Ethics and Standards - Standard V-A: Diligence And Reasonable Basis

Standard V has three subsections:

  • Standard V-A: Diligence and Reasonable Basis
  • Standard V-B: Communication with Clients and Prospective Clients
  • Standard V-C: Record Retention

Standard V-A: Diligence and Reasonable Basis_____________

Members and Candidates must:

1. Exercise diligence, independence and thoroughness in analyzing investments, making investment recommendations and taking investment actions.

2. Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation or action.

Reasoning behind Standard V-A
It's an all–too-common practice for a participant in the investment industry to pass a "hot stock tip" onto clients. While some professional practitioners will research and investigate such ideas before recommending them to clients, many others simply pass along that information as a way of keeping in contact with clients who have a high net worth and prompting additional trading action (on which the broker collects commissions). For the creators of the Standards of Professional Conduct of the CFA Institute, Standard V-A, Diligence and Reasonable Basis, is designed to reduce and eliminate such practices. Moreover, and partly as a result of the Standards promoted by the CFA Institute and other regulatory bodies, the investing process is much more highly developed today when compared to the Standards from years ago. The specific techniques and methods developed to practice investment research have been encouraging to those who believe that such analysis leads to better recommendations and better performance for clients.

To be sure, hot stock tips still have their proponents and practitioners – just watch any cable channel devoted to financial and business news. For most of us, there's some intrigue to playing "buy, sell or hold" on one of these programs and asking a leading analyst for a 30-second soundbite on a company. The internet chat rooms that provide a forum for discussion among day traders will continue to proliferate, and in the case of some sectors (usually small caps and IPOs, usually technology), these forums can offer immediate ideas for a portfolio manager. The basic premise of this Standard is that the market has always been filled with ideas that can be acted upon immediately. An idea is not the same as a recommendation – it takes a process to go from idea to recommendation.

This Standard recognizes that many investment professionals are not directly involved in the investment process. Perhaps they are primarily involved in the client relationship effort, and within that client relationship, specific portfolio transactions are recommended.

To avoid a violation, professionals' recommendations should be based on:

  • their own firm's research
  • another person's research, where conclusions are based on research complying with this Standard (diligence, thoroughness)
  • research prepared for general distribution by a bank or brokerage
  • quantitative methods, such as computer stock screens or ranking models based on fundamental criteria

Key Points to Remember about Standard V-A

  • Exercise diligence in investigating the accuracy of a research report being used as the basis for a recommendation. The market is filled with worthwhile research and with substandard research – years of experience are needed to learn to distinguish between the two. Quantitative conclusions are usually predicated on the quality of the data and the size of the sample, while fundamental research will vary depending on the methodology of the individual writing the report.
  • For recommendations to buy or sell foreign securities, consider the differences between foreign and domestic standards. Particularly in emerging markets, the extent of corporate disclosure can be minimal, and accounting standards are often rudimentary, with typical ratios such as debt level and net profit margin being difficult to compare to an industry peer in a domestic market. Moreover, securities regulations do not serve to protect the investor to the same extent as in mature markets. Liquidity can be sparse, and currency fluctuations can affect performance.

Applying Standard V-A

  • Be sensitive to business considerations. If the need to diligently research and gather information to investigate a company conflicts with an ongoing business relationship with that firm, an analyst may need to balance those conflicting responsibilities, and (if necessary) point out where necessary information could not be obtained.
  • Is the research using a best-case scenario in a business situation as if it were the average or expected scenario? This is a common technique to justify a buy recommendation, but it essentially violates the misrepresentation tenet of the Standard. Research is considered higher quality when it presents a range of possible scenarios.
  • Recommendations disseminated in internet chat rooms or on cable TV shout-fests are not considered compliant with this Standard. CFA charterholders are not precluded from participating in such forums, but the nature of this Standard is to require diligence and thoroughness and to require records to be created and retained. Moreover, it is difficult to fact-check this information to verify misrepresentations.

How to Comply
To summarize, the following areas should be the primary focus:

  • The Security - Each research process is likely to be unique, but whatever the particular basis for a specific recommendation might be, it should generally be consistently applied to the company's history of recommendations. Many research shops employ a general template of information that is always to be included with a recommendation (e.g. a summary of specific business factors, important financial statistics and ratios) to help guide compliance and ensure that the analyst employs a consistently diligent effort.
  • The Portfolio - Is this security (and its expected level of risk) appropriate for all portfolios, or is it too risky for some, or perhaps not aggressive enough for others? CFA charterholders and candidates are obligated to examine the needs and circumstances of the clients on an ongoing basis, not just when the account opens. Portfolio theory emphasizes the need to diversify as a tool for reducing risk; thus any approach that concentrates a portfolio in just a couple of investments may not be in compliance.
  • The Records - The importance of maintaining a complete track record of reasons for investment decisions is reinforced by the need to make this requirement a separate Standard in the revised list that becomes effective in 2006 (please refer to Standard V–C). Files can establish a paper trail and help protect the manager from accusations that a certain security (should it turn out badly) was not bought with an adequate basis and rationale.
Standard V-B: Communication With Clients And Prospective Clients
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