How seriously do you take the professional standards section of this examination?  Citing a personal example, I firmly believe that scoring 70%+ on this section decided my pass for level three.  Committing to score 70%+ on this topic must be part of your exam strategy.

On the test candidates can expect two item sets total (10% of the test) – one in the morning and one in the afternoon.

Item Set = 1 story + 6 multiple choice questions

The item set’s story (which can be several small stories) will walk you through situations involving firms, government/regulatory bodies, and people - charterholders, candidates, investors, beneficiaries, and so on.

Correct answers will center on your ability to apply: seven professional standards of conduct, the Soft Dollar Standards, and the Research Objectivity Standards.

<strong>Tip:</strong> the most conservative choice is not always the correct choice and when local laws differ with the standards, the stricter of the two must be followed.

<strong>Material (refer to study sessions one and two in your Level II CFA Program Curriculum©):</strong>
<ol>
	<li>The Code of Ethics (six components)</li>
	<li>The Seven Standards – likely tested in both item sets; possibly covering one and a part of the other.</li>
	<li>CFAI Soft Dollar Standards – likely part of one item set; worst case would be nearly all of one item set</li>
	<li>CFAI Research Objectivity Standards – same as Soft Dollars.</li>
	<li>Prudent Investor Rule</li>
</ol>
 

CFA Level 2: Ethic & Professional Standards – Introduction

<ol start="1">
	<li>Act with integrity.</li>
	<li>Place the profession and client interests above personal interests.</li>
	<li>Use reasonable care and independent judgment when engaging in professional activities.</li>
	<li>Practice in a professional and ethical manner and encourage others to do the same.</li>
	<li>Promote integrity in capital markets.</li>
	<li>Maintain and improve professional competence.</li>
</ol>
It is not recommended to overly focus on the Code for this subject but candidates should have general knowledge of the six components.

 

The Code of Ethics – Short Version of the Six Components

These are part of all three tests, so memorize them.  They apply to members and candidates.  An extension note is provided for each, to enhance understanding; the extensions represent a single example but are not exhaustive.
<div>
<h3>1. Professionalism</h3>
</div>
<div>
<ul>
	<li><strong>Know the law.</strong>
Extension: Members discovering or suspecting a legal violation should report this to their supervisor or the firm's compliance department.</li>
	<li><strong>Preserve independence and objectivity.</strong>
Extension: Modest gifts to members are allowable, but you must reject offers that would threaten objectivity.</li>
	<li><strong>Do not misrepresent.</strong>
Extension: Member may not copy the work of another without citing the source of the material.</li>
	<li><strong>Misconduct (not engaging in).</strong>
Extension: Member must not act in a manner that creates a lack of confidence in professional judgment, like drinking on the job.</li>
</ul>
<div>
<h3>2. Capital Market Integrity</h3>
</div>
<div>
<ul>
	<li><strong>Material non-public info</strong> - Do not act or cause others to act when you have it.
Extension: Info can be deemed material if it is knowledge that an investor would want to know before making a buy/sell decision.</li>
	<li><strong>Market manipulation</strong> - not acting to distort prices of inflate trading volumes with the intent to deceive market participants.
Extension: Members must not spread false rumors designed to drives prices up, so a position can be sold at an artificially high price.</li>
</ul>
<div>
<h3>3. Duties to Clients</h3>
</div>
<div>
<ul>
	<li><strong>Loyalty, prudence and care.</strong>
Extension: An investment manager should handle client transactions with the same level of care that he/she would apply to his/her own assets.</li>
	<li><strong>Fair dealing.</strong>
Extension: If a recommendation has recently changed, then the investment manager should inform the client seeking to implement an investment decision to the contrary.</li>
	<li><strong>Suitability.</strong>
Extension: If a manager is investing to a dedicated strategy, such as large cap domestic stocks, then he/she must adhere to that strategy.</li>
	<li><strong>Performance presentation.</strong>
Extension: Members cannot imply that past performance is an indicator of future returns.</li>
	<li><strong>Confidentiality.</strong>
Extension: the member/candidate must keep client (current, former, and prospective) info confidential unless: info concerns illegal client activity, the law requires disclosure, or the client permits disclosure.</li>
</ul>
<div>
<h3>4. Duties to Employers</h3>
</div>
<div>
<ul>
	<li><strong>Loyalty.</strong>
Extension: Member cannot engage in activity that competes with their employer's interest.</li>
	<li><strong>Additional compensation.</strong>
Extension: Members must obtain written consent from all stakeholder parties, when third party compensation could even potentially create a conflict of interest with the employer.</li>
	<li><strong>Responsibilities of supervisors.</strong>
Extension: Members should decline in writing to accept supervisory responsibility when the firm does not have an adequate internal compliance system.</li>
</ul>
<div>
<h3>5. Investment Analysis, Recommendations, and Actions</h3>
</div>
<div>
<ul>
	<li><strong>Diligence and reasonable basis.</strong>
Extension: Members are allowed to use third party research to make a recommendation as long as they have made a sufficient effort to determine that the research is quality.</li>
	<li><strong>Communications with clients.</strong>
Extension: Members must distinguish between fact and opinion when discussing investments with clients.</li>
	<li><strong>Record retention.</strong>
Extension: If there are no specific legal regulations, firms are recommended to retain records for seven years.</li>
