Code of Ethics and Standards of Professional Conduct Flashcards
Violations of Code and Standards
> disciplinary sanctions by CFA Institute
- Revocation of membership
- Revocation of candidacy in the CFA program
- Revocation of right to use the CFA designation
The Code of Ethics
> integrity, competence, diligence, respect, ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the
investment profession, and other participants in the global capital markets
integrity of the profession and the interests of clients above personal interests
use reasonable care and exercise independent professional judgment
practice and encourage others to practice in a professional and ethical manner
promote the integrity and viability of the global capital markets
maintain and improve professional competence + other proffs
Standards of Professional Conduct
I. Professionalism
A. Knowledge of the Law
B. Independence and Objectivity
C. Misrepresentation
D. Misconduct
II. Integrity of capital markets
A. Material Non-public Information
B. Market Manipulation
III.Duties to clients
A. Loyalty, Prudence, and Care
B. Fair Dealing
C. Suitability
D. Performance Presentation
E. Preservation of Confidentiality
IV. Duties to employers
A. Loyalty
B. Additional Compensation Arrangements
C. Responsibilities of Supervisors
V. Investment analysis, recommendations, and actions
A. Diligence and Reasonable Basis
B. Communication with Clients and Prospective Clients
C. Record Retention
VI. Conflict of interest
A. Conflicts Disclosure
B. Priority of Transactions
C. Referral Fees
VII. Responsibilities as a CFA Institute member or CFA program candidate
A. Conduct as Participants in CFA Institute Programs
B. Reference to CFA Institute, the CFA designation, and the CFA program
I. Professionalism
A. Knowledge of the Law (Guidance)
- Follow the more strict of the applicable law or the Code and Standards
- Must comply with applicable law or regulations
- Must not engage in conduct that constitute a violation even
though legal - In absence of any applicable law or regulation, adhere to Code and Standards
- Members and candidates are responsible for violations knowingly participate or assist
- If member believe activities are illegal or unethical:
- Must dissociate or separate from activity
- May require member to leave employment in severe cases
- First step is to bring to employer’s attention
- CFA Institute strongly encourages report of violations by members
- mindful of where their products are sold
- Supervisors should understand applicable laws and regulations of countries or regions of origination
- due diligence when transacting cross-border
business
I. Professionalism
A. Knowledge of the Law (Recommended procedures)
- Stay informed (laws, rules, regulations and case law, education)
- Review procedures on a regular basis
- Maintain current files (reference copies)
- Distribution area laws (understand applicable laws)
- Legal counsel ( seek the advice of compliance personnel or legal counsel)
Dissociation (resign employment to dissociate)
* Firms (develop/and or adopt a code of ethics)
- Provide information on applicable laws
* Distribute relevant information to employees
- written protocols for reporting suspected violations of laws, regulations, and company policies
I. Professionalism
I(B): Independence and Objectivity (Guidance)
- Buy-side clients
- pressure on sell-side analysts
- Portfolio managers respect and foster intellectual honesty of sellside research
- Fund manager relationships
- not accept gifts, entertainment, or travel funding that may be perceived as impairing their decisions
- Investment banking relationships
- Sell-side firms put pressure on their analysts for favorable research reports
on current or prospective investment banking clients - Firm managers provide an environment in which analysts are neither coerced nor enticed into misleading research
- Public companies
- Analysts may issue favorable reports by companies they cover
- Analysts should perform due diligence when conducting research
Credit rating agency opinions - Provide a service by grading fixed-income products offered by companies
- Analysts employed by rating agencies should ensure that procedures are in place to
prevent undue influences from a sponsoring company - Issuer-paid research
- Reports bridge the gap created by a lack of coverage
- Fraught with potential conflicts
- Investors may be misled into thinking research is from an independent
source - Independent analysts must strictly limit type of compensation they accept for conducting
issuer-paid research - Best practice is to accept a flat fee
- Travel funding
- Best practice is to use commercial transportation
- If unavailable, members may accept modestly arranged travel
I. Professionalism
