Ch. 5 Investment Advisory Practices

Question 1

IAs and IARs are considered _____ when advising their clients

Answer 1

Fiduciaries

Question 2

What is a fiduciary?

Answer 2

a person who acts for, and on behalf of, another person

Question 3

There are essentially two approaches to consider in the evolution of the fiduciary relationship:

Answer 3

Prudent Man Rule and the Uniform Prudent Investor Act (UPIA)

Question 4

Under the UPIA, a fiduciary, such as an IA, custodian, or trustee, may make individual investments that are:

Answer 4

risky as long as the overall risk/reward profile of the account remains suitable

Question 5

The UPIA also permits fiduciaries to delegate investment responsibilities to competent _____

Answer 5

Third parties

Question 6

the inclusion of an investment that’s risky (could or could not) be beneficial for an entire portfolio since it may result in a higher return.

Answer 6

COULD

Question 7

What are soft dollars?

Answer 7

commission rebates that money managers (IAs) receive for channeling some or all of their trades through certain brokerage firms

Question 8

A trader solicits an advisory firm to send its securities trades to his broker-dealer. In exchange for the business, the trader agrees to pay bonuses to IA employees using a portion of the commissions. Is this practice acceptable?

Answer 8

No. The practice of using earned commissions to pay bonuses to the IA’s employees is an unacceptable form of soft-dollar rebating. These actions don’t directly benefit the advisory client. Instead, they benefit the IA and its employees.

Question 9

For investment advisors and their representatives, the suitability obligation has two components ____ and ____

Answer 9

Know your Customer and Know your Products

(1) the duty to inquire and (2) the duty to give only suitable advice

Question 10

What if an investment adviser representative lacks all of the requested information because the client refuses to provide complete details? Can IARs make assumptions about their clients?

Answer 10

No, IARs may not make assumptions about their clients

Question 11

There are three basic asset classes—stocks (equity securities), bonds (fixed-income investments), and money-market instruments (cash equivalents, such as CDs, etc.). Broadly speaking, the percentage of each of these three asset classes that investors should have in their portfolios depends on two things: _____ and ____

Answer 11

Time horizons and risk tolerances

Question 12

At the same time, more conservative investors with low risk tolerances (unable to handle marked changes in the value of their portfolios) should put a greater percentage of their assets in _____

Answer 12

bond portfolios

Question 13

A young couple enters an investment adviser’s office with the objective to invest $30,000. The money is to be used as a down payment on a new home in two months. The couple tells the investment adviser representative to try to generate as much money as possible in the next 60 days. What should the IAR recommend?

Answer 13

IARs must pay close attention to their clients’ goals and risk tolerance. This couple will need to liquidate the $30,000 in 60 days and cannot risk losing their down payment. Although the couple indicated the desire for high returns, they also have a liquidity need. The most appropriate recommendation is money-market instruments (high-quality, short-term debt) due to their stable prices and low risk of default. Examples include T-bills, money-market funds, and bank-issued CDs.

Question 14

A young woman in her mid-20s is seeking advice about how to invest an inheritance she recently received. She plans to use the money to return to school to get her MBA in three years. In the meantime, she has a well-paid position at a consulting firm in a major city and is paying a considerable amount in state and federal income taxes. She says that she heard a variable annuity is a great way to invest in the stock market while avoiding taxes. What should the IAR recommend?

Answer 14

The IAR should tell her not to purchase a variable annuity. Variable annuities are long-term investments—they’re not suitable for investors who want liquidity or plan to withdraw their money in a few years. Investors, such as this one, who withdraw money in less than 5-7 years, will usually incur significant withdrawal penalties. Since she’s under the age of 59½, she may need to pay a tax penalty as well. The IAR should recommend alternatives, such as a bond fund, or perhaps a municipal bond fund since taxes are a concern.

Question 15

A couple in their early 50s need help deciding what to do with the large payout that the husband received from his retirement plan when he changed jobs last year. The husband rolled the payout into an IRA where it’s currently invested in a money-market fund. They’re both healthy and don’t plan to retire for another 15 years. They also indicate that they’re willing to take some risk.

Answer 15

This couple still has many years to go until retirement. They also need to consider that their money may have to last for another 20 to 30 years once they retire. One or both of them may live into their 80s or 90s. The IAR should advise them to move their money out of the money-market fund and into stock and bond funds instead.

Question 16

An older, wealthy couple consults an adviser about the best way to invest the money in the 529 College Savings Plans they’ve set up for their grandchilden’s educations. The children are one, three, and five years old. Since this couple is retired, most of their portfolio is invested in fixed-income securities, such as Treasuries and corporate and municipal bonds. They ask the adviser if they should invest their grandchidlren’s 529 plan accounts the same way. What should the IAR say?

