1.When Members and Candidates are in an advisory relationship with a client, they must:
a) make a reasonable inquiry into a client's or prospective client's investment experience, risk and return objectives, and financial constraints prior to making any investment recommendation or taking investment action and must reassess and update this information regularly.
b) determine that an investment is suitable to the client's financial situation and consistent with the client's written objectives, mandates and constraints before making an investment recommendation or taking investment action.
c) judge the suitability of investments in the context of the client's total portfolio.
2.When Members and Candidates are responsible for managing a portfolio according to a specific mandate, strategy or style, they must only make investment recommendations or take investment actions that are consistent with the stated objectives and constraints of the portfolio.
Reasoning behind Standard III-C
On a simple level, most people have the same concept in mind when consulting a financial professional: "make me money". The reality is much more complicated. Countless stories can be told of an inexperienced young stockbroker who assumes everyone is the same and sells every single client and prospect on the prevailing hot idea, only to discover that today's hot idea is tomorrow's idea gone bust. After the bust, the angry client is likely to come back and say, "Hey, I'm getting ready to retire - I really only wanted you to protect what I have, or (more accurately) what I used to have."
The inexperienced stockbroker becomes defensive, and says that it's not at all what the client initially said: "You told me to make you money." This type of exchange, unfortunately, is all too common, and it gives the financial planning business a bad reputation. One of the CFA Institute's missions is to improve the public perception of the investment industry. It has adopted this Standard to reduce the misunderstandings that have often characterized the client-manager relationship in the past.
Of course, it's entirely appropriate for some folks to ask to "play the market" and invest aggressively, and adopt strategies that could pay off huge if, for example, interest rates fall precipitously, or the price of a commodity such as oil increases to a far greater degree than what was expected. Many people are eager to take chances with an account - especially if they are already wealthy and have an additional base of savings, so the potential of a huge loss of principal is no big deal in the big picture. However, for some others, it might be their primary nest egg, and they might be nearing the point when they wish to retire. They may say to a financial consultant, "make me money", since they read about how the market has made millionaires out of average folks just like them. But it's the role of the financial professional to provide a reality check and to cover what is possible and what is not likely and/or excessively risky.
This Standard has several objectives :
1. Learn about Your Client - Everyone is different, with a unique array of circumstances, tolerances and objectives. We cannot approach the client-consultant relationship with the notion that one basic investment strategy is appropriate for everyone. To make a reasonable inquiry means that, starting when the client relationship is being established and before actual investments are made, we first gather the necessary information and ask the necessary questions. It is the responsibility of the consultant to develop such an inquiry; however, questions such as "What does this client require in terms of annual income?" or "What is this client's tolerance for risk?" should be answered easily as a result of this process. This requirement also recognizes that client circumstances invariably change. Learning about your client is not a one-time deal; it's an ongoing exercise. Specific language in the Standard has made this ongoing exercise an ethical requirement.
2. Choose What Is Suitable for Your Client - This objective ties together the formal inquiry into client circumstances with what is actually done in the client's account. For example, an investment advisor might develop a client survey to help discover client objectives and tolerances, but then stick those surveys in some remote filing cabinet and simply give everyone the same portfolio. Fulfilling the purpose of this Standard requires that the actual investments chosen and strategy employed are consistent with the information gathered.
This suitability consideration applies to the total portfolio, not to the individual securities. For example, selling call options is a potentially risky strategy if the underlying stock rallies. However, a covered call strategy, where the underlying stock is already owned when writing calls, mitigates this risk and can serve to enhance income in a stagnant market. An exam question might test whether puts and calls are suitable for a conservative investor - some people will guess "no", but the actual answer is that they may be, depending on the total portfolio.
3.Educate Your Client on the Basics - Now that we've learned about our client and have chosen a suitable strategy based on that information, it's time to present what we're going to do. The most basic principle when rendering this explanation is to distinguish between fact and opinion. For example, if a Treasury note pays a 5% coupon, it's a fact that buying a $10,000 face value will net an annual income of $500. However, if a mutual fund has returned 12% annually for the past 10 years, it's an opinion that the same fund will continue to return 12%.
4. Educate Your Client on the Details - After we cover the basics (e.g. what is fact and what is opinion), the client should be given a summation of the entire process. Are stocks selected based on fundamentals or on quantitative methods? Are changes in strategy made by one person or by a committee? Every detail isn't absolutely required - but in general, the more we practice full disclosure, the better.
Applying Standard III-C
The client/advisor relationship is an ongoing two-way exchange of information. Case studies that apply this Standard will likely examine whether pertinent information was properly exchanged or discussed (full disclosure).
Client to Advisor: Factors in applying suitability include the following:
- Age/Time to Retirement - Generally speaking, an investment strategy should become gradually less aggressive as a client gets older, but time to retirement is also a factor - someone retiring at age 50 would be treated differently than someone who is motivated to work until age 75. Moreover, with life expectancies increasing, clients can live 30-40 years after retiring. Some of their assets must assume a long-term orientation.
