Standard V
- V Investment Analysis, Recommendations, and Actions
- V(A) Diligence and Reasonable Basis. Members and Candidates must:
Exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions. Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action.
Guidance The application of this Standard depends on the investment philosophy adhered to, members’ and candidates’ roles in the investment decision making process, and the resources and support provided by employers. These factors dictate the degree of diligence, thoroughness of research, and the proper level of investigation required.
Guidance, Reasonable Basis The level of research required to satisfy the requirement for due diligence will differ depending on the product or service offered. A list of some things that should be considered prior to making a recommendation or taking investment action includes:
- Global and national economic conditions.
- A firm’s financial results, operating history, and business cycle stage. Fees and historical results for a mutual fund.
- Limitations of any quantitative models used. A determination of whether peer group comparisons for valuation are appropriate.
Guidance, Using Secondary or Third Party Research
Members should encourage their firms to adopt a policy for periodic review of the quality of third party research, if they have not. Examples of criteria to use in judging quality are:
- Review assumptions used. Determine how rigorous the analysis was.
- Identify how timely the research is. Evaluate objectivity and independence of the recommendations.
Guidance, Using Quantitative Research
Members must be able to explain the basic nature of the quantitative research and how it is used to make investment decisions. Members should consider scenarios outside those typically used to assess downside risk and the time horizon of the data used for model evaluation to ensure that both positive and negative cycle results have been considered.
Guidance, Developing Quantitative Techniques The Standard requires greater diligence of members and candidates who create quantitative techniques than of those who use techniques developed by others. Members and candidates must understand the technical details of the products they offer to clients. A member or candidate who has created a quantitative strategy must test it thoroughly, including extreme scenarios with inputs that fall outside the range of historical data, before offering it to clients.
Guidance, External Advisers
Members should make sure their firms have procedures in place to review any external advisers they use or promote to ensure that, among other things, the advisers:
- Have adequate compliance and internal controls. Present returns information that is correct.
- Do not deviate from their stated strategies.
Guidance, Group Research and Decision Making
Even if a member does not agree with the independent and objective view of the group, he does not necessarily have to decline to be identified with the report, as long as there is a reasonable and adequate basis.
Recommended Procedures for Compliance Members should encourage their firms to consider these policies and procedures supporting this Standard:
- Have a policy requiring that research reports and recommendations have a basis that can be substantiated as reasonable and adequate.
- Have detailed, written guidance for proper research and due diligence. Have measurable criteria for judging the quality of research, and base analyst compensation on such criteria.
- Have written procedures that provide a minimum acceptable level of scenario testing for computer based models and include standards for the range of scenarios, model accuracy over time, and a measure of the sensitivity of cash flows to model assumptions and inputs. Have a policy for evaluating outside providers of information that addresses the reasonableness and accuracy of the information provided and establishes how often the evaluations should be repeated.
- Adopt a set of standards that provides criteria for evaluating external advisers and states how often a review of external advisers will be performed.
Application of Standard V(A) Diligence and Reasonable Basis
Example 1:
Ben Strong, CFA, works in the investment banking department of Martellus, Ltd. The firm is anticipating that the green energy credits enjoyed by some of the firms will shrink. Because the demand for this tax advantaged category is currently high, Strong convinces several companies that they should undertake new equity financings promptly before the credit shrinks.
Strong, however, has limited bandwidth and is unable to provide the due diligence necessary to accurately price these issues. Strong decides to simply apply a multiple to the current level of credits these firms receive, and plans to dive deeper once the workload becomes manageable.
Comment:
Strong should only accept the work that he and his department can handle. By using an ad hoc multiple, Strong has neglected to research all the other relevant aspects that should be considered when pricing new issues, and thus has not performed sufficient due diligence. This lack of basis could result in shares being priced incorrectly.
Example 2:
A member in the corporate finance department of a securities firm prices IPO shares without doing adequate research because she wants to get them to market quickly.
Comment:
This is a violation of Standard V(A).
