V.B: INV. ANALYSIS, REC & ACTION - Communications with Clients and Prospective Clients
Informing Clients of the INVESTMENT PROCESS:
1. MUST adequately describe to CLIENTS and PROSPECTIVE clients the MANNER in which the member conducts the inv. decision-making process. 2. MUST keep clients and other interested parties INFORMED on an ongoing basis about CHANGES to the inv. process. 3. Understanding the basic characteristics of an investment is of great importance in judging the suitability of that investment on a stand-alone basis, but it is especially important in determining THE IMPACT each investment will have on the characteristics of a portfolio. 4. A firm's INVESTMENT POLICY may include the use of OUTSIDE ADVISORS to manage various portions of the clients' assets under management. 5. SHOULD inform about the SPECIALIZATION or DIVERSIFICATION expertise provided by the EXTERNAL ADVISORS(s)
Distinction between FACT and OPINION in Reports
1. OPINION MUST be separated from FACT. 2. Violations often occur when reports FAIL to separate the PAST from the FUTURE by not indicating that earnings estimates, changes in the outlook for dividends, and/or future market price information are OPINIONS subject to future circumstances. 3. In the case of complex quantitative analyses, analysts MUST clearly separate FACT from STATISTICAL conjecture and should identify the KNOWN LIMITATIONS of an analysis. 4. LIMITS of statistically developed projections, because this omission leaves readers unaware of the limits of the published projections.
QUESTION 10 Scott works for a regional brokerage firm. He estimates that Walkton Industries will increase its dividend by US$1.50 a share during the next year. He realizes that this increase is contingent on pending legislation that would, if enacted, give Walkton a substantial tax break. The US representative for Walkton's home district has told Scott that, although she is lobbying hard for the bill and prospects for its passage are favorable, concern of the US Congress over the federal deficit could cause the tax bill to be voted down. Walkton Industries has not made any statements about a change in dividend policy. Scott writes in his research report, "We expect Walkton's stock price to rise by at least US$8.00 a share by the end of the year because the dividend will increase by US$1.50 a share. Investors buying the stock at the current time should expect to realize a total return of at least 15% on the stock." According to the Standards: A. Scott violated the Standards because he used material inside information. B. Scott violated the Standards because he failed to separate opinion from fact. C. Scott violated the Standards by basing his research on uncertain predictions of future government action.
10. The correct answer is B. This question relates to Standard V(B)-Communication with Clients and Prospective Clients. Scott has issued a research report stating that he expects the price of Walkton Industries stock to rise by US$8 a share "because the dividend will increase" by US$1.50 per share. He has made this statement knowing that the dividend will increase only if Congress enacts certain legislation, an uncertain prospect. By stating that the dividend will increase, Scott failed to separate fact from opinion.
QUESTION 57
57. C is correct. In the months following Brown's change in financial status, Klein is least likely to violate Standard V(B) relating to communication with clients because he disclosed the basic format and other pertinent information regarding PlusAccounts and he distinguished between fact and opinions. During the time period, Klein does not make any new recommendations to Brown and thus is least likely to violate the Standard relating to Communication with Clients and Prospective Clients. During the period, Klein is in jeopardy of violating several other standards including those relating to Loyalty, Prudence, and Care; Suitability; and Diligence and Reasonable Basis. Because of the fee structure, PlusAccount status is not suitable for a client who trades infrequently. Klein neglects his duty of loyalty, prudence, and care by maintaining the PlusAccount Status for more than one year after Brown's change in trading activity. A diligent review of the account would indicate whether a client has a reasonable basis for maintaining PlusAccount status. Thus, Klein is most likely to violate Standards III(A), III(C), and V(A) during the period in question.
QUESTION 59
59. A is correct. Vinken does not violate any CFA Standards of Professional Conduct in his letter. In accordance with Standard III(D)—Performance Presentation, he presents fair, accurate, and complete information when he identifies actual and simulated performance results. Also in accordance with the Standard, he does not guarantee superior future investment returns. In accordance with Standard V(B)—Communication with Clients and Prospective Clients, Vinken describes to his clients and prospective clients the process and logic of the new investment model. By providing the basic details of the model, Vinken provides his clients the basis for understanding the limitations or inherent risks of the investment strategy.