- Income Needs - Clients who are drawing meaningful monthly income from an account would probably not want all of it invested in aggressive equity funds. At the same time, an individual with a $1-million account, requiring $50,000 a year, wouldn't necessarily need an average 5% income from the portfolio. It's entirely appropriate to satisfy the withdrawal needs with a combination of current income yield and capital gains.
- Tolerance for Risk - Discussions about previous bad investment experiences and how an investment loss affects a client are absolutely essential.
- Total Net Worth - In cases where a new account is only a 5% to 10% slice of a client's larger financial picture, the approach taken by the advisor can be much different. Given the total picture, what does the client expect from this account? Current income? Aggressive speculation? On the other hand, if the account represents a substantial portion of the client's total savings, an investment plan may need to account for both short-term income and long-term growth, all within the same account.
- Other Unique Factors - For example, given the onerous effect that taxes can have on investment performance, is the degree of tax efficiency a primary consideration to this client? If tax efficiency isn't important (or a complete non-factor for tax-exempt portfolios), the resulting investment approach might change.
Advisor to Client: Appropriate disclosures include the following:
- General Overview of Process - There's no specific formula on what must be covered, as clients have varying degrees of sophistication when it comes to investing, as well as varying ideas of what specifically matters to them. Even for those who care little to discuss the details, some discussion on how investment strategy is developed and the return/risk expectations of a policy is required.
- Major Changes in Process - For example, a change might be necessitated by the growth of the organization. An advisor of small-cap accounts may see growth to the point where market liquidity (ability to move into and out of stocks) is affecting the ability to carry out a previously conceived investment process that favored micro caps (and marketed this process to clients and potential clients). If restricting investments to companies with a market capitalization of $250 million or less is now too narrow and the advisor must expand the range of investments in order to handle the increased asset base, this change in policy would be material. Perhaps the inclusion of companies with a market cap of between $250 million and $500 million is appropriate, or the inclusion of foreign-based stocks is deemed necessary. Whatever is decided, any material change in investment approach could potentially impact a client's decision to retain that manager and must be disseminated prior to implementation.
- Loss of Key Personnel - While the performance record of an investment strategy is the property of the firm, it's also a product of the work of the individual manager who led the development of the process, directed the research, made the investment decisions and so forth. A change in investment personnel can affect the client's decision to affiliate with that firm in the first place, or it can be a nonissue. Either way, the firm is obligated to provide adequate disclosure of key personnel changes. In addition, if the switch in personnel prompts a change in investment approach - for example, from an active strategy to a passive one - the manager may need to modify advisory fees accordingly. A client might be paying a premium fee for a manager's reputation or for the rigor of the research process and should not be required to pay the same premium if he or she is now going to be invested in a mix of passive index funds.
Some examples of the application of standard III(C) follow:
An independent investment advisory was previously an account manager with a hedge fund, with which he still maintains personal and business connections. To attract new clients, the advisor offers below market management fees and provides his new clients with direct access to the hedge fund. The investment advisor puts as many of his new clients in the hedge fund as possible. Standard III(C) has been violated because the risk profile of the hedge fund may not be suitable for every client. Additionally, standard V(A) – Diligence and Reasonable Basis may also have been violated.
Investment Policy Requirements
The chief investment officer (CIO) of a large financial subsidiary wants to improve the diversification and returns of its investment portfolio. The investment policy statement for the subsidiary authorizes highly liquid investments, such as highly rated corporate or government bonds, with a five-year maturity or less. The CIO has discovered an exciting new investment in a private equity fund, which includes a three-year lock-up period but an exit option in stages after that. The CIO invests 4% in the fund, leaving the portfolio well within guidelines for overall equity exposure. The CIO violated both standard III (A) – Loyalty, Prudence and Care, as well as standard III(C).
The fund does not fit the requirements for highly rated, liquid investments. Additionally, the lockup period and laddered exit structure of the fund suggests the investment could last beyond the required maturity limits of no more than five years.
How to Comply
Draft Investment Policy Statement - This is drawn from information contained on a written survey and in the client/advisor interview. The resulting policy statement should include the following ingredients:
- Client Identification - who they are, their age and time horizon, beneficiaries, previous investment experience
- Client Objectives - return expectations, needs for income and growth, tolerance for risk, need to limit downside risk potential and to preserve the initial invested capital
- Portfolio Constraints - current and future expected liquidity needs, regular contributions into account, regular withdrawals out of the account, tax considerations, time horizon, regulatory or legal circumstances, individual preferences and restrictions (no tobacco or gambling stocks, for example), guidance on proxy voting.
- Periodic Review Process - Think of the investment policy statement as the foundation of a relationship that should be ongoing and is expected to evolve over time. An annual review will help establish the benefits of ongoing communication, help identify changing circumstances and facilitate a re-examination of the specific guidelines contained in the investment policy statement. In addition, logging all history of client contact, phone calls and emails initiated and received, issues discussed and changes made as a result will help improve the understanding of the client's unique financial circumstances.
- Suitability Tests - Regulators increasingly are requiring that firms establish suitability tests. Test procedures should be established to include an analysis of the how different investments will impact portfolio diversification, a comparison of investment risks to client risk tolerance, and a test to ensure the investment fits the investment strategy.
Standard III-D: Performance Presentation
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