Answer 16

The IAR should explain to them that their investment needs are different from those of their grandchildren. Since their grandchildren will not be starting college for 13 to 17 years, a portion of these accounts should be invested in stocks. An allocation of 75% stocks and 25% bonds would be appropriate. As the children approach college age, the funds should be shifted away from stocks into fixed-income investments and money-market instruments.

Question 17

Answer TRUE or FALSE to the following statements regarding investment adviser representatives (IARs).
_____ a. IARs are required only to inquire about their clients’ investment objectives.
_____ b. IARs have a greater responsibility to their clients than agents of broker-dealers.
_____ c. IARs should always avoid speculative securities when making recommendations to clients.
_____ d. If a client doesn’t disclose all of the information requested by an IAR, the IAR may assume that the client has other assets and sources of income.
_____ e. With an existing soft-dollar arrangement, an IAR may recommend a broker-dealer’s execution services in return for being able to attend a seminar that’s free of all travel expenses.

Answer 17

a. (False) When analyzing a client’s needs, IARs should examine the client’s entire financial profile, which includes his current financial situation and experience.
b. (True) Agents provide execution service and earn a commission, while IA representatives receive a fee for providing advice that must be appropriate based on the client’s needs. The key consideration for the IA representative must always be the client’s best interest.
c. (False) The UPIA specifically states that no asset class should be avoided, and any risk should be managed.
d. (False) IARs may consider only the information provided by the client.
e. (False) IAs and IARs may use soft-dollar arrangements unless the commission rebates are used to specifically benefit their clients.

Question 18

Under current guidelines, fiduciaries should emphasize which of the following considerations when choosing investments?

a. Ensuring that the client’s capital will be preserved
b. Purchasing only investments that are authorized by the legal list of the state in which the client resides
c. Developing an investment policy in accordance with the client’s goals and risk tolerance
d. Maximizing long-term returns by investing solely in common stocks

Answer 18

(C) Modern views of a fiduciary’s duties in choosing investments place less emphasis on preservation of capital and more emphasis on risk management, appropriate diversification, and developing an investment policy that’s consistent with client goals.

Question 19

Soft-dollar arrangements are between a(n):

a. Broker-dealer and a client in which the client agrees to pay for trades electronically
b. IA and an IAR in which the IAR will rebate a certain portion of his advisory fee
c. IA and a client in which the IA also acts as the IAR
d. Broker-dealer and an IA in which the IA directs transactions to the broker-dealer in exchange for commission rebates used to purchase services that will benefit its advisory clients

Answer 19

(D) A soft-dollar arrangement is a situation in which an investment adviser directs brokerage transactions to a specific broker-dealer in exchange for commission rebates that are used to purchase services that will ultimately benefit the advisory client. Acceptable forms of soft-dollar arrangements include research reports and certain software.

Question 20

An investment adviser and its representatives should take which TWO of the following steps to satisfy suitability obligations to their clients?
I. Ask customers about the securities they’re interested in purchasing
II. Ask clients about their financial circumstances, investment experience, and investment objectives
III. Recommend only appropriate investments to their clients
IV. Guarantee their clients against significant investment losses
a. I and III
b. I and IV
c. II and III
d. II and IV

Answer 20

(C) According to the SEC, an investment adviser’s suitability obligation has two components: (1) the duty to inquire and (2) the duty to give only suitable advice. The duty to inquire includes asking clients about their financial situation, investment experience, and investment objectives.

Question 21

An IAR is first meeting with a couple who are both in their mid-40s. They own their home and their children are grown, but they’ve never saved anything for their retirement. The husband is self-employed and the wife works for a small company that doesn’t offer retirement benefits. The IAR advises them to open IRA accounts and make the maximum possible contributions each year. How should the contributions to these IRA accounts be invested?

a. 100% in money-market funds
b. 50% in money-market funds and 50% in bond funds
c. 45% in stock funds and 55% in bond funds
d. 100% in a variable annuity

Answer 21

(C) Presumably, this couple still has approximately 10 years until they retire. Therefore, a large portion of their retirement accounts should be invested in stocks. Choices (a) and (b) don’t provide them with much potential for growth. As for choice (d), variable annuities are generally unsuitable investments for IRA accounts. One of the major advantages of variable annuities is tax-deferred growth, but all the earnings within an IRA are already tax-deferred. There’s no need to duplicate these benefits.