I(B): Independence and Objectivity (Recommended procedures)
- Protect integrity of opinions
- Establish policies: research reports reflect the unbiased opinion of the
analyst - Create a restricted list
- If the firm is unwilling to disseminate adverse opinions, firms should be removed from
research universe - Restrict special cost arrangements
- Members should pay for commercial transportation and hotel charges
- Air transportation should not be reimbursed by corporate issuer
- Use of corporate aircraft should only be used when it is not possible to use commercial
transportation - Limit gifts
- Limit gifts to token items
- Customary, ordinary business-related entertainment is acceptable provided it is not
designed to influence the member - Firms consider a value limit for acceptable gifts based on local or regional
customs
-Restrict investments - Firms should develop formal policies related to employee purchases of equity or equityrelated IPOs
- Firms should require prior approval for employee participation in IPOs
- Strict limits should be imposed on acquiring securities in private placements
- Review procedures
- Firms should implement effective supervisory and review procedures
- Independence policy
- Formal written policy on independence and objectivity of research
- Ensure that research analysts do not report to and are not controlled by any department
- Appointed officer
- Firms should appoint a senior officer with oversight responsibilities for compliance with
firm’s code of ethics - Firms should provide every employee with procedures and policies for reporting
potentially unethical behavior and violations of regulations
I. Professionalism
I(C): Misrepresentation (recommended procedures)
Factual presentations
- Each member must understand limit of firm’s or individual’s capabilities
- Need to be accurate and complete in presentations
- Firms can provide guidance for employees making written or oral presentations
* Written list of the firm’s available services and description of firm’s qualifications
- Firms can specifically designate which employees are authorized to speak on behalf of the firm
* Qualification summary
- Each member should prepare a summary of:
* Qualifications and experience
* List of services they are capable of performing
* Verify outside information
- Members should encourage their employers to develop procedures for verifying
information about third-party firms
* Maintain webpages
- Regularly monitor webpages to ensure they contain current information
- Ensure all reasonable precautions have been taken to protect site’s integrity,
confidentiality, and security
* Plagiarism policy
- Maintain copies
* Keep copies of all research reports and any information relied on in preparing the research report
- Attribute quotations
* Attribute any direct quotations to their sources including:
- Projections
- Tables
- Statistics
- Model/product ideas
- New methodologies
* attributions not required for recognized financial and statistical reporting services
- Attribute summaries
* Attribute to their sources any paraphrases or summaries of material prepared by others
I. Proffessionalism
I(D): Misconduct
- Code of ethics
- Develop and/or adopt a code of ethics
- Every employee should subscribe
- Make clear that inappropriate personal behavior will not be tolerated
- List of violations
- a list of potential violations and their disciplinary sanctions to all
employees - Employee references
- Check references of potential employees
II(A): Material Nonpublic Information (HIghlights)
Material information
- Disclosure would have an impact on price of a security or if investors want to know the information before making an investment decision
* Specificity of the information
* Extent of difference from public information
* Nature and reliability of the information Nonpublic
- Until disseminated or available to the marketplace in general
- Disseminated is defined as ‘made known to’
- Disclosure at an analysts’ meeting does not make the disclosed information ‘public’
II(A): Material Nonpublic Information – Guidance
- Mosaic Theory
- Combination of material public and non-material non-public information to develop a
conclusion about a firm - Analysts are free to act on this mosaic of information
* No violation of the Standard
II(A): Material Nonpublic Information – Recommended procedures
- Achieve public dissemination
- Member or candidate should make a reasonable effort to disseminate material
information - Encourage the company to publish the information
- If not possible, do not take any investment action based on the information
- Adopt compliance procedures
- Prevent misuse of material non-public information
- Should suit particular characteristics of a firm such as size
- Adopt disclosure procedures
