Reading 2-V: Standards of Professional Conduct & Guidan Investment

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CFA Institute Area 1-2: Ethical and Professional Standards
Session 1: Code of Ethics and Professional Standards
Reading 2-V: Standards of Professional Conduct & Guidance: Investment Analysis, Recommendations, and Action
LOS A.: Diligence and Reasonable Basis.

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An analyst notices that for most years that a given class of assets has an abnormally high rate of return, the asset class often has an abnormally low rate of return the next year. Based upon this information, according to Standard V(A), Diligence and Reasonable Basis, the analyst can recommend:

A) short selling assets that have had a good previous year to all clients.

B) none of these choices.

C) short selling assets that have had a good previous year to clients with a low tolerance for risk.

D) an increased allocation of Treasury bills (T-bills) for all portfolios of assets that have increased dramatically in the previous year.

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Answer and Explanation

An analyst should not make a recommendation based only upon a statistical anomaly. Furthermore, none of the other choices would be appropriate. Clients with low risk tolerance should not short sell assets. The analyst cannot make a recommendation to all clients because each client has different characteristics and portfolios. The one answer that may have some merit is to increase the allocation of T-bills in portfolios that have had recent, dramatic increases. This would be for the purposes of maintaining a balanced portfolio. But the decision to rebalance must be made on a case-by-case basis and not for all portfolios.

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A client calls his money manager and asks the manager to liquidate a large portion of his assets under management for an emergency. The manager warns the client of the risk of selling many assets quickly but says that he will try to get the client the best possible price. This is a violation of:

A) Standard III(C), Suitability.

B) Standard V(B), Communication with Clients and Prospective Clients.

C) none of the Standards listed here.

D) Standard V(A), Diligence and Reasonable Basis.

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Answer and Explanation

The money manager has done his duty. He has warned the client of the risk and made no explicit promises concerning what he can and cannot do.

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An analyst receives a research report from a colleague. The colleagues report has an elaborate table with performance data on publicly traded stocks. The colleague says the data in the table consists of measures provided by Standard & Poors. The analyst finds the table a useful reference for a report she is writing. She uses several pieces of data from the table. The analyst is potentially in violation of:

A) Standard V(A) if she does not first verify the data in the table is accurate.

B) no particular standard because this is appropriate activity.

C) Standard II concerning the obligations to the capital markets.

D) Standard I(C) concerning the use of the work of others.

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Answer and Explanation

Since the data in the table supposedly comes from Standard & Poors, a recognized data source, the analyst does not have to cite the source of the data. However, the analyst needs to use reasonable care and verify that the data is accurate by going back to the source. Had the analyst printed the table prepared by her colleague without acknowledgement, the analyst would have violated Standard I(C), Misrepresentation.

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In the process of recommending an investment, in order to comply with Standard V(A), Diligence and Reasonable Basis, a CFA Institute member must:

A) have a reasonable and adequate basis for the recommendation.

B) do all of these.

C) support a recommendation with appropriate research and investigation.

D) exercise independence and thoroughness.

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Answer and Explanation

All of these are explicitly required by Standard V(A).

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An analyst receives a report from his research department that summarizes and interprets a recent speech from the chairman of the U.S. Federal Reserve. The summary says that the chairman thinks inflation is under control. Based upon this summary, the analyst says in his next newsletter that inflation is under control. This is a violation of:

A) Standard V(A), Diligence and Reasonable Basis, and Standard V(B), Communication with Clients and Prospective Clients.

B) none of the Standards listed here.

C) Standard V(B), Communication with Clients and Prospective Clients, only.

D) Standard V(A), Diligence and Reasonable Basis, only.

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Answer and Explanation

The analyst should verify that the research department has interpreted the chairmans speech correctly. The analyst must make it clear that the statement concerning inflation is only an opinion. No one knows if that is true or not at any point in time. Based upon the given information, we cannot say that the analyst is violating only one standard. The analyst may also be violating plagiarism in accordance with Standard I(C), Misrepresentation. Hence, the answer citing the two standards and not limiting violations to just those two standards is the best answer.

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Susan Plumb is the supervisor of her firms research department. Her firm has been seeking the mandate to underwrite Wings Industries proposed secondary stock offering. Without mentioning that the firm is seeking the mandate, she asks Jack Dawson to analyze Wings common stock and prepare a research report. After reasonable effort, Dawson produces a favorable report on Wings stock. Plumb then adds a footnote describing the underwriting relationship with Wings and disseminates the report to the firms clients. According to CFA Institute Standards of Professional Conduct, these actions are:

A) not a violation of any Standard.

B) a violation of Standard V(A), Diligence and Reasonable Basis.

C) a violation of Standard VI(A), Disclosure of Conflicts.

D) a violation of Standard IV(A), Loyalty to Employer.

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Answer and Explanation

The fact that the firm is seeking the mandate does not preclude the research department from performing analytical work on the security. As long as the final recommendation is based upon reasonable facts, not the desire to obtain the mandate, there is no violation.

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Wes Smith, CFA, works for Advisors, Inc. In order to remain in compliance with Standard V(A), Diligence and Reasonable Basis, Smith may recommend a security in which of the following situations?

A) Smith overhears a highly-regarded analyst from a rival firm recommend that the security is a good investment.

B) Smith reads a favorable review of the security in a widely read periodical.

C) Advisors' research department recommends a stock.

D) For any of the reasons listed here.

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Answer and Explanation

Smith will be in violation if he acts solely on the basis of an opinion of an employee of another firm, since he does not know (or has not confirmed) the factual information that underlies the recommendation. The same can be said about what he read in the periodical. Use of information within the firm can be relied upon unless the Smith has reason to believe the source lacks a sound basis.

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A financial analyst and CFA Institute member sends a preliminary research report on a company to his supervisor. The supervisor approves the report, but then the analyst receives news that causes him to revise downward the earnings estimate of the company. The analyst resubmits the report to the supervisor with the new earnings estimate. The analyst soon finds out that the supervisor plans to release the first version of the report with the first earnings estimate without a reasonable and adequate basis. In response to this the analyst must:

A) only insist that the first report be followed up by a revision.

B) insist that the supervisor change the earnings forecast or remove his (the analyst's) name from the report.

C) only take the issue up with regulatory authorities.

D) both insist that a follow up report be issued and take up the issue with regulatory authorities.

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Answer and Explanation

According to Standard V(A), Diligence and Reasonable Basis, the analyst must exercise diligence, independence, and thoroughness when performing investment analysis, making a recommendation, or taking investment action. The analyst should document the difference in opinion including any request to remove his or her name from the report.

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An analyst writes a report and includes the forecasts of an econometric model developed by the firms research department. The analyst identifies the source of the forecast and includes all the relevant statistics concerning the model and his opinion of the models accuracy. With respect to Standard V(A), Diligence and Reasonable Basis, the analyst has:

A) violated the Standard by including quantitative details in a report.

B) complied with the Standard.

C) violated the Standard by giving his opinion of the accuracy of a model developed by his research department.

D) violated the Standard by not testing the model himself.

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Answer and Explanation

Including quantitative details in a report is not a violation of the Standard. The analyst has more of an obligation to give an opinion on the accuracy of the model than withhold such an opinion. Although the analyst should use reasonable care to verify information included in a report, retesting models developed by the research department of a firm is not explicitly required.