Compliance Supervision in Bear Markets

Over the past few weeks and months, we have seen the impact of the markets on the financial system. The Federal Reserve has used interest rates as a tool of Monetary Policy to address inflation, and the effect of this uncertainty has resulted in shaky Equity Markets.

According to documentation provided by InvesTech Research, the most volatile years in the stock market occur in bear markets, and some of the bigger bear markets have seen 1% to 2% swings on nearly half the trading days in the calendar year. [1]

We’ve officially entered a bear market, defined as a drop of 20% or more from the previous peak.

Since 1957, the median market return (measured against the S&P 500) has been positive one month, three months, six months, and one year after officially entering bear market territory. [2]

Major equity benchmarks had a tough time finding direction Monday, September 19 as traders geared for another super-sized US rate increase amid fears on whether the Federal Reserve could overtighten and raise the odds of a hard landing. Treasury 10-year yields hovered near 3.5% while the two-year rate, which is more sensitive to imminent policy moves, hit the highest since 2007. [3]

After their meeting in late September 2022, The Federal Open Market Committee (FOMC) raised the target range for the federal funds rate by 75 basis points (bp), or 0.75 percentage points. The new target range is 3.00% to 3.25%. [4]

Volatile markets generally create anxiety among investors, which translates to an increased frequency of contact with their advisers. When the value of investment accounts appreciates, clients are usually pleased with their adviser’s recommendations. However, in bear markets, clients are more likely to question the suitability of the recommendations that have translated into what they view as negative portfolio management performance. Adequate compliance preparation can reduce stress for the adviser and improve the strength of client relationships.

The Impact of Market Volatility on Client Behavior

One of the essential elements of advisory services from a compliance standpoint is client education. Ultimately, regulators are not likely to be convinced that a client understands the investment strategy their adviser recommends if the client does not have a basic understanding of how individual recommendations contribute to their long-term investment strategy. When clients complain about down markets, the adviser must show adequate due diligence regarding client education. Many advisers will notice an uptick in client calls and emails questioning the status of their investments in down markets. How these calls are handled can quickly translate into either increased client trust in the relationship or client skepticism regarding how their accounts are being managed.

Compliance Preparation for Advisers

When clients call in a panic due to news of market downturns, a prepared adviser will experience lower levels of anxiety resulting from the call as compared to an adviser that is caught off guard. A prepared adviser will generally have three items on hand.

1. Current and recently reviewed Investment Policy Statement - Ideally, the adviser will have a somewhat recent IPS, with the client's signature, that displays the investment strategy, investment methodology, and responsibilities of both the adviser and the client in managing the portfolio.
2. Notes on most recent client communications - The ability to recall the most recent contact and interaction with the client allows the adviser to connect the current market conditions with implementing a long-term strategy that was agreed upon initially.
3. Prepared commentary in response to current market conditions - The opportunity to display knowledge and expertise regarding market conditions can significantly reduce the client’s anxiety during market downturns.

Dealing with Client Complaints

One of the more difficult situations for advisers is dealing with client complaints. Most Written Supervisory Procedures manuals will address the process for complaint handling, but there will remain grey areas to manage anytime a client provides negative feedback. The most common questions to be addressed may include:

• Is the grievance the client is communicating a direct result of negligence on behalf of the adviser, or are there variable factors outside the adviser’s control?
• Has there been an error with the custodian or another third-party that needs to be considered as a part of the investigation?
• Has the adviser executed adequate due diligence in the client complaint?
• Does the complaint have “merit,” or is the client simply voicing frustration about general market conditions or account service timelines and processes?
• Is the client’s complaint regarding a trading or money-movement request, and if so, what other compliance categories need to be addressed in coordination with the complaint resolution process?

The Chief Compliance Officer's responsibility is to investigate client complaints thoroughly, and the questions mentioned above can be a great place to start the investigation. Documenting the responses to these inquiries creates a solid foundation for the rationale behind the method by which the complaint is inevitably resolved.

Suppose a client complains about the performance of their portfolio. In that case, the extent to which the adviser has adequately maintained documentation will directly correlate to the effectiveness of the complaint resolution, both from a compliance and relationship management perspective. Instances in which the adviser can review a recently updated Investment Policy Statement or Risk Tolerance Questionnaire, and the client recalls having checked these items before can, in some cases, reduce a “client complaint” to a “conversation about market volatility.” The maintenance of client profile information (age, time horizon, investment experience, etc.) is equally as important. As long as the client’s portfolio has been managed in accordance with the suitability criteria, the adviser has done due diligence in this area of compliance.

Advisers are not responsible for controlling market volatility. They are only responsible for educating their clients and maintaining documentation to show the suitability of securities recommendations.

Clients voicing their concerns in market downturns don’t necessarily translate into a client complaint. Many Chief Compliance Officers will require both the client’s market commentary and a subsequent failure to maintain books and records evidencing the suitability of recommendations, to classify the client’s comments as a complaint.

[1] https://www.nasdaq.com/articles/recession-or-not-we-could-be-in-the-eye-of-the-storm

[2] https://www.forbes.com/sites/jonathanboyar/2022/06/17/how-to-navigate-the-stock-market-volatility

[3] https://www.bloomberg.com/news/articles/2022-09-18/stocks-set-for-cautious-open-in-key-week-for-fed-markets-wrap

[4] https://www.investopedia.com/fed-raises-rates-75-bp-at-september-2022-meeting-6741920

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