QUESTION 62
62. B is correct. Standard V(B)—Communication with Clients and Prospective Clients requires the member or candidate to separate and distinguish "facts from opinions" in the presentation of analyses and investment recommendations. Statement 1 in the newsletter states that "China's pegging of the yuan to the US dollar will end within the next 12 months which will lead to the yuan increasing in value by more than 40%, supporting our over-weighting of Chinese-related stocks in the portfolio." Khadri does not clearly differentiate between opinion and fact. The statement about the future of oil pricing is not as questionable because Khadri uses the term "should" which helps clients understand that this is an opinion and not a certainty. Members may communicate opinions, estimates, and assumptions about future values and possible events but they must take care to differentiate fact from opinion.
Guidance (2)
Clear, frequent, and thorough communication practices is critical to providing high-quality financial services to clients. 1. Should communicate in a rec. the FACTORS that were INSTRUMENTAL in making the inv. rec. 2. A critical part of this requirement is to distinguish clearly between OPINION and FACTS. 3. In preparing a research report, MUST present the basic characteristics of the security being analyzed, which will allow the reader to evaluate the report and incorporate info the reader deems relevant to his inv. decision-making process. 4. In preparing a recommendation about, for example, an ASSET ALLOCATION strategy, alternative investment vehicle, or structured investment product, the member SHOULD include FACTORS that are relevant to whatever ASSET CLASS are being discussed. 5. In all cases, the UPSIDE POTENTIAL & DOWNSIDE risk expressed in terms of EXPECTED TOTAL RETURNS SHOULD be among the factors communicated.
Example 1 (Sufficient Disclosure of Investment System): Sarah Williamson, director of marketing for Country Technicians, Inc., is convinced that she has found the perfect formula for increasing Country Technicians' income and diversifying its product base. Williamson plans to build on Country Technicians' reputation as a leading money manager by marketing an exclusive and expensive investment advice letter to high-net-worth individuals. One hitch in the plan is the complexity of Country Technicians' investment system—a combination of technical trading rules (based on historical price and volume fluctuations) and portfolio construction rules designed to minimize risk. To simplify the newsletter, she decides to include only each week's top five "buy" and "sell" recommendations and to leave out details of the valuation models and the portfolio structuring scheme.
Comment: Williamson's plans for the newsletter violate Standard V(B). Williamson need not describe the investment system in detail in order to implement the advice effectively, but she must inform clients of Country Technicians' basic process and logic. Without understanding the basis for a recommendation, clients cannot possibly understand its limitations or its inherent risks.
Example 4 (Notification of Fund Mandate Change): May & Associates is an aggressive growth manager that has represented itself since its inception as a specialist at investing in small-cap US stocks. One of May's selection criteria is a maximum capitalization of US$250 million for any given company. After a string of successful years of superior performance relative to its peers, May has expanded its client base significantly, to the point at which assets under management now exceed US$3 billion. For liquidity purposes, May's chief investment officer (CIO) decides to lift the maximum permissible market-cap ceiling to US$500 million and change the firm's sales and marketing literature accordingly to inform prospective clients and third-party consultants.
Comment: Although May's CIO is correct about informing potentially interested parties as to the change in investment process, he must also notify May's existing clients. Among the latter group might be a number of clients who not only retained May as a small-cap manager but also retained mid-cap and large-cap specialists in a multiple-manager approach. Such clients could regard May's change of criteria as a style change that distorts their overall asset allocations.
Example 6 (Notification of Changes to the Investment Process): RJZ Capital Management is an active value-style equity manager that selects stocks by using a combination of four multifactor models. The firm has found favorable results when back testing the most recent 10 years of available market data in a new dividend discount model (DDM) designed by the firm. This model is based on projected inflation rates, earnings growth rates, and interest rates. The president of RJZ decides to replace its simple model that uses price to trailing 12-month earnings with the new DDM.
Comment: Because the introduction of a new and different valuation model represents a material change in the investment process, RJZ's president must communicate the change to the firm's clients. RJZ is moving away from a model based on hard data toward a new model that is at least partly dependent on the firm's forecasting skills. Clients would likely view such a model as a significant change rather than a mere refinement of RJZ's process.
Example 7 (Notification of Changes to the Investment Process): RJZ Capital Management loses the chief architect of its multifactor valuation system. Without informing its clients, the president of RJZ decides to redirect the firm's talents and resources toward developing a product for passive equity management—a product that will emulate the performance of a major market index.
