Views on improving the integrity of global capital markets
22 July 2013

Standards of Practice Handbook Updated: “Significant” Risks, Limitations of the Investment Process

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With the 11th edition of the CFA Institute Standards of Practice Handbook out for public comment, I’ll use this space to delve deeper into the more prominent changes proposed for this edition.

In the aftermath of the global financial crisis, there have been many discussions on what was actually known about the myriad of financial investment products backed by actual mortgages. Securitizations of direct loans were repackaged and sold again. Additionally, derivative products were developed that contained little to no direct connection to a particular asset or set of assets. These products were being developed and sold to satisfy investor demand.

In retrospect, what appeared to be lost in the development and sales process was an acknowledgement of the known significant risks and limitations associated with the investment modeling process. Products based on financial model forecasts are structured according to the input data. In hindsight, it is easy to question whether the modelers were considering all practical forecast of inputs, such as future home sales and prices. But more importantly, were investors informed of the scope of the inputs actually being used?

During the Handbook review by the Standards of Practice Council (SPC), the members discussed whether there was sufficient emphasis on the need to clearly disclose important aspects of risks and limitations of the investment process. Currently Standard V(B) Communication with Clients and Prospective Clients reads:

Members and Candidates must:

  1. Disclose to clients and prospective clients the basic format and general principles of the investment processes they use to analyze investments, 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.

Clearly, both risk and limitation could be identified as a factor important to investment analysis, with the standard then requiring disclosure. Additionally, the 10th edition of the Handbook includes a section of guidance to this standard titled “Identifying Limitations of Analysis.” The guidance reinforces the standard by having members and candidates “outline known limitations of the analysis.” It further identifies several types of risks (credit, financial, and market) as basic characteristics of an investment in need of evaluating when making recommendations.

Given the attention these concepts garnered in the guidance, the SPC members have proposed to update Standard V(B) to the following:

Members and Candidates must:

  1. Disclose to clients and prospective clients the basic format and general principles of the investment processes they use to analyze investments, select securities, and construct portfolios and must promptly disclose any changes that might materially affect those processes.
  2. Disclose to clients and prospective clients significant limitations and risks associated with the investment process.
  3. 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.
  4. Distinguish between fact and opinion in the presentation of investment analyses and recommendations.

A key aspect of this addition is the focus on “significant” risks and limitations, as there will always be some element of risk involved with investing. The intent is not to create an overtly burdensome standard that would lead to endless disclosures about what potentially might occur. It was determined important to clearly identify and disclose the significant risks and limitations that were important factors.

The updated guidance highlights that the risks and limitations deemed significant will vary based upon factors such as the individual circumstances of the clients and the investment process used in making the recommendations. Some identified areas for disclosures include the use of leverage and risks that arise for the use of complex financial instruments. The liquidity, or more importantly the illiquidity, of an investment is identified as a potential limitation that will require disclosure.

Ultimately, the guidance recognizes that only significant risks and limitations known at the time of the recommendation can be disclosed. While some investments may decline in value, this loss may not indicate that a member or candidate failed to disclose the appropriate risks. However, keep in mind there are other standards, like Standard V(A) Diligence and Reasonable Basis, which require one to investigate investment opportunities appropriately before recommending them to clients.

The public comment period remains open until 30 September. Everyone is welcome to provide comments for the SPC to consider before the final recommendations are submitted for approval by the CFA Institute Board of Governors later this year. Please send all feedback to [email protected].

The updated Code and Standards are anticipated to become effective for members 1 July 2014.

About the Author(s)
Glenn Doggett, CFA

Glenn Doggett, CFA, was a director of professional standards for CFA Institute. His responsibilities included providing member guidance in applying the ethics and standards of practice policies, supporting related educational and public awareness activities, and working with the Standards of Practice Council of CFA Institute on its initiatives. He was a co-host of the free, live, interactive webinars used by CFA Institute to promote ethical decision making and global best practices. Previously, Mr. Doggett, as a member of the CFA Institute Financial Reporting Policy Group, represented membership interests regarding reporting and disclosures initiatives, including XBRL. Prior to joining CFA Institute, he worked in the financial information sector with SNL Financial, where he focused on the real estate and energy industries, directing the development and maintenance of a financial data storage system. Mr. Doggett holds a BA in economics from the University of Virginia. He was awarded the CFA charter in 2006 and is a member of CFA Society Virginia.

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