A North Dakota-based RIA and its part-owner will pay the Securities and Exchange Commission more than $933,000 for holding client accounts in leveraged exchange traded funds for long periods of time, despite warnings in the funds’ prospectuses about doing just that.
The settled charges against Classic Asset Management and its part-owner and IAR Douglas Schmitz come several months after the SEC’s Examinations Division cited advisors’ recommendations of complex investment vehicles (including leveraged ETFs) as chief areas of focus in gauging whether registrants were dodging fiduciary duties or Regulation Best Interest requirements.
In the order, the commission argued the firm breached its fiduciary duties by misunderstanding the “fundamental characteristics” of the leveraged ETFs and also fell short in monitoring the performance of the ETFs.
Jason J. Burt, director of the SEC’s Regional Office in Denver, said investment advisors’ fiduciary duty to act in their clients’ best interest is “particularly important” when investing their clients in complex products like leveraged ETFs.
"Complex products present unique risks, and investment advisors must ensure that there is a reasonable basis to recommend these products before purchasing them for clients,” he said.
Classic Asset Management is based in Fargo, North Dakota, and has been registered with the SEC since 2006. The firm offers advisory services to individuals, pensions, trusts, estates, charitable organizations and corporations, working with 917 clients with about $150 million in managed assets across 1,891 accounts.
In addition to indirectly owning one-third of Classic Asset Management, Schmitz is an owner and registered rep for Classic, the RIA’s affiliated b/d, according to his BrokerCheck profile.
Starting in January 2017 through the end of 2020, the RIA began holding leveraged ETFs in client accounts. The products’ prospectuses often included warnings about inherent risks, which the commission noted were often included in boldface on the first page of the prospectuses. In some cases, they warned against holding the ETFs longer than one day, with the SEC quoting one such warning.
“For periods longer than a single day, the fund will lose money if the Index’s performance is flat, and it is possible that the fund will lose money even if the level of the Index rises,” the warning read. “Longer holding periods, higher index volatility and greater leverage each exacerbate the impact of compounding on an investor’s returns.”
The prospectuses cautioned advisors purchasing the products to assess the performance of the index often, even daily (which the commission argued Classic and Schmitz failed to do). The firm continued to invest in leveraged ETFs, with clients’ portfolios “often highly concentrated” in the complex products, according to the SEC.
Of the approximately 290 clients Schmitz advised between 2017 and 2020, about 76% included investments in leveraged ETFs, with the complex products making up about 56% of the total market value of client accounts he managed, according to the commission.
During this period, Schmitz held the leveraged ETFs in client accounts for an average of 331 days, with 90% of them held longer than 100 days; less than 1% of them were sold in just one day, as some of the products’ prospectuses advised.
This stasis meant clients suffered “substantial losses” during the period in question, according to the order. The commission argued that neither Schmitz nor the firm had a “reasonable basis” to assume the products were right for clients.
“Despite the language in the prospectuses, Respondents did not fully appreciate the LETFs’ most consequential attributes, including that the LETFs were designed as short-term trading tools and that there were material risks to holding the LETFs in significant amounts for periods considerably longer than recommended by the issuers,” the order read.
Calls to Classic seeking comment were not returned as of publication time.
The firm and Schmitz did not admit or deny the findings, but in addition to the fine, agreed to a cease-and-desist order, as well as censures.