- Ensure information is disseminated to the marketplace in an equitable manner
- Analysts should be treated fairly
- Issue press releases
- Companies should consider issuing press releases prior to analyst meetings
- Meetings should be scripted to decrease chance that further information will be disclosed
- If nonpublic information is disclosed the company should promptly issue a press release
- Firewall elements
- Information barrier used to prevent communication of material nonpublic information
- Minimum elements
- Substantial control of relevant interdepartmental communications
- Review of employee trading through watch, restricted and rumor lists
- Documentation of procedures
- Heightened reviews of proprietary trading when firm is in possession of material nonpublic information
Appropriate interdepartmental communications - Firms of all sizes and types benefit from improving documentation of their internal
enforcement of firewall procedures - Procedures should compiled and formalized
- Physical separation of departments
- Firms should consider physical separation of departments and files
- Prevention of personnel overlap
- Reporting system
- Authorized people should review and approve communications between departments
- Coordinate process of ‘looking over the wall’
- Personal trading limitations
- Firms should consider restrictions
- Should carefully monitor proprietary and personal trading
- Firms should require employees to make reports
- Record maintenance
- Multi-service firms should maintain written records of communications between various
departments - Firms should place a high priority on training
- Proprietary trading procedures
- A prohibition on all types of proprietary activity when in possession of material nonpublic information is not appropriate
- Communication to all employees
- Written compliance policies and guidelines should be circulated to all employees of a firm
II(B): Market Manipulation (Guidance)
- Information-based manipulation
- Includes spreading false rumors to induce trading by others
- Members must refrain from ‘pumping up’ the price of an investment and then ‘dumping’ it
- Transaction-based manipulation
- Actions that affect price of a security
- securing a controlling, dominant position in a financial instrument to exploit and manipulate the price of a related derivative and/or the underlying asset
III. Duties to clients
III(A): Loyalty, Prudence, and Care (Recommended procedures)
- Regular account information
- Should submit an itemized statement to clients at least quarterly
- Client assets should be segregated from other party’s assets
- Client approval
- If unsure about appropriate course of action, disclose in writing to client and obtain client
approval - Firm policies
- Address following topics when drafting statements/manuals containing policies and
procedures: - Follow all applicable rules and laws
- Establish investment objectives of the client
- Consider all the information when taking actions
- Diversify
- Carry out regular reviews
- Deal fairly with all clients with respect to investment actions
- Disclose conflicts of interest
- Disclose compensation arrangements
- Vote proxies
- Maintain confidentiality
- Seek best execution
- Place client interests first
III. Duties to clients
III(B): Fair Dealing (Recommended procedures)
- Develop firm policies
- Treat customers and clients fairly
- Recommended for all firms who disseminate investment recommendations or take
investment action - Make the firm aware of possible violations of fair-dealing practices
- Initial recommendations do not need to be made available to all customers
* Should be based on suitability and known interest
* Not on any preferred or favored status - Fair-dealing compliance procedures
- Limit number of people who know a recommendation will be disseminated
- Shorten the time frame between decision and dissemination
- Publish guidelines for pre-dissemination behavior
- Simultaneous dissemination to ensure all clients are treated fairly
- Maintain a list of clients and their holdings in order to facilitate notifications to customers
or clients of a change in investment recommendation - Develop and document trade allocation procedures
- Disclose trade allocation procedures
- Disclose how the firm selects accounts to participate in an order
- Procedures must be fair and equitable
- Establish systematic account review
- Review accounts regularly to ensure no client or customer is being given preferential
treatment - Disclose levels of service
- Disclose if the organization offers different levels of service for the same fee or different
fees - Different levels of service should not be offered to clients selectively
III. Duties to clients
III(C) Suitability (advisory relationship with client)