Example 3:
A member screens a database of investment managers and sends a recommendation of five of them to a client. Subsequently, but before the client receives the report, one of the recommended firms loses its head of research and several key portfolio managers. The member does not update her report.
Comment:
This is a violation as the member should have notified the client of the change in key personnel at the management firm.
Example 4:
A member writes a report in which she estimates mortgage rates. After reviewing it, a majority of the investment committee vote to change the report to reflect a different interest rate forecast. Must the member dissociate herself from the report?
Comment:
The same facts may give rise to different opinions and as long as the committee has a reasonable and adequate basis for their (differing) opinion, the member is under no obligation to ask that her name be removed from the report or to disassociate from issuing the report.
Example 5:
A member makes a presentation for an offering his firm is underwriting, using maximum production levels as his estimate in order to justify the price of the shares he is recommending for purchase.
Comment:
Using the maximum possible production without acknowledging that this is not the expected level of production (or without presenting a range of possible outcomes and their relative probabilities) does not provide a reasonable basis for the purchase recommendation and is a violation of the Standard.
Example 6:
A member posts buy recommendations in an internet chat room based on “conventional wisdom” and what the public is currently buying.
Comment:
A recommendation that is not based on independent and diligent research into the subject company is a violation of the Standard.
Example 7:
A member is a principal in a small investment firm that bases its securities recommendations on third party research that it purchases.
Comment:
This is not a violation as long as the member’s firm periodically checks the purchased research to determine that it has met, and still meets, the criteria of objectivity and reasonableness required by the Standard.
Example 8:
A member selects an outside advisor for international equities based solely on the fact that the selected firm has the lowest fees for managing the international equities accounts.
Comment:
This is a violation of Standard V(A). The member must consider performance and service, not just fees, in selecting an outside advisor for client accounts.
Example 9:
A member investigates the management, fees, track record, and investment strategy of a hedge fund and recommends it to a client who purchases it. The member accurately discloses the risks involved with the investment in the hedge fund. Soon afterward, the fund reports terrible losses and suspends operations.
Comment:
The bad outcome does not mean there has necessarily been a violation of Standard V(A). A member who has performed reasonable due diligence and disclosed investment risks adequately has complied with the requirements of Standard V(A), regardless of the subsequent outcome.
- V(B) Communication with Clients and Prospective Clients. Members and Candidates must:
1. Disclose to clients and prospective clients the nature of the services provided, along with information about the costs to the client associated with those services. 2. Disclose to clients and prospective clients the basic format and general principles of the investment processes they use to analyze investments, select securities, and construct portfolios and must promptly disclose any changes that might materially affect those processes. 3.
Disclose to clients and prospective clients significant limitations and risks associated with the investment process. 4. Use reasonable judgment in identifying which factors are important to their investment analyses, recommendations, or actions and include those factors in communications with clients and prospective clients.
5. Distinguish between fact and opinion in the presentation of investment analysis and recommendations.
Guidance Proper communication with clients is critical to provide quality financial services.
Client facing members and candidates must describe to clients and prospects the nature of the services they are offering and the costs to the clients of those services, both at the initiation of a relationship and on an ongoing basis if the services or their costs change. While the Standard does not require disclosure of specific money amounts (this might not always be possible, as in the case of percentage fees), it does require members and candidates to provide reasonably detailed information about costs, including costs that may arise from using the services of third parties.
Members must distinguish between opinions and facts and always include the basic characteristics of the security being analyzed in a research report.
Members must illustrate to clients and prospects the investment decision making process utilized.
All means of communication are included here, not just research reports.
In preparing recommendations for structured securities, allocation strategies, or any other nontraditional investment, members should communicate those risk factors specific to such investments. In all cases, members should communicate the potential gains and losses on the investment clearly in terms of total returns. Members are required to communicate significant changes in the risk characteristics of an investment or strategy and to update clients regularly about changes in the investment process, including any risks and limitations that have been newly identified.
When using projections from quantitative models and analysis, members may violate the Standard by not explaining the limitations of the model and the assumptions it uses, which provides a context for judging the uncertainty regarding the estimated investment result.