Comment: By failing to disclose to clients a substantial change to its investment process, the president of RJZ has violated Standard V(B).
Example 2 (Providing Opinions as Facts): Richard Dox is a mining analyst for East Bank Securities. He has just finished his report on Boisy Bay Minerals. Included in his report is his own assessment of the geological extent of mineral reserves likely to be found on the company's land. Dox completed this calculation on the basis of the core samples from the company's latest drilling. According to Dox's calculations, the company has more than 500,000 ounces of gold on the property. Dox concludes his research report as follows: "Based on the fact that the company has 500,000 ounces of gold to be mined, I recommend a strong BUY."
Comment: If Dox issues the report as written, he will violate Standard V(B). His calculation of the total gold reserves for the property based on the company's recent sample drilling is a quantitative opinion, not a fact. Opinion must be distinguished from fact in research reports.
Example 8 (Notification of Changes to the Investment Process): At Fundamental Asset Management, Inc., the responsibility for selecting stocks for addition to the firm's "approved" list has just shifted from individual security analysts to a committee consisting of the research director and three senior portfolio managers. Eleanor Morales, a portfolio manager with Fundamental Asset Management, thinks this change is not important enough to communicate to her clients.
Comment: Morales must disclose the process change to all her clients. Some of Fundamental's clients might be concerned about the morale and motivation among the firm's best research analysts after such a change. Moreover, clients might challenge the stock-picking track record of the portfolio managers and might even want to monitor the situation closely.
Example 10 (Notification of Changes to the Investment Process): Michael Papis is the chief investment officer of his state's retirement fund. The fund has always used outside advisers for the real estate allocation, and this information is clearly presented in all fund communications. Thomas Nagle, a recognized sell-side research analyst and Papis's business school classmate, recently left the investment bank he worked for to start his own asset management firm, Accessible Real Estate. Nagle is trying to build his assets under management and contacts Papis about gaining some of the retirement fund's allocation. In the previous few years, the performance of the retirement fund's real estate investments was in line with the fund's benchmark but was not extraordinary. Papis decides to help out his old friend and also to seek better returns by moving the real estate allocation to Accessible. The only notice of the change in adviser appears in the next annual report in the listing of associated advisers.
Comment: Papis has violated Standard V(B). He attempted to hide the nature of his decision to change external managers by making only a limited disclosure. The plan recipients and the fund's trustees need to be aware when changes are made to ensure that operational procedures are being followed. See also Standard IV(C)-Responsibilities of Supervisors, Standard V(A)-Diligence and Reasonable Basis, and Standard VI(A)-Disclosure of Conflicts.
Example 13 (Notification of Risks and Limitations): Brickell Advisers offers investment advisory services mainly to South American clients. Julietta Ramon, a risk analyst at Brickell, describes to clients how the firm uses value at risk (VaR) analysis to track the risk of its strategies. Ramon assures clients that calculating a VaR at a 99% confidence level, using a 20-day holding period, and applying a methodology based on an ex ante Monte Carlo simulation is extremely effective. The firm has never had losses greater than those predicted by this VaR analysis.
Comment: Ramon has not sufficiently communicated the risks associated with the investment process to satisfy the requirements of Standard V(B). The losses predicted by a VaR analysis depend greatly on the inputs used in the model. The size and probability of losses can differ significantly from what an individual model predicts. Ramon must disclose how the inputs were selected and the potential limitations and risks associated with the investment strategy.
Example 14 (Notification of Risks and Limitations): Lily Smith attended an industry conference and noticed that John Baker, an investment manager with Baker Associates, attracted a great deal of attention from the conference participants. On the basis of her knowledge of Baker's reputation and the interest he received at the conference, Smith recommends adding Baker Associates to the approved manager platform. Her recommendation to the approval committee included the statement "John Baker is well respected in the industry, and his insights are consistently sought after by investors. Our clients are sure to benefit from investing with Baker Associates."
Comment: Smith is not appropriately separating facts from opinions in her recommendation to include the manager within the platform. Her actions conflict with the requirements of Standard V(B). Smith is relying on her opinions about Baker's reputation and the fact that many attendees were talking with him at the conference. Smith should also review the requirements of Standard V(A) regarding reasonable basis to determine the level of review necessary to recommend Baker Associates.