- Investment policy statement
- Put needs, circumstances, objectives of each client in a written investment policy statement
- Take into account:
- Client identification
- Investor objectives
- Investor constraints
- Performance measurement benchmarks
- Regular updates
- Investor’s objectives and constraints should be maintained and reviewed periodically
- Compare client constraints with capital market expectations to arrive at an appropriate asset allocation
- Annual review is reasonable unless economic circumstances dictate otherwise
- Suitability test policies
- Firms should be encouraged to develop related policies and procedures
- Differ according to size of the firm and scope of services provided
- Test procedures
- Firms should be encouraged to develop related policies and procedures
- An analysis of the impact on portfolio’s diversification
- Comparison of investment risks with client’s assessed risk tolerance
- Fit of the investment with the required investment strategy
III. Duties to clients
III(D): Performance Presentation (Recommended procedures)
- Apply GIPS Standards
- Compliance with GIPS standards is best method to meet obligations under Standard III (D)
- Compliance without applying GIPS Standards
- Considering knowledge and sophistication of audience
- Presenting performance of weighted composite of similar portfolios rather than using a single representative account
- Including terminated accounts as part of performance history
- Including disclosures that fully explain the performance results being reported
- Maintaining data and records used to calculate performance being presented
III. Duties to clients
III(E): Preservation of Confidentiality
- Standard applies to information gained during a client relationship even if the
person or entity is no longer a client - Simplest, most conservative, and most effective way to comply
- Avoid disclosing any client information except to authorized fellow employees
- Before making disclosure of information outside scope of confidential relationship
- Check if information is relevant to work being performed for the client
- Will it enable the service to the client to be improved?
- Follow firm’s electronic information storage procedures
- Provide information required by applicable law and Professional Conduct Program
(PCP) investigation (if allowed under applicable law)
IV – Duties to Employers
IV(A): Loyalty (Guidance)
- Employer responsibilities
- Members are encouraged to provide their employers with a copy of the Code and
Standards - Employers are not adhered to the Code and Standards
- Independent practice
- Members must abstain from independent competitive activity which conflicts with
interests of their employer - Notify employer of any plan to engage in independent practice
- Should not provide services until they receive consent from employer
- Can make preparations to begin such a
service
- Can make preparations to begin such a
- Leaving an employer
- Continue to act in employer’s best interest
- Must not engage in any conflicting activities, until resignation becomes effective
- Examples of potential violations:
- Misappropriation of trade secrets
- Misuse of confidential information
- Solicitation of employer’s clients prior to cessation of employment
- Self-dealing
- Misappropriation of clients or client lists
- Can make preparations to go into a competitive business, as long as they do not breach the employee’s duty of loyalty
- Simple knowledge of names and existence of former clients
- Not confidential information
- Firm records cannot be taken
- If an independent contractor, oral and written agreement between member and the client
- Whistle blowing
- Interests of members, candidates and employers are secondary to protecting the
integrity of capital markets and clients’ interests - If conflicts occur (e.g. employer engaged in illegal or unethical activity), activities that
would normally violate a member’s or candidate’s duty to their employer may be justified - Nature of employment
- Members and candidates must determine whether they are employees or independent
contractors in order to determine the applicability of Standard IV(A)
IV – Duties to Employers
IV(A): Loyalty (Recommended procedures)
- Competition policy
- Must understand any restrictions placed by employer offering similar services outside the
firm - Policy may outline procedures for requesting approval or strict prohibition
- Termination policy
- Must understand termination policies of their employer
- Clear procedures regarding resignation process, including how it will be disclosed to
clients and staff - Incident-reporting procedures
- Should be aware of firm’s policies related to whistle-blowing
- Encourage their firms to adopt industry best practices
- Employee classification
