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Reading 9 - Ethical and Professional Standards Sample

Wanda Brunner, CFA, is reviewing a draft fund prospectus for her new “Leveraged Long Coffee” (LLC), a closed-end fund. LLC uses a of combination fundamental and technical trading models to evaluate individual securities. She notes the LLC prospectus has several disclosures which cause her to worry that prospective clients will avoid her fund.
  • Disclosure 1: “LLC charges a flat 3.00% of assets under management.”
  • Disclosure 2: “LLC may invest up to 40% of the fund’s assets in securities which are not related to coffee or other consumer products.”
  • Disclosure 3: “LLC relies only on fundamental valuation of individual securities.”

Which of the following standards will most likely be violated by distribution of the prospectus?
A)
Standard III(C) Duties to Clients: Suitability because the fees are exorbitant.
B)
Standard III(C) Duties to Clients: Suitability because it misleads the reader as to the process by which securities are selected.
C)
Standard III(C) Duties to Clients: Suitability because the fund can hold an excessive portion of the portfolio in non-core assets.



LLC must adequately disclose the basic security selection and portfolio construction process, and the portfolio manager recommendations and investment actions must be consistent with the stated objectives and constraints of the fund. By failing to acknowledge the fund’s dependence on technical trading, the fund fails to meet this standard.

BlueRock Fund uses a proprietary asset selection model that it believes gives the firm a competitive advantage. The model is applied to a universe of all small-cap domestic equities and all publicly-traded corporate bonds. The asset allocations generated by this model range from +200 percent in small-cap equities/-100 percent in bonds to +200 percent in bonds/-100 percent in small-cap equities. Since the fund can invest in both equities and bonds, it is classified as a balanced fund. In the prospectus BlueRock describes the fund’s investment policy as “a balanced fund, with 50 percent of the assets invested in bonds and 50 percent in equities, on average.” On this basis, BlueRock is:
A)
in violation of CFA Institute Standards concerning the disclosure of security selection and portfolio construction processes.
B)
not in violation of any CFA Institute Standard.
C)
in violation of the CFA Institute Standard concerning Fiduciary Duty.



Clearly, the risk profile of this fund is much different from a typical balanced fund. In fact, it could be effectively described as a hedge fund if +200/-100 allocations are typical. BlueRock is in violation of the Standard concerning disclosure of security selection and portfolio construction processes.

TOP

Adequate investment policy disclosure typically means clearly identifying the policy in:
A)
an annual letter to all fund shareholders.
B)
the prospectus.
C)
the annual report.



Adequate disclosure is typically accomplished by clearly stating the policy in the prospectus.

TOP

A manager of pooled funds must do all of the following to remain in compliance with the Standards EXCEPT:
A)
Disclose basic security selection processes.
B)
Print the investment policy statement in all quarterly reports.
C)
Notify potential investors of any changes in investment policy.



There is no requirement to include the investment policy statement in all quarterly reports.

TOP

An internal audit of Vega Fund has determined that the fund is out of compliance with its investment policy statement as disclosed in the prospectus. Vega should do all of the following EXCEPT:
A)
revise the investment process in order to be consistent with the investment policy statement.
B)
revise the internal audit procedure to allow such occurrences in the future.
C)
seek authorization should it be determined that the investment policy requires alteration.



It would appear that the internal audit procedure has effectively uncovered a compliance violation, and that is an objective of the procedure. Hence, there is no need to revise the internal audit procedure.

TOP

A manager of pooled funds must do all of the following to remain in compliance with the Standards EXCEPT:
A)
seek authorization for any proposed changes.
B)
disclose portfolio construction processes.
C)
seek authorization for any trade that involves more than 1 percent of the fund's assets.



There is no requirement to seek authorization for trades on the basis of size.

TOP

Wanda Brunner, CFA, is preparing for her first meeting with the Johnsons—her firm’s newest clients. She makes notes regarding disclosure of the investment process. These notes most likely include reminders to:
A)
notify her supervisors of any potential change in the security selection and portfolio construction process.
B)
anticipate changes in her clients’ investment objectives that could cause them to leave her firm.
C)
adequately disclose the basic security selection and portfolio construction process.



Wanda should adequately disclose the basic security selection and portfolio construction process. Wanda should generally stick with the stated investment strategy in the IPS, notify clients and prospective clients of any potential change in the security selection and portfolio construction process, and secure documentation of authorization for proposed changes.

TOP

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