CFA Institute Standards: What Is Stance on Funds That Skip Traditional Analysis?

Evolving technologies and greater access to information make it easier than ever to diligently study public companies. Analysts and investors can download firm financial data from public company websites or third-party data providers. Some regulators are beginning to provide downloadable data through recent eXtensible Business Reporting Language (XBRL) requirements as well. All these information sources can support a wide variety of thorough investment models. Whether your focus is free cash flow, debt leverage, or interest coverage, today’s market participants have access to broad sets of data for determining the next investment opportunity.

That same evolution in technology and information access is also leading to investment strategies that do not directly incorporate traditional financial analysis. While not the first to initiate a fund based on nonfinancial metrics, Sprott Asset Management recently filed a prospectus for a new exchange-traded fund — the Sprott Buzz Social Media Insights ETF. This fund intends to make investment decisions solely on social insights.

According to the prospectus, the principle investment strategy “utilizes a proprietary, rules-based quantitative methodology developed by Buzz Indexes Inc. (the “Index Provider”) to identify the US equity securities with the most “positive insights” collected from social media networks. Such positive insights are a measure of the degree of positive company sentiment as well as the breadth of active discussion about each company by participants on social media networks. The Index Provider’s proprietary analytical model ranks the degree of positive company sentiment as well as the breadth of active discussion about each company by the participants on social media networks.”

The plan is to invest at least 90% of fund assets in the top 25 stocks in the index ranking, with appropriate monthly rebalancing.

What is missing from the description of the investment strategy is any mention of actual financial performance of the public companies. You may question how a fund that does not engage in such analysis could be considered to have been diligently researched. Certainly no CFA® charterholder could be involved with the development or recommendation of this or similar funds. Right? Not really.

CFA Institute Code and Standards Can Apply to Any Investment Strategy

The principle of diligence and reasonable basis, addressed in the CFA Institute Code of Ethics and Standards of Practice, is applicable to any investment strategy, regardless of the importance of financial analysis to the actual recommendations. There are no prescribed ratios that must be calculated or specific firm attributes that must be identified and considered in the guidance to the Standard.

What is required is that the analysis performed to support the investment strategy must be independently conducted and display appropriate rigor. The information used must support the investment basis given to each security. For a fund based on social media insights, it could display the thoroughness of the research by including a multitude of social media platforms. The reliance upon one platform, for example Twitter or Facebook, may give investors reason to doubt the recommendations due to potential manipulation. The prospectus for this fund discusses the risks of relying upon social media analytics as a primary investment strategy. Through acknowledging the need to incorporate data of diverse sources and types, the fund seeks to strengthen the validity of the recommendations.

“‘Social media’ is an umbrella term that encompasses various activities that integrate technology, social interaction and content creation. Social media may use many technologies, including, but not limited to, blogs, microblogs, wikis, photos and video sharing, podcasts, social networking, and virtual worlds. Some examples of social media sites include, but are not limited to, the following: Facebook, Twitter, LinkedIn, FAtoday, YouTube, Flickr, MySpace, Digg, Reddit, RSS, etc.”

The development of a fund that does not contain financial data is not directly prohibited by the Code and Standards. A fund driven by price momentum may be as agnostic to financial ratios as this social insights proposal. What is required is that sufficient efforts be exhibited to ensure the recommendations align with the investment strategy upon which the clients agreed.

Through the prospectus, investors in this ETF are presented with the objectives and risks associated with social insights investing. More traditional investors may feel that social media discussions are mere market noise and will stay away from this fund. For other investors, the discussions reflect valuable investment insights and may be excited by this fund. For CFA Institute members and candidates in the CFA Program, the efforts undertaken, not the specific nature of the information, will determine if their actions remain aligned with the principle of diligence and reasonable basis, as well as the other elements of the Code and Standards.

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