Members and candidates must inform clients about limitations inherent to an investment. Two examples of such limitations are liquidity and capacity. Liquidity refers to the ability to exit an investment readily without experiencing a significant extra cost for doing so.
Capacity refers to an investment vehicle’s ability to absorb additional investment without reducing the returns it is able to achieve.
Recommended Procedures for Compliance
Selection of relevant factors in a report can be a judgment call, so be sure to maintain records indicating the nature of the research, and be able to supply additional information if it is requested by the client or other users of the report.
Application of Standard V(B) Communication with Clients and Prospective Clients
Example 1:
A member sends a report to his investment management firm’s clients describing a strategy his firm offers in terms of the high returns it will generate in the event interest rate volatility decreases. The report does not provide details of the strategy because they are deemed proprietary. The report does not consider the possible returns if interest rate volatility actually increases.
Comment:
This is a violation on two counts. The basic nature of the strategy must be disclosed, including the extent to which leverage is used to generate the high returns when volatility falls. Further, the report must include how the strategy will perform if volatility rises, as well as if it falls.
Example 2:
A member’s firm changes from its old equity selection model, which is based on price- sales ratios, to a new model based on several factors, including future earnings growth rates, but does not inform clients of this change.
Comment:
This is a violation because members must inform their clients of any significant change in their investment process. Here, the introduction of forecast data on earnings growth can be viewed as a significant change because the old single variable model was based on reported rather than forecast data.
Example 3:
A member’s firm, in response to poor results relative to its stated benchmark, decides to structure portfolios to passively track the benchmark and does not inform clients.
Comment:
This is a significant change in the investment process and must be communicated to clients.
Example 4:
At a firm where individual portfolio managers have been responsible for security selection, a new policy is implemented whereby only stocks on an approved list constructed by the firm’s senior managers may be purchased in client accounts. A member who is a portfolio manager does not inform his clients.
Comment:
This is a violation of the Standard because it represents a significant change in the investment process.
Example 5:
A member changes his firm’s outside manager of real estate investments and provides information of this change only in the firm’s annual report where outside advisers are listed.
Comment:
This is a violation of the Standard. The member should notify clients immediately of such a change in the firm’s investment process.
Example 6:
A member discovers that an error in one of his firm’s quantitative models led to a number of trades in one portfolio that should not have been made. The member corrects the error in the model and rebalances the portfolio to reverse the erroneous trades, but does not report the issue.
Comment:
The member violated the Standard by failing to disclose both the error and the corrective action to clients.
Remember, the argument that clients “won’t care” about a process change can be turned around to “there’s no reason not to disclose the change.”
- V(C) Record Retention. Members and Candidates must develop and maintain appropriate records to support their investment analysis, recommendations, actions, and other investment related communications with clients and prospective clients.
Guidance Members must maintain research records that support the reasons for the analyst’s conclusions and any investment actions taken. Such records are the property of the firm. If no other regulatory standards or firm policies are in place, the Standard recommends a 7 year minimum holding period.
All communications with clients through any medium, including emails and text messages, are records that must be retained.
A member who changes firms must recreate the analysis documentation supporting her recommendation using publicly available information or information obtained from the company and must not rely on memory or materials created at her previous firm.
Recommended Procedures for Compliance This recordkeeping requirement generally is the firm’s responsibility.
Application of Standard V(C) Record Retention
Example 1:
A member bases his research reports on interviews, his own analysis, and industry reports from third parties on his industry and related industries.
Comment:
The member must keep records of all the information that went into the research on which his reports and recommendations are based.
Example 2:
When a member leaves a firm at which he has developed a complex trading model, he takes documentation of the model assumptions and how they were derived over time with him because he will use the model at his new firm.
Comment:
Taking these materials without permission from his previous employer is a violation of his duties to his (previous) employer. While he may use knowledge of the model at the new firm, the member must recreate the supporting documents. The originals are the property of the firm where he worked on developing the model.