cfa: 1. ethical & professional standards

My books arrived on Thursday, and I began studying over the weekend. The first 166 pages dealt with "Ethical and Professional Standards," which lays out the 7 Standards that all CFA charterholders and candidates must adhere to, including: Professionalism, Integrity of Capital Markets, Duties to Clients, Duties to Employer, Investment Analysis/ Recommendations/ Actions, Conflicts of Interest, and Duties to the CFA Institute. Half of the 4 Readings comprising this section also dealt with the "Global Investment Practice Standards (GIPS)," which has already been adopted by 25 countries as the standard for measuring and comparing investment performance. What surprised me most to learn, however, was that according to the CFA Topic Areas, the Ethics section had a higher percentage of test questions (15%) than every other section on the test besides "Financial Reporting & Analysis" (20%) and "Asset Valuation" (30%)!

The 8 sections that comprise GIPS include: Fundamentals of Compliance, Input Data, Calculation Methodology, Composite Construction, Disclosures, Presentation & Reporting, Real Estate, and Private Equity. A typical test question might ask you to recognize the various sections of GIPS, such as:

"With respect to the Global Investment Performance Standards, which of the following is one of the eight major sections that reflect the elements involved in presenting performance information?"
A. Real Estate.

B. Derivatives.

C. Legal and Ethical Considerations.

The answer is "A" by definition of the 8 sections that comprise GIPS.

Most of the 36 questions that followed the Ethics section would describe a potential ethical violation, and ask whether or not it was a violation, and which standard was violated:

"One of the discretionary accounts managed by Farnsworth is the Jones Corporation employee profit-sharing plan. Jones, the company president, recently asked Farnsworth to vote the shares in the profit-sharing plan in favor of the company-nominated slate of directors and against the directors sponsored by a dissident stockholder group. Farnsworth does not want to lose this account because he directs all the account's trades to a brokerage firm that provides Farnsworth with useful information about tax-free investments. Although this information is not of value in managing the Jones Corporation account, it does help in managing several other accounts. The brokerage firm providing this information also offers the lowest commissions for trades and best execution. Farnsworth investigates the director issue, concludes that management's slate is better for the long-run performance of the firm than the dissident group's slate, and votes accordingly. Farnsworth:
A. violated the Standards in voting the shares in the manner requested by Jones but not in directing trades to the brokerage firm.

B. did not violate the Standards in voting the shares in the manner requested by Jones or in directing trades to the brokerage firm.

C. violated the Standards in directing trades to the brokerage firm but not in voting the shares as requested by Jones.

D. violated the Standards in voting the shares in the manner requested by Jones and in directing trades to the brokerage firm.

The answer is "B". This may seem like a trick question at first. It is easy to lose concentration through the sheer size of the question, and the information contained. At face value it seems that Farnsworth lacks objectivity, and is not serving the best interests of his clients. More specifically, the two main issues of concern are: 1) does Farnsworth violate the standard of "Duties to Client: III(A) - Loyalty, Prudence, and Care)" by voting for the company-nominated slate of directors at the request of Jones, the company president? 2) does Farnsworth violate the same standard by directing trades to a brokerage firm to receive research reports that do not benefit the Jones Corporation? It would be easy to conclude that both of these issues would, in fact, be a violation. However, the reason why they are NOT violations is because Farnsworth came to his own independent decision after researching the issue (it just so happened that it is the same group that Jones recommended), and second, the clients benefit from the "lowest commissions for trades and best execution," so the issue of the research reports are irrelevant in this context. You can imagine a completely different answer had Farnsworth not researched the slate of directors, or if the brokerage firm had not provided the best prices and execution. The questions can be very subtle.

That wraps of Ethics, and now it's time to turn to "Quantatative Methods"! I hope to finish this section, which is 356 pages, by next week, at which point I'll post up my findings.