Level 1 CFA® Exam Ethics, Standard III (C)
This lesson is on Standard III (C): Suitability. The standard is quite important because it tells you all about the advisory relationship with a client and the duties that follow, including the Investment Policy Statement creation.
An Investment Policy Statement (IPS) is a document that you will be obliged to create whenever you find yourself in an advisory relationship with a client. The document is a kind of the client’s investment profile description.
You are in an advisory relationship with a client when, for example, you give an investment recommendation to your client or when you act as the manager of the client’s portfolio.
The IPS is a document of high significance both to you and to your client because when in an advisory relationship with a client – you should be able to judge whether a given recommendation or a particular investment action is suitable to your client or not.
Also, remember that your investment advice should be always reasonable, i.e. it should reflect the fine judgment of a prudent person.
Now, how to create the IPS and what exactly will you find in this kind of document?
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Responsibilities of the Client
Full disclosure of any investment-related information on the part of the client is also crucial.
Why?
Let’s assume that you work as a portfolio manager and you have a new client. You find out that the client allocates her assets with a different portfolio manager. The client should inform you about this when you create her IPS. Otherwise, you won’t be able to manage her portfolio with full responsibility for her investments. Not being aware of the other portfolio, you will be able to judge the suitability of investments only for the portfolio that you manage and this may be harmful to the whole financial situation of your client.
Unless you are aware of the existing situation, however, the best you can do is to take care of the bit you are responsible for.
Portfolio Diversification & Risk
When making decisions concerning the suitability of a given investment recommendation or action, apart from the investor’s characteristics also the structure of the portfolio is significant. What it means is that the portfolio should be diversified – it reduces the level of risk associated with investing.
As far as investment risk is concerned, it should be carefully judged by professionals staying in advisory relationships with clients. Some investments, such as those with high leverage or limited liquidity, should be chosen for clients with great prudence.
You consider an investment bearing great risk but also enormous chances of profit for one of your clients. The client has high risk tolerance and the investment is good for the client according to his IPS.
What is the best course of action before you add the investment to the client's portfolio?
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Managing a Fund
As a CFA member or candidate, you may be also responsible for managing a fund, and not an individual client.
Managing a fund often means managing to a specified mandate or index. Then, you have to manage the fund in such a way as to adopt the mandate or index to your decisions. This kind of acting will ensure the suitability of provided services.
Remember, however, that as a fund manager you are not responsible for the suitability of the fund for a particular client. This is the role of the person that remains in the advisory relationship with the client.
- Before you start your work for a client, you are obliged to create his or her investment profile. This profile description is commonly known as an Investment Policy Statement (IPS).
- When advising your clients, you have to take their unique requirements, risk profiles, and any other relevant information into account to give suitable recommendations and take suitable investment actions on behalf of your client.
- As an investment professional you have to be aware of the level of client portfolio diversification and take it into consideration in taking investment actions for your client.
- You will be also obliged to act to a stated investment objective or mandate, which will specifically describe any investment actions that you will be allowed to take.
CFA Exam: Suitability
- KNOWLEDGE ABOUT THE CLIENT: In an advisory relationship with a client, gather information about the client at the start of the relationship. A reasonable inquiry into the clients’ investment experience, risk and return objectives, and financial constraints is – alongside effective investment suitability determination – one of the pillars of a successful adviser/client relationship.
- WITHHELD INFORMATION: If a client withholds relevant information, the suitability analysis may be incomplete (it will be based on the information provided).
- EFFECTIVE SUITABILITY DETERMINATION: First, determine if a given investment is suitable for a client. Then, assess the suitability of the investment in the context of the client's total portfolio.
- RISK PROFILE: When determining the suitability of an investment consider the client’s tolerance for risk. Mind that the same recommendation for comparable clients, e.g., having a similar salary, may not be suitable due to the difference in their risk tolerance and/or additional factors (the client with a larger asset base may have higher risk tolerance). Also, pay attention to risk-related issues such as leverage and limited liquidity!
- ENTIRE PORTFOLIO: Diversification, i.e., combining various investments in a portfolio, is likely to provide a more acceptable level of risk exposure than having all assets in a single investment. The most important aspects of a particular investment are those that affect the characteristics of the total portfolio!
- INVESTMENT STRATEGY: Suitability is not only about the portfolio’s diversification or the client’s assessed risk tolerance. The investment should also fit the required investment strategy (or a specific mandate, if there is one).
- UPDATING THE IPS: Changes in client constraints or expectations may lead to fundamental changes in asset allocation. For an individual client, important changes may include personal tax status, health, liquidity needs, risk tolerance, amount of wealth beyond that represented in the portfolio, or the ability to provide for current income needs.
- ESG: If a preference for incorporating environmental, social, and governance (ESG) issues into the investment process is clearly mandated – incorporate these criteria, which go beyond financial metrics, into the investment decision-making process. The importance of ESG issues may change for the client over time and be different after a while than at the start of the advisory relationship. This is yet another reason for regular updates of the IPS.
- UNSOLICITED TRADE REQUESTS: If a client requests for trades that do not properly align with the risk and return objectives outlined in the client’s IPS and if such trades can have a material impact on the portfolio, mind the following responsibilities:
- make reasonable efforts to balance the request with your responsibility to follow the agreed-on IPS,
- refrain from making the trade until you discuss the concerns with the client,
- educate the client on how the request deviates from his or her IPS,
- make the client understand how the requested trade may affect his or her goals or risk levels as stated in the IPS,
- wait for the client’s approval for executing unsuitable trades (the client should at least acknowledge the discussion and accept the conditions that make the recommendation unsuitable),
- use this opportunity to update the clients’ IPS if this is what you deem prudent.
ADVISORY VS EXECUTIVE: Suitability is a term relevant for the advisory relationship with a client (client/adviser relationship). However, not every relationship with a client is advisory. When simply executing the client’s specific BUY or SELL instructions for securities, e.g., shares in mutual funds, or as a sell-side analyst, you may not have the opportunity to judge the suitability of a particular investment for the ultimate client.