- Need to understand status within their employer firm
- Firms are encouraged to adopt a standardized classification structure
- e.g. part-time, full-time, outside contractor
- Indicate how firm’s policies apply to each employee class
IV – Duties to Employers
IV(B): Additional Compensation Arrangements (Recommended procedures)
- Written report to employer
- Specifying any compensation to be received, in addition to compensation or benefits
received from employer - Terms of compensation
- Nature of the compensation
- Approximate amount of compensation
- Duration of the agreement
- Compensation includes direct or indirect payments, gifts, or other benefits
IV – Duties to Employers
IV(C): Responsibilities of Supervisors
- Must make reasonable efforts to detect and prevent violations of the Code and
Standards by persons acting under your supervision - Does not matter if they do not have a CFA Institute affiliation
- Tasks of supervision can be delegated but the supervisor remains responsible
- Failure to prevent or detect violations
- Not a violation provided reasonable steps were taken to detect and prevent such
violations - Decline to accept supervisory responsibility in writing if there is an inadequate
compliance system - If supervisors detect or receive reports of violations, they must promptly initiate an
investigation to determine the extent of the wrongdoing - Supervisors should take steps to prevent repeat violations
IV – Duties to Employers
Recommended procedures
- Code of ethics or compliance procedures:
- Recommend employers adopt a code of ethics
- Fundamental, principle-based, ethical and fiduciary concepts
- Implemented by detailed, firm-wide compliance policies and procedures
- Should be written in plain language
- Adequate compliance procedures:
- Supervisor complies with Standard IV (C) when identifying potential violations and
develops compliance procedures to prevent such violations - Contained within a clearly written and accessible manual
- If a violation is discovered, a supervisor should:
- Respond promptly
- Conduct a thorough investigation to determine scope of wrongdoing
- Increase supervision or place appropriate limitations on wrongdoer, pending outcome of
investigations - Review procedures for potential changes to prevent recurrence of similar violations
Standard IV – Duties to Employers
IV(B): Additional Compensation Arrangements
- Written report to employer:
- Specifying any compensation to be received, in addition to compensation or benefits received from employer
- Terms of compensation
- Nature of the compensation
- Approximate amount of compensation
- Duration of the agreement
- Compensation includes direct or indirect payments, gifts, or other benefits
Standard IV – Duties to Employers
IV(A): Loyalty
Guidance
- Employer responsibilities:
- Members are encouraged to provide their employers with a copy of the Code and
Standards - Employers are not adhered to the Code and Standards
- Independent practice:
- Members must abstain from independent competitive activity which conflicts with
interests of their employer - Notify employer of any plan to engage in independent practice
- Should not render services until they receive consent from employer
* Can make preparations to begin such a service - Leaving an employer:
- Continue to act in employer’s best interest
- Must not engage in any conflicting activities, until resignation becomes effective
- Examples of potential violations:
- Misappropriation of trade secrets
- Misuse of confidential information
- Solicitation of employer’s clients prior to cessation of employment
- Self-dealing
- Misappropriation of clients or client lists
- Can make preparations to go into a competitive business, as long as they do not breach the employee’s duty of loyalty
- Simple knowledge of names and existence of former clients
- Not confidential information
- Firm records cannot be taken
- If an independent contractor, oral and written agreement between member and the client
- Whistle blowing
- Interests of members, candidates and employers are secondary to protecting the
integrity of capital markets and clients’ interests - If conflicts occur (e.g. employer engaged in illegal or unethical activity), activities that
would normally violate a member’s or candidate’s duty to their employer may be justified - Nature of employment
- Members and candidates must determine whether they are employees or independent
contractors in order to determine the applicability of Standard IV(A)
Ethics can be described as
as a set of moral principles that provide guidance for our behavior; these may be moral principles shared by a community or societal group
Standards of conduct
serve as benchmarks for the minimally acceptable behavior required of members of a group.
