Level 1 CFA® Exam Ethics, Standard V (A)
This and the next lesson are about Standard V: Investment Analysis, Recommendations, and Actions. Today, we will discuss issues covered by Standard V (A), namely diligence and reasonable basis applied to investment analysis, recommendations, and actions.
The level of diligence and reasonable basis depends on numerous factors including the position and the relation to the client.
The more you are involved in the relationship and the decision made, the greater diligence you should apply to your actions.
Defining Diligence & Reasonable Basis
Diligence = care and thoroughness exercised when providing services to clients
Reasonable care = balanced use of various and appropriate resources, e.g., company reports, third-party research, results from quantitative models, etc.
Making a Recommendation
Before making a recommendation or an analysis:
- you should address all issues connected with the subject of your recommendation or analysis,
- you should also have a reasonable basis that supports your decisions and actions.
To achieve this you should make use of various resources and not base your conclusions on one source of information only. For example:
- you shouldn’t use results obtained using quantitative models only because – as with every method – it has its limitations,
- moreover, you should use current data rather than outdated ones.
By assuming this kind of due diligence and reasonable basis, you will be able to reach thorough conclusions suitable for your clients.
Use current data and different models to support your recommendations and analyses.
Secondary or Third-party Research
Another important thing you have to remember deals with using secondary or third-party research in your work.
The last thing we are going to shortly discuss is group work.
Remember that when you work in a group, it is the whole group that is responsible for final results and decisions.
It is possible that the mutual effort will lead to conclusions that are contrary to your individual opinion. If you feel, however, that the results and decisions are reached through consensus and the whole process is thorough and professional, there is be no need to overtly disagree with the results of work.
Assume that a group of analysts is to provide research on the shares of ABC Company. Maria is a CFA candidate and a member of the group. As the work proceeds, it turns out that there are some conflicting opinions over the analysis of ABC Company shares. Maria does not agree with the analysis included in the report. What should Maria do to remain in compliance with Standard V (A)?
After what we’ve said so far, we know that if an analyst takes part in group research, the conclusions reached may differ from his or her opinion or judgment. What is crucial is whether the analyst believes the conclusions to be well-founded and to have a reasonable and adequate basis.
Thus, if Maria is comfortable with the process of reaching the conclusions of the analysis and she believes the analysis to have an adequate basis, she need not dissociate from the final result even if it doesn’t reflect her opinion.
If, however, this is not the case and, say, the final result has no adequate basis, Maria should demand that her name be excluded from the report.
- The more you are involved in the relationship with your client and the decision made, the greater diligence you should apply to your actions.
- Use current data and different models to support your recommendations and analyses.
- Be careful when using secondary or third-party research in your work.
- When you take part in group research, it’s ok if the conclusions reached differ from your judgment as long as the conclusions are well-founded and have a reasonable and adequate basis.
CFA Exam: Diligence and Reasonable Basis
- KNOWLEDGE: General knowledge (e.g., about a type of stocks), recent news articles, and your wisdom of the markets are not enough to form a reasonable and adequate basis (e.g., when making a stock recommendation). Your investment decisions and actions need to be based on various resources and supported by appropriate research and investigation.
- RESOURCES: The resources you use to make an investment decision or action should be both diverse and appropriate, e.g., for the security under consideration. Diversified resources include company reports, third-party research, and quantitative models.
- SECONDARY or THIRD-PARTY RESEARCH: Depending on the source of the information and data to be used, the required level of your inquiry will differ, e.g., reviewing the accuracy of the information and data from the internet sources vs information and data from established research organizations. You may rely on others in your company to determine whether secondary or third-party research is sound and use the information in good faith unless you have a reason to question its validity or the processes and procedures used by those responsible for the research.
- QUANTITATIVELY ORIENTED RESEARCH MODELS: The understanding of the parameters used in a model as well as the assumptions and limitations inherent in such a model and how they may affect the output results is crucial. The output of used investment models should be tested and the possible positive and negative scenarios for analysis should include factors that are likely to have a substantial influence on the investment value, e.g., you need to understand the limitations of the model in case of a limited available historical information or the inaccurate predictions it can render about the fund performance if market conditions change negatively.
- NEW QUANTITATIVE MODELS: Being responsible for creating new quantitative products and services is linked with even a higher level of diligence compared to the individuals who ultimately use the analytical output, e.g., if your model gives investment recommendations – you are accountable for the quality of those recommendations. The new models should be thoroughly reviewed and tested prior to product distribution.
- EXTERNAL ADVISERS: When selecting an external adviser (or subadviser) to manage, e.g., a specifically mandated allocation, a proper solicitation must be conducted to select the most appropriate adviser. Such selection should be based on a full and complete review of the adviser’s services, performance history, and cost structure (it cannot be based on the fee alone).
- SUFFICIENT EFFORT: A thorough investigation and verification of the companies and their operations should be conducted, e.g., before their stock is added to the client’s portfolio – to make sure it increases the portfolio’s diversity.