Investment Analysis, Recommendations, and Actions | CFA Level I Ethics
We’re about to dive into another important standard for CFA Level I Ethics – Investment Analysis, Recommendations, and Actions. We’ll explore the three sub-items: Diligence and Reasonable Basis, Communication With Clients and Prospective Clients, and Record Retention.
5A. Diligence and Reasonable Basis
Managing a client’s portfolio involves analyzing potential investments, determining if they’re suitable for the client, and acting on the client’s decision. Standard 5A focuses on diligence and reasonable basis in these three stages.
Key points:
- Members and candidates must exercise diligence, independence, and thoroughness in analyzing investments, making recommendations, and taking investment actions.
- A reasonable and adequate basis, supported by appropriate research, is required for any investment analysis, recommendation, or action.
- Ensure accurate and appropriate quantitative models are used and tested under multiple market scenarios.
- Review external advisers and sub-advisors rigorously, and evaluate secondary or third-party research for soundness.
For example, you shouldn’t recommend an investment simply because a colleague recommended it. Instead, examine the investment’s attributes and consider if it meets your client’s needs.
Application (Proper Evaluation of Investment Options):
Jane Smith, a junior investment analyst at XYZ Investments, is responsible for conducting research on potential investment opportunities in the renewable energy sector. She has identified two companies, GreenTech and EcoPower, as potential investments for her firm’s clients. Instead of relying solely on recent news articles or market sentiment, Jane thoroughly investigates each company’s financial statements, management team, and competitive position within the industry. She also consults with industry experts and evaluates the potential regulatory changes that could impact the sector. After completing her research, Jane provides a detailed report to her team, recommending GreenTech as the better investment option based on her findings.
Comment: Jane has adhered to Standard V(A) by conducting a thorough investigation and developing a reasonable basis for her recommendation. She has performed proper due diligence by analyzing multiple aspects of the companies, consulting with experts, and considering potential regulatory changes that may impact the renewable energy sector.
Application (Using Multiple Sources for Analysis):
Michael Brown is an equity analyst at a small investment management firm. He is assigned to conduct research on the pharmaceutical industry and identify potential investment opportunities. Michael starts his research by reviewing the latest financial reports and industry publications. He also attends industry conferences, where he listens to presentations from various pharmaceutical companies and speaks with industry experts. Additionally, he considers factors such as the pipeline of new drugs, regulatory approvals, and potential patent expirations. By combining insights from multiple sources, Michael is able to develop a comprehensive understanding of the industry and make well-informed investment recommendations.
Comment: Michael has complied with Standard V(A) by utilizing multiple sources of information to develop a reasonable basis for his investment recommendations. He has conducted sufficient due diligence by reviewing financial reports, attending industry conferences, and considering a range of factors that may impact the pharmaceutical industry. This approach ensures that his investment recommendations are based on a thorough analysis of the industry and its prospects.
5B. Communication With Clients and Prospective Clients
Standard 5B covers all types of communication with clients, from research reports and social media posts to phone conversations and presentations.
Key points:
- Disclose the basic format and general principles of investment processes without revealing specific strategies or proprietary models.
- Promptly disclose any changes in the investment process, including newly identified risks and limitations.
- Use reasonable judgment in identifying factors important to investment analyses and include them in communications.
- Distinguish between fact and opinion in investment analyses and recommendations.
Remember, expectations based on statistical modeling and analysis are not facts. Be sure to clarify that your opinions are, in fact, opinions and not statements of fact.
Application (Transparent Fee Structure):
John Stevens is a financial advisor at Wealth Management Solutions, a firm that offers investment advice and portfolio management services. When onboarding new clients, John explains the firm’s investment approach and management fees in detail. However, he fails to mention that the firm receives a commission from certain mutual funds for recommending them to clients. This commission might influence the firm’s recommendations, potentially leading to conflicts of interest.
Comment: John has violated Standard V(B) by not disclosing the commission-based incentives that could influence the firm’s investment recommendations. To comply with Standard V(B), John should fully disclose the fee structure and any potential conflicts of interest to ensure clients have a comprehensive understanding of how the firm operates and makes investment recommendations.
Application (Changes in Risk Profile):
Laura Adams is a portfolio manager at a boutique investment firm that specializes in managing portfolios for high net worth individuals. One of her clients, Emily, has recently retired and expressed concerns about preserving her wealth. Laura decides to adjust Emily’s portfolio to reduce risk, transitioning from a more aggressive growth strategy to a conservative income-generating approach. However, Laura does not communicate this change to Emily, believing that it is in her best interest to preserve her wealth.
Comment: Laura has violated Standard V(B) by not informing her client about the changes made to her portfolio and the corresponding shift in risk profile. As a portfolio manager, Laura should communicate any significant changes in investment strategy or risk profile to her clients, ensuring they are informed and able to make educated decisions about their investments. To comply with Standard V(B), Laura should promptly disclose the changes made to Emily’s portfolio and explain the rationale behind them.
5C. Record Retention
Finally, Standard 5C requires members and candidates to maintain appropriate records to support investment analyses, recommendations, actions, and other investment-related communications.
Key points:
- Develop and maintain appropriate records in physical or electronic form, including emails, text messages, blog posts, and social media posts.
- Retain materials used in analysis to substantiate your basis of recommendation, such as interview notes, computer-based model outputs, and third-party research papers.
- Records are the property of the firm, and you cannot take them with you when you leave without permission.
Application (Maintaining Client Communication Records):
Samantha Clark is a financial advisor at a wealth management firm. She regularly communicates with her clients through phone calls, emails, and in-person meetings to discuss their investment objectives and provide updates on their portfolios. However, Samantha does not consistently document these communications, believing her memory is sufficient to recall any important details.
Comment: Samantha’s failure to maintain records of her client communications violates Standard V(C). To comply with this standard, she should systematically document all relevant client interactions, including notes from phone calls, copies of email correspondence, and summaries of in-person meetings. These records will not only help her in providing accurate and consistent advice but also protect her and her firm in case of any disputes or misunderstandings.
That wraps up Standard 5! Be sure to read through case studies in the curriculum, as there’s a lot of testable material here. See you at Standard 6, where we’ll discuss conflicts of interest!
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