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Ethical and Professional Standards 【Reading 10】Sample

When comparing the fiduciary responsibility under the Prudent Investor Rule (PIR) with that under the Prudent Man Rule (PMR), which of the following is CORRECT? The PIR does:
A)
permit the delegation of investment responsibility to third parties; the PMR does not permit the delegation of investment responsibility to third parties.
B)
permit the delegation of investment responsibility to third parties; the PMR does permit the delegation of investment responsibility to third parties.
C)
not permit the delegation of investment responsibility to third parties; the PMR does permit the delegation of investment responsibility to third parties.



Under the PIR, delegation of investment to third parties is permitted, but this is not allowed under the PMR.

The new Prudent Investor Rule states that the practice of diversification:
A)
is not as important as generating current income.
B)
should not be practiced because it is too costly.
C)
is expected in portfolios as a method of reducing risk.



The new Prudent Investor Rule states that diversification is expected as a method of reducing risk. This contrasts to the old Prudent Man Rule which measured each investment by its own merits and not in the context of the portfolio. Abandoning diversification because of costs is never mentioned, nor is there mention that diversification is mutually exclusive with delegating authority or generating current income.

TOP

Which of the following statements about trustee actions is CORRECT? Trustees must consider:
A)
an investment's risk/reward profile as it relates to the portfolio.
B)
the risk of an investment without regard to its return.
C)
neither the risk nor the return of the portfolio, instead focusing on trading costs.



The new Prudent Investor Rule states that an investment's risk/reward profile must be considered as it relates to the overall risk of the portfolio. Both risk and return must be considered in tandem.

TOP

Which of the following statements is part of the basic principles of the new Prudent Investor Rule?
A)
Excessive trading and fees should be avoided.
B)
Current income for the trust is totally disregarded in favor of growth.
C)
Trustees must consider each investment against its own merits.



Current income must be considered in tandem with the need for growth. Investments in a portfolio should be considered based on the contribution to the portfolio's risk. Diversification is expected to reduce risk.

TOP

With regard to diversification, which of the following statements best summarizes a manager’s fiduciary responsibility under the Prudent Investor Rule (PIR)?
A)
The manager always has a duty to diversify in a way that no more than 5% of the client’s assets are in the securities of a single issuer, with the exception of sovereign debt such as U.S. government securities.
B)
The manager has a duty to diversify client assets unless it is in the client’s best interests not to diversify.
C)
The manager always has a duty to diversify in a way that no more than 5% of the client’s assets are in the securities of a single issuer.



The PIR requires the manager to diversify unless it is in the client’s interest not to diversify. For example, the client may have a small business exposure that he seeks to offset by going short in a set of securities that are concentrated in a specific industry. This would be permissible if the lack of diversification were deemed to be in the best interest of the client.

TOP

Which of the following fiduciary standards is carried over from the old Prudent Man Rule to the new Prudent Investor Rule?
A)
Partiality.
B)
Professionalism.
C)
Loyalty.



Loyalty is the only term listed that is included. Loyalty means the absence of conflicts of interest and acting in the best interest of beneficiaries.

TOP

Xavier Newsome, CFA, serves as trustee for the Block Corporation's trust. Newsome is 31 years old. The trust requires a certain amount of current income to support Mr. Block's widow. After her death, the trust proceeds will go to the Block grandchildren. Newsome is a member of a running club as are several of the Block grandchildren. As part of his duties as trustee, Newsome makes portfolio decisions that favor growth of the principal and puts the current income at risk. Has he violated any fiduciary standards?
A)
No, because he acted impartially.
B)
Yes, because he did not act impartially.
C)
Yes, because he did not use caution.



Newsome was not impartial with respect to the current income beneficiary relative to the remaindermen interests. (Remaindermen refers to the group that is to receive the remainder of the trust once its term is complete. Of course, some trusts never expire so not every trust has remaindermen.) This could also be perceived as a loyalty violation in that he did not act in the best interest of all beneficiaries. Caution deals with the investment decisions of the portfolio.

TOP

The Standard on portfolio investment recommendation and actions requires a degree of diligence and expertise that is closest to the:
A)
Prudence Man Rule.
B)
New Prudent Investor Rule.
C)
Diligent Person Rule.



The Standard requires elements of portfolio theory and expertise that are foundations of the New Prudent Investor Rule.

TOP

When we describe fiduciary duty as being process-oriented and dynamic this means that the fiduciary responsibility will be properly discharged if the manager:
A)
implements a process that views asset risk in isolation and updates these risk estimates on a regular basis.
B)
implements a process that yields returns that are above average on a risk-return basis and updates the process over time.
C)
develops an investment policy statement that is suitable for the client and reviews the client's situation on a regular basis.



Process-oriented means that there is a focus on the investment process, and that this is embodied in an investment policy statement that considers the client’s circumstances and risk-tolerance. Dynamic means that the investment process should change over time to take into account changes in the client’s circumstances. A review of the client’s circumstances is mandated to occur no less frequently than annually–more often if there is a major change in circumstances.

TOP

A given client has specified that her primary concern is preservation of principal. Last year the value of this client’s account has declined by 8%. Which of the following statements is CORRECT?
A)
This constitutes a violation of the manager's fiduciary responsibility only if the manager deviated from a properly constructed investment policy for this account.
B)
This does not constitute a violation of the manager's fiduciary responsibility, regardless of the nature of the investment policy statement for the account.
C)
This constitutes a violation of the manager's fiduciary responsibility regardless of whether the manager deviated from a properly constructed investment policy for this account.



The key concept is that the portfolio investment decision must be process-oriented. The nature of the process is a function of the client’s specific situation and tolerance for risk, and this is embodied in an investment policy statement. So long as the investment policy statement is properly conceived and is adhered to by the manager, there is no violation of fiduciary responsibility.

TOP

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