Views on improving the integrity of global capital markets
23 August 2018

Ethics in Practice: Assessing Hedge Funds for Investment. Case and Analysis–Week of 20 August

CFA Institute Ethical Decision-Making Framework

How did you do evaluating this week’s (20 August) case? Check out the analysis below.

Case

Soto manages assets for high-net-worth individuals, family groups, foundations, endowments, and similar institutions. Many of his clients have expressed interest in investing a portion of their assets in alternative investments to boost their portfolio return. Soto recommends particular alternative assets, including hedge funds, to his clients and monitors those investments on his clients’ behalf. Soto has developed written policies and procedures that he consistently applies when evaluating potential hedge fund investments, but he does not disclose these policies and procedures to his clients. Soto generally meets in-person with the hedge fund managers at the funds’ offices to discuss their implemented investment strategy, understand the culture of the manager, have increased access to review documents, and speak with the fund’s personnel. Unless he sees a red flag, Soto does not conduct comprehensive background checks on the managers and their key personnel.

Several of the hedge fund managers he chooses as investments for his clients have undisclosed potential conflicts of interests, such as compensation arrangements or business activities with affiliates. When choosing potential hedge fund investments, Soto ensures that the investment style of the fund is suitable for his clients and intermittently checks to verify the fund’s commitment to that style over time. Although Soto does not independently verify the funds’ relationships with service providers, such as administrators and custodians, he does carefully evaluate the auditors of the fund when he is not familiar with the auditor. Some of the funds that Soto choses as investments for his clients have multiple changes in key third-party service providers over time. Soto relies on third-party legal consultants to review legal documents to evaluate such issues as redemption terms and restrictions. Soto relies on marketing material prepared by the hedge funds to provide his clients with as accurate as possible information about the investment. What do you think of Soto’s actions?

  1. Soto’s actions are acceptable under the CFA Institute Code of Ethics and Standards of Professional Conduct.
  2. Soto’s actions violate the CFA Institute Code of Ethics and Standards of Professional Conduct.

Analysis

This case involves CFA Institute Standard V(A): Diligence and Reasonable Basis, which requires CFA Institute members to exercise diligence, independence, and thoroughness in analyzing investments and making investment recommendations. In choosing hedge fund investments for his clients, Soto must undertake appropriate due diligence in evaluating the funds for potential investment for his clients. Does Soto’s actions meet the due diligence and reasonable basis requirement of the CFA Institute Code and Standards? Soto takes many steps to thoroughly evaluate the hedge fund investments, including consistently applying written policies and procedures when engaging in due diligence; holding in-person meetings at the funds’ offices to understand the investment strategy, evaluate the manager, meet with key personnel, and make sure the investment is suitable for his clients; investigating the auditor of the fund when it is unfamiliar; having the legal documents of the fund reviewed; and using the funds’ own statements and promotional material in an effort to accurately describe the fund to his clients.

But some of Soto’s actions may not have been as strong as they could be, leading him to miss potential red flags. Although he adopts due diligence policies and procedures, he does not disseminate those to clients. He does background checks of fund personnel only when he sees a “red flag” leading him to miss potential conflicts of interest on the part of fund personnel. He does not check employment history, legal and regulatory matters, news sources, and independent references of firm personnel. He checks on a fund’s strategy and suitability for his clients, but he does not regularly go back to check the fund for style drift. He does not independently verify the relationships with certain fund service providers (administrators, custodians) and looks into the auditor only when he is not already familiar with them, potentially missing business relationship or other conflicts of interests that could undermine their independence. He outsources the legal document review to a third party, which may be appropriate if Soto does not have legal expertise but could be an issue if the third-party review is not thorough or as complete as necessary. Finally, by relying on the marketing material of the fund and not creating his own independent information for his clients, he could be providing false or misleading information prepared by the fund itself. Assessing due diligence is a very facts and circumstances specific exercise. If a client were to challenge Soto’s due diligence efforts as insufficient under Standard V(A), whether his diligence is adequate would likely depend on the specific facts of the case.

This case is based on a 2014 Risk Alert by the US SEC Office of Compliance Inspections and Examinations.

Have an idea for a case for us to feature? Send it to us at ethicscases@cfainstitute.org.


More About the Ethics in Practice Series

Just as you need to practice to become proficient at playing a musical instrument, public speaking, or playing a sport, practicing assessing and analyzing situations and making ethical decisions develops your ethical decision-making skills. The Ethics in Practice series gives you an opportunity to “exercise” your ethical decision-making skills. Each week, we post a short vignette, drawn from real-world circumstances, regulatory cases, and CFA Institute Professional Conduct investigations, along with possible responses/actions. We then encourage you to assess the case using the CFA Institute Ethical Decision-Making Framework and through the lens of the CFA Institute Code of Ethics and Standards of Professional Conduct. Then join the conversation and let us know which of the choices you believe is the right one and explain why. Later in the week, we will post an analysis of the case and you can see how your response compares.


Image Credit: ©CFA Institute

About the Author(s)
Jon Stokes

Jon Stokes is the Director of Ethics and Standards Education at CFA Institute. His responsibilities include design and creation of on-line ethics education, development and maintenance of the CFA Institute Code of Ethics and Standards of Professional Conduct, and the design and management of the CFA Institute Ethical Decision-Making and Giving Voice to Values education programs. Stokes holds a JD degree.

1 thought on “Ethics in Practice: Assessing Hedge Funds for Investment. Case and Analysis–Week of 20 August”

  1. 3rd Party Legal counsel standards are much lower than CFA standards, so it is possible or even likely that funds deemed legal fail the following standards.

    III A – Members must act to the benefit of their Clients – Hedge Fund general partners (GPs) have waived their fiduciary responsibility to pension funds and other LPs; Vague and misleading wording allows HF firms to take advantage of their asymmetric position of power vis-à-vis investors and the lack of transparency in their activities. Analyses of limited partnership agreements (LPAs) have also uncovered clauses that specifically allow HF firms to waive their fiduciary responsibility towards their limited partners — leading to serious conflicts of interest

    IIIB Fair Dealing “The General Partner may take its own interests into account in the exercise of such discretion. The exercise of such discretion may negatively impact the Limited Partners

    VI A Conflicts of Interests, Disclosure – GP’s have waived their fiduciary responsibility to pension funds and other LPs and having conflicts in the secret contracts

    VI(B) Priority of Transactions, by allowing general partners to benefit at the expense of limited partnerships. Again, secret but typical language allows this in these contracts.

    The fact that Soto does not require GIPS which requires net & gross performance and thus real fee disclosure, he could be violating these 2 standards.

    IIID Performance Presentation – Many GP’s have manipulated the value of companies in their fund’s portfolio;

    VI C Fee Disclosure – HF general partners (GPs) have misallocated HF firm expenses and inappropriately charged them to investors; have failed to share income from portfolio company monitoring fees with their investors, and have collected transaction fees from portfolio companies without registering as broker-dealers as required by law. Also allowed undisclosed fee arrangements

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