Low Volatility High Dividend Index Fund (SP5LVHD), has a YTD return of 7.11% (through 3-3-2016) versus a 3.35% loss on the S&P 500 Index. The fund’s return is probably a testament to both its low volatility orientation and the impact that dividends have historically on total market returns. According to Standards & Poors, since 1926, the income from dividends has accounted for approximately 33% of the S&P 500 Index’s total returns. More recently, during the twenty-five year period of 1989-2014, dividends accounted for approximately 50% of the S&P 500 Index’s total return.

Does that every investor should invest in low volatility mutual funds and/or the S&P 500 Low Volatility High Dividend Index? Not at all. Obviously depends on a client’s personal investment parameters and needs. The funds were mentioned to illustrate possible considerations for investors in light of adverse market indicators.

Put simply, investment advisers and other investment fiduciaries cannot simply watch investors lose money and say”it’s the markets, everyone is losing money.” As a securities litigator, I love those types of cases because it’s like “shootin’ fish in a barrel.” All I have to do is pull out the Levy v. Bessemer Trust decision and the adviser has to pull out his checkbook.

Levy involved a client that was worried about the potential of loss in his portfolio due to the fact that his portfolio had a concentrated position in one stock. When he asked his adviser if there were ways to mitigate his potential loss, the adviser did not discuss the possible use of options to protect against downside risk. The client subsequently suffered a significant loss due to the concentrated stock position.

The client sought advice from another adviser who informed the client of the possible use of options, especially collars, that could have provided the client with the downside protection he had sought. The client sued the initial adviser for his misrepresentation and negligence in not alerting the client to the option to use options to protect the client’s portfolio. In denying the adviser’s motion to dismiss the case, the court ruled that the question of whether an adviser had a duty to at least advise a client of viable loss prevention options presented a valid question for a jury to decide.

The takeaway from Levy is that advisers cannot simply stand by and watch investors suffer significant losses and then blame it on the markets. Whether an advisers likes or dislikes a particular strategy that could provide a client with downside protection, Levy and other similar decisions have established that investment advisers and other invest-ment fiduciaries have, at a minimum, a legal duty to advise a client of such strategies, both the positive and negative aspects of same, and then let the client decide on whether to use same. The adviser should also document both the disclosures that the adviser provided and have the client acknowledge their decision in writing.

I have already had a couple of advisers call me telling me that some of their clients were upset over the 2016 losses and mentioning legal action against them. As I have said on numerous occasions, the decision to own one’s own RIA firm includes the duty to learn and stay current with all applicable legal and compliance standards. Under 94-44, a broker-dealer only has a legal obligation to monitor and supervise their registered representatives that also serve as investment adviser representatives (IAs). As the court pointed out in Levy, if you hold yourself out to the public as an IA, you are representing that you have the special knowledge associated with such a position.

Many people are predicting a down year for the U.S. stock markets. While no one can predict the future, advisers should consider whether to discuss available investment strategies that could provide clients with downside protection. For some clients, especially older and risk averse clients, low volatility mutual funds, including the S&P 500 Low Volatility High Dividend Index fund might be a viable option for at least a portion of their portfolio.

Note: The Levy decision is available at 1997 U.S. Dist. LEXIS 11056. A discussion of the case is available online at http://corporate.findlaw.com/litigation-disputes/s-amp-p-index-too-speculative-to-prove-lost-profits-against.html

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
This entry was posted in compliance, fiduciary compliance, fiduciary law, investments, RIA, RIA Compliance, securities, securities compliance, wealth management, wealth preservation and tagged , , , , , , , , , . Bookmark the permalink.