Cracking Standard III: Duties to Clients | CFA Level I Ethics
Today we’re tackling Standard III: Duties to Clients, focusing on sections 3C (Suitability), 3D (Performance Presentation), and 3E (Preservation of Confidentiality).
3C. Suitability
Standard III(C) comes in two flavours: one for those in an advisory relationship with clients and another for fund managers managing pooled investments like index funds and mutual funds. Let’s break it down!
1. Advisory Relationship
As an investment advisor, follow these steps to build a suitable portfolio for your client:
- Understand your client’s investment background and knowledge.
- Determine their return objectives and risk tolerance.
- Establish portfolio constraints, considering time horizon, tax exposure, liquidity needs, legal constraints, and unique circumstances.
Remember the acronym RRTTLLU to help you recall these points. Document these findings in an Investment Policy Statement (IPS), which guides your decision-making and explains your investment rationale to the client. Update the IPS annually or before any material changes to the portfolio.
When assessing the suitability of an investment, consider both the IPS and the investment’s impact on the client’s total portfolio. Diversification is key! Don’t forget about unsolicited trade requests – follow the appropriate steps to ensure they’re compatible with the client’s IPS and overall portfolio.
2. Fund Managers
For fund managers, the focus is on ensuring investment recommendations and actions align with the stated objectives and constraints of the portfolio. For example, a large-cap income fund manager shouldn’t invest heavily in small-cap companies, even if it might improve the fund’s performance.
Application (Investment Suitability—Life Changes):
Morgan Adams, an investment adviser, has a long-term client named Emma Johnson. Emma recently went through a divorce and her financial circumstances have changed significantly. However, Morgan continues to maintain the same investment strategy for Emma that was in place before her divorce.
Comment: Morgan is violating Standard III(C) by not reassessing Emma’s financial situation after her divorce. As an investment adviser, Morgan should recognize that the change in Emma’s circumstances warrants a reevaluation of her investment strategy to ensure it remains suitable for her current needs and goals.
Application (Fund Management—Consistency with Fund Objectives):
Sophia Rodriguez manages a conservative income-focused mutual fund that primarily invests in high-quality bonds and dividend-paying stocks. She learns about an exciting new technology startup that has the potential for rapid growth but is highly speculative and does not pay dividends. Despite the inconsistency with the fund’s objectives, Sophia decides to invest a portion of the fund’s assets in the startup.
Comment: Sophia is violating Standard III(C) by investing in an asset that does not align with the fund’s objectives and risk profile. As a fund manager, Sophia must ensure that the investments she makes are consistent with the fund’s stated objectives and risk profile, which in this case focus on conservative income generation. By investing in a speculative, non-dividend paying startup, Sophia is disregarding the interests of her fund’s investors and their expectations for a conservative income-focused investment strategy.
3D. Performance Presentation
When presenting investment performance information, ensure it’s fair, accurate, and complete. Avoid misstating performance or misleading clients about your or your firm’s investment performance. Provide full disclosure of investment performance data to clients and potential clients.
Remember, past performance doesn’t guarantee future results – don’t imply that clients will earn similar returns. If you have limited time to present, be transparent about the limited information provided and offer detailed information upon request.
Compliance with Global Investment Performance Standards (GIPS) isn’t mandatory, but it’s a recommendation. If you choose not to adopt GIPS, follow these guidelines to ensure compliance with Standard III(D):
- Consider your audience’s knowledge and sophistication.
- Present the performance of a weighted composite of similar portfolios.
- Include terminated accounts in performance history, with clear termination dates.
- Disclose all relevant information, such as model results and gross/net returns.
Application (Transparent Performance Presentation and Benchmark Comparison):
Jane Wilson, a portfolio manager at Stellar Wealth Management, manages a mid-cap value fund. In her performance presentation to prospective clients, she compares the fund’s returns to both the S&P MidCap 400 Value Index and the Russell Midcap Value Index, which are appropriate benchmarks for her fund. Jane clearly discloses the time periods covered by the performance data, her role in managing the fund, and any significant changes in the fund’s strategy or management during the reported time periods.
Comment: Jane is not violating Standard III(D) as she is providing a fair, accurate, and complete representation of the fund’s performance. By comparing the fund’s returns to appropriate benchmarks, disclosing relevant information about the performance data, and being transparent about her role and any significant changes, Jane ensures that prospective clients receive accurate and complete information to make informed decisions about investing in her fund.
Application (Performance Presentation after Portfolio Manager Change):
David Thompson recently took over the management of a large-cap equity fund at Alpha Capital. The fund has had a strong track record under the previous manager for the past ten years. In his performance presentation to potential clients, David showcases the fund’s impressive ten-year track record without disclosing that he has only been managing the fund for the past six months and that the majority of the performance was achieved under the previous manager.
Comment: David is violating Standard III(D) by not providing a complete and accurate representation of the fund’s performance. He must disclose that the majority of the past performance was achieved under the previous manager and that he has only recently taken over the management of the fund. By not providing this information, David is potentially misleading potential clients about his own abilities and the continuity of the fund’s performance.
Standard 3E: Preservation of Confidentiality
Protect the confidentiality of current, former, and prospective clients’ information, unless:
- It concerns illegal activities.
- Disclosure is required by law.
- The client permits disclosure.
Keep electronic client data secure and up-to-date, and follow legal and company requirements regarding information disclosure. Consult compliance personnel or legal counsel if in doubt. Note that you’re not legally required to divulge confidential information for a CFA Institute Professional Conduct Program investigation, but you won’t be violating Standard 3E if you choose to do so. Always respect client confidentiality, even if the client relationship has ended.
Application (Confidentiality Breach and Remediation):
Peter Thompson, an investment analyst at BlueSky Investments, accidentally sends an email containing confidential information about one of his clients, Mary Johnson, to another client, Mark Wilson. Upon realizing his mistake, Peter immediately contacts both Mark and Mary, apologizes for the breach, and asks Mark to delete the email without reading or sharing its contents. Peter also informs his supervisor about the incident and works with the company’s compliance department to implement stricter email controls and additional employee training on maintaining client confidentiality.
Comment: Although Peter inadvertently breached Standard III(E) by accidentally disclosing confidential information, he took prompt and appropriate steps to mitigate the situation. By acknowledging the mistake, apologizing, and requesting the deletion of the email, Peter demonstrated his commitment to client confidentiality. Moreover, by reporting the incident and working on preventive measures, he shows a proactive approach to avoiding similar breaches in the future.
Wrapping Up
And there you have it – Standard III: Duties to Clients, covered in a nutshell. This is a crucial topic, so be sure to read through the case studies in the curriculum text. Now, you’re one step closer to mastering CFA Level I Ethics. See you at Standard IV!
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