LM03 Guidance for Standards I-VII

Part 6

Standard III (C) Suitability

1. When members and candidates are in an advisory relationship with a client, they must:
   1. a.Make a reasonable inquiry into a client’s or prospective client’s investment experience, risk and return objectives, and financial constraints prior to making any investment recommendation or taking investment action, and must reassess and update this information regularly.
   2. b. Determine that an investment is suitable to the client’s financial situation and consistent with the client’s written objectives, mandates, and constraints before making an investment recommendation or taking investment action.
   3. c. Judge the suitability of investments in the context of the client’s total portfolio.
2. When members and candidates are responsible for managing a portfolio to a specific mandate, strategy, or style, they must make only investment recommendations or take only investment actions that are consistent with the stated objectives and constraints of the portfolio.

Interpretation:

Determine the suitability of an investment before taking action based on the clients’ circumstances and other factors. It is the responsibility of members and candidates who provide investment advice to a client to determine the suitability of an investment. Sell-side analysts and other members who execute instructions are not responsible for suitability analysis.

Guidance:

• Developing an investment policy: Gather client information (personal data, objectives, risk, and circumstances) at the start of the relationship. Develop an IPS that outlines return requirements, risk tolerance, and all investment constraints. IPS also outlines the roles and responsibilities of the parties in the advisory relationship, when periodic reviews will be conducted and the IPS reevaluated.
• Updating an investment policy: IPS is to be updated at least annually to reflect changes in market expectations and circumstances of the client. Needs and circumstances of the clients can change at any time and the investment recommendations/decisions must take note of this. Examples of changes in an individual’s circumstances: tax status, number of dependents, liquidity needs, loss of job/change in current income, etc.
• The need for diversification: Combining different investments reduces the risk of a portfolio having all assets in a single investment. An investment that is relatively risky on its own may be suitable in the context of the entire portfolio.
• Addressing unsolicited trading requests
  • Requests from clients for trades that do not align with the risk and return objectives of a client’s IPS: Members and candidates must take efforts to balance the client’s request while not deviating from the IPS.
  • Unsolicited requests that are not suitable investments: If your clients ask you to make a trade that is not in accordance with the IPS, then refrain from making the trade until you discuss it with the client. Educate the client about the deviation from the current IPS.
  • If the client insists on making the trade and if you think it will have a material impact on the portfolio, update the IPS. If the client refuses to have the IPS modified, then determine the future of the advisory relationship.
• Managing to an index or mandate: Invest according to the mandate. For example, assume you are a portfolio manager for a small cap fund and your mandate is to include stocks below a certain market capitalization. You would be deviating from the mandate if you buy large cap stocks even if you expect large caps to perform exceptionally well.

Recommended Procedures for Compliance:

• Investment policy statement: Both individual and institutional investors must have an IPS. The IPS should outline the following: client identification, investor objectives, investor constraints, and performance measurement benchmarks.
• Regular updates: IPS is to be updated on a regular basis (at least annually) to reflect changing circumstances and capital market expectations.
• Suitability test policies: Firms must be encouraged to have test procedures to determine the suitability of investments for different types of clients.

Standard III (D) Performance Presentation

When communicating investment performance information, members and candidates must make reasonable efforts to ensure that it is fair, accurate, and complete.

Guidance:

• Provide credible performance information to clients and prospective clients. Should not state that past performance can be obtained again.
• Avoid misstating performance or misleading clients.
• If the presentation is brief, make detailed supporting information available to clients and prospects on request.

Recommended Procedures for Compliance:

Applying the GIPS standards is recommended, but not required. Firms that claim compliance without applying GIPS standards must do the following:

• Consider the knowledge and sophistication of the audience.
• Present the performance of the weighted composite of similar portfolios rather than using a single representative account. Assume there are three portfolios with similar mandates worth 2 million, 10 million, and 8 million. If they generated returns of 9%, 2%, and 2%, respectively, then take a weighted average of returns.
• Include terminated accounts as part of performance history. Also state when those accounts were terminated.
• Include disclosures that fully explain the performance results being reported.
• Maintain the data and records used to calculate the performance being presented.

Standard III (E) Preservation of Confidentiality

Members and Candidates must keep information about current, former, and prospective clients confidential unless:

1. The information concerns illegal activities on the part of the client.
2. Disclosure is required by the law.
3. The client or prospective client permits disclosure of the information.

Guidance:

• Status of client: Even if an entity is no longer a client, members and candidates must maintain the confidentiality of client records.
• Compliance with laws: Comply with applicable law. If a client is involved in illegal activities and the applicable law requires members and candidates to maintain confidentiality, then the information must not be disclosed.
• Electronic information and security: Members and candidates need to be aware of possible accidental disclosures. They should take care when communicating sensitive client information. For instance, assume two clients an investment manager is dealing with, have similar names. When sending an e-mail with updated IPS, the investment manager types in the name of the intended recipient and doesn’t realize that it goes to the other client instead of the intended recipient. Such mistakes can have dire consequences.
• Professional conduct investigations by CFA Institute: If permissible under law, members and candidates must cooperate with PCP and provide information about a client in support of an investigation. Any information given to PCP stays confidential.

Recommended Procedures for Compliance:

• The simplest, most conservative, and most effective way to comply with Standard III (E) is to avoid disclosing any information received from a client, except to authorized fellow employees who are also working for the client.
• Communicating with clients: Follow firm-supported communication methods and compliance procedures when communicating confidential information.

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