Martin must obtain written consent from Future to keep his existing clients but need not inform his existing clients of his new part-time employment at Future.unless
conflict of interest arise
Capital Market Theory
Existence of unique optimal risky portfolio
* All investors have same economic expectation
- Homogeneity of expectations
- Everyone should have the same risky portfolio
* Different expectations will lead to different risky portfolios
Capital market line (CML)
* Specific CAL
- Uses market portfolio as optimal risky portfolio
* Market portfolio
- Includes all tradable, investable risky assets, or anything that has value
- E.g. stocks, bonds, real estate, human capital
Pricing of Risk and Computation of Expected Risk
Return
Systematic risk
* Non-diversifiable
* Cannot be avoided and is inherent in overall market
* E.g. interest rates, inflation, economic cycles, political uncertainty,
and widespread natural disasters
* Magnified by using leverage
Non-systematic risk
* Risk limited to a particular asset or industry
* E.g. failure of a drug trial, major oil discoveries, or an airliner crash
* Avoid through diversification
- Choose assets not highly correlated with each other
- No reward for a risk that can be diversified away
Total variance
Total variance = Systematic variance + Non-systematic variance
Pricing of Risk and Computation of Expected Risk
Calculation and interpretation of Beta
* Return-generating model
- Provides an estimate of an expected return given certain
parameters
- E.g. multi-factor model using macroeconomic, fundamental and statistical factors
Macroeconomic factors:
Economic growth, interest rates, inflation rates, productivity employment, and
consumer confidence
Fundamental factors:
Earnings, earnings growth, cash flow generation, investment in research, advertising,
and number of patents
Statistical factors:
Historical and crosssectional data analyzed to identify factors that explain variance and covariance in returns
Beta
- Positive Beta
- Return of an asset moves in same direction of market
- Negative Beta
- Return of an asset moves in opposite direction of market
- Unusual to find assets with a consistently negative beta
- Risk-free asset
- Beta = 0
- Covariance with other assets = 0
- E.g. Treasury bills and gold
The Capital Asset Pricing Model
Assumptions
- Investors are risk-averse
- Investors expect to be compensated for accepting risk
- Investors maximize utility
- Investors want higher returns not lower returns
- Investors are rational
- Markets are frictionless, without transaction costs or taxes
- Investors plan for same single holding period
- Investors have homogenous expectations or beliefs
- All investments are infinitely divisible
- Investors are price-takers
- No investor is large enough to influence the market
Security Market Line (SML) expected return vs beta
- All properly priced securities plot on SML, including efficient and inefficient securities or assets
- Slope = Rm-Rf = Market risk premium
The Capital Asset Pricing Model (CAPM)
E(R)=Rf+β( E(R) - Rf)
The Capital Asset Pricing Model
Applications of CAPM
- Estimate of expected return
- Use in project appraisal
- Portfolio performance evaluation
Sharpe ratio = Rp - Rf / sigmap
Treynor ratio = Rp - Rf / betap
M^2 = (Rp - Rf)* (sigmaM/sigmaP) - (Rm - rF)
- Calculate if portfolios outperform market on a risk-adjusted
basis
* Portfolio matching performance of market = M2 = 0
* Portfolio outperforming market = M2 > 0
Jensen’s Alpha
- Based on systematic risk
- Actual return – expected return
alpha_p = Rp - (Rf + betap(Rm -Rf)]
The Capital Asset Pricing Model
Security selection using SML
above SML
Undervalued – positive Alpha - Buy
below SML
Overvalued – negative Alpha - Sell
The Capital Asset Pricing Model
Limitations of CAPM
Theoretical limitations:
* Only systematic risk is priced into CAPM
- Easy to understand
- Very restrictive and inflexible
* Single-period model
- Does not consider multi-period implications
- Cannot capture factors that vary over time
Practical limitations:
* Market portfolio includes non-investable assets such as
human capital
* Market participants use different proxies
* Estimation issues surrounding beta
* CAPM is a poor predictor of returns
* Investors do not have homogenous expectations
* Different SMLs
The Standards of Professional Conduct proscribe
The Code of Ethics prescribes
- knowingly violating securities acts and laws.
- the other behaviors.