Example 11 (Notification of Errors): Jérôme Dupont works for the credit research group of XYZ Asset Management, where he is in charge of developing and updating credit risk models. In order to perform accurately, his models need to be regularly updated with the latest market data. Dupont does not interact with or manage money for any of the firm's clients. He is in contact with the firm's US corporate bond fund manager, John Smith, who has only very superficial knowledge of the model and who from time to time asks very basic questions regarding the output recommendations. Smith does not consult Dupont with respect to finalizing his clients' investment strategies. Dupont's recently assigned objective is to develop a new emerging market corporate credit risk model. The firm is planning to expand into emerging credit, and the development of such a model is a critical step in this process. Because Smith seems to follow the model's recommendations without much concern for its quality as he develops his clients' investment strategies, Dupont decides to focus his time on the development of the new emerging market model and neglects to update the US model. After several months without regular updates, Dupont's diagnostic statistics start to show alarming signs with respect to the quality of the US credit model. Instead of conducting the long and complicated data update, Dupont introduces new codes into his model with some limited new data as a quick "fix." He thinks this change will address the issue without needing to complete the full data update, so he continues working on the new emerging market model. Several months following the quick "fix," another set of diagnostic statistics reveals nonsensical results and Dupont realizes that his earlier change contained an error. He quickly corrects the error and alerts Smith. Smith realizes that some of the prior trades he performed were due to erroneous model results. Smith rebalances the portfolio to remove the securities purchased on the basis of the questionable results without reporting the issue to anyone else.
Comment: Smith violated V(B) by not disclosing a material error in the investment process. Clients should have been informed about the error and the corrective actions the firm was undertaking on their behalf. See also Standard V(A)-Diligence and Reasonable Basis.
Example 5 (Notification of Fund Mandate Change): Rather than lifting the ceiling for its universe from US$250 million to US$500 million, May & Associates extends its small-cap universe to include a number of non-US companies.
Comment: Standard V(B) requires that May's CIO advise May's clients of this change because the firm may have been retained by some clients specifically for its prowess at investing in US small-cap stocks. Other changes that require client notification are introducing derivatives to emulate a certain market sector or relaxing various other constraints, such as portfolio beta. In all such cases, members and candidates must disclose changes to all interested parties.
Example 9 (Sufficient Disclosure of Investment System): Amanda Chinn is the investment director for Diversified Asset Management, which manages the endowment of a charitable organization. Because of recent staff departures, Diversified has decided to limit its direct investment focus to large-cap securities and supplement the needs for small-cap and mid-cap management by hiring outside fund managers. In describing the planned strategy change to the charity, Chinn's update letter states, "As investment director, I will directly oversee the investment team managing the endowment's large-capitalization allocation. I will coordinate the selection and ongoing review of external managers responsible for allocations to other classes." The letter also describes the reasons for the change and the characteristics external managers must have to be considered.
Comment: Standard V(B) requires the disclosure of the investment process used to construct the portfolio of the fund. Changing the investment process from managing all classes of investments within the firm to the use of external managers is one example of information that needs to be communicated to clients. Chinn and her firm have embraced the principles of Standard V(B) by providing their client with relevant information. The charity can now make a reasonable decision about whether Diversified Asset Management remains the appropriate manager for its fund.
Example 3 (Proper Description of a Security): Olivia Thomas, an analyst at Government Brokers, Inc., which is a brokerage firm specializing in government bond trading, has produced a report that describes an investment strategy designed to benefit from an expected decline in US interest rates. The firm's derivative products group has designed a structured product that will allow the firm's clients to benefit from this strategy. Thomas's report describing the strategy indicates that high returns are possible if various scenarios for declining interest rates are assumed. Citing the proprietary nature of the structured product underlying the strategy, the report does not describe in detail how the firm is able to offer such returns or the related risks in the scenarios, nor does the report address the likely returns of the strategy if, contrary to expectations, interest rates rise.
Comment: Thomas has violated Standard V(B) because her report fails to describe properly the basic characteristics of the actual and implied risks of the investment strategy, including how the structure was created and the degree to which leverage was embedded in the structure. The report should include a balanced discussion of how the strategy would perform in the case of rising as well as falling interest rates, preferably illustrating how the strategies might be expected to perform in the event of a reasonable variety of interest rate and credit risk-spread scenarios. If liquidity issues are relevant with regard to the valuation of either the derivatives or the underlying securities, provisions the firm has made to address those risks should also be disclosed.
Example 12 (Notification of Risks and Limitations): Quantitative analyst Yuri Yakovlev has developed an investment strategy that selects small-cap stocks on the basis of quantitative signals. Yakovlev's strategy typically identifies only a small number of stocks (10-20) that tend to be illiquid, but according to his backtests, the strategy generates significant risk-adjusted returns. The partners at Yakovlev's firm, QSC Capital, are impressed by these results. After a thorough examination of the strategy's risks, stress testing, historical back testing, and scenario analysis, QSC decides to seed the strategy with US$10 million of internal capital in order for Yakovlev to create a track record for the strategy. After two years, the strategy has generated performance returns greater than the appropriate benchmark and the Sharpe ratio of the fund is close to 1.0. On the basis of these results, QSC decides to actively market the fund to large institutional investors. While creating the offering materials, Yakovlev informs the marketing team that the capacity of the strategy is limited. The extent of the limitation is difficult to ascertain with precision; it depends on market liquidity and other factors in his model that can evolve over time. Yakovlev indicates that given the current market conditions, investments in the fund beyond US$100 million of capital could become more difficult and negatively affect expected fund returns. Alan Wellard, the manager of the marketing team, is a partner with 30 years of marketing experience and explains to Yakovlev that these are complex technical issues that will muddy the marketing message. According to Wellard, the offering material should focus solely on the great track record of the fund. Yakovlev does not object because the fund has only US$12 million of capital, very far from the US$100 million threshold.
Comment: Yakovlev and Wellard have not appropriately disclosed a significant limitation associated with the investment product. Yakovlev believes this limitation, once reached, will materially affect the returns of the fund. Although the fund is currently far from the US$100 million mark, current and prospective investors must be made aware of this capacity issue. If significant limitations are complicated to grasp and clients do not have the technical background required to understand them, Yakovlev and Wellard should either educate the clients or ascertain whether the fund is suitable for each client.
Different FORMS of Communication
Communication is not confined to a written report of the type traditionally generated by an analyst researching a security, company, or industry. 1. A presentation of information can be made via any means of communication, including in-person recommendation or description, telephone conversation, media broadcast, or transmission by computer (e.g., on the internet). 2. The nature of these communications is highly diverse—from ONE WORD ("buy" or "sell") to in-depth reports of more than 100 pages. 3. A communication may contain a general recommendation about the MARKET, ASSET ALLOCATION, or CLASSES of investments (e.g., stocks, bonds, real estate) or may relate to a SPECIFIC SECURITY. 4. If recommendations are contained in CAPSULE form (such as a RECOMMENDED STOCK LIST), members SHOULD NOTIFY clients that additional information and analyses ARE AVAILABLE from the producer of the report.
Identifying LIMITATIONS of Analysis
Inv. advice based on QUANTITATIVE research MUST BE SUPPORTED by READILY AVAILABLE reference material & SHOULD be applied in a manner CONSISTENT with previously applied methodology; IF changes in methodology are made, they should be HIGHLIGHTED. 2. SHOULD outline KNOWN LIMITATIONS of the analysis & conclusions contained in their investment advice. 3. In evaluating the basic characteristics of the inv. being recommended, SHOULD consider in the report the potential total RETURNS and the principal RISKS inherent in the expected returns, which may include CREDIT RISK, FINANCIAL risk (specifically, the use of LEVERAGE or financial DERIVATIVES), and OVERALL MARKET RISK. 4. Once the process has been completed, the member who prepares the report MUST INCLUDE those elements that are important to the analysis and conclusions of the report so that the reader can follow and challenge the report's reasoning.
Guidance
Members and Candidates MUST: 1 Disclose to CLIENTS and PROSPECTIVE clients the BASIC FORMAT and GENERAL PRINCIPLES of the inv. processes they use to analyze inv., select securities, and construct portfolios and MUST PROMPTLY disclose ANY CHANGES that might materially affect those processes. 2 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. 3 Distinguish between FACT and OPINION in the PRESENTATION of investment analyses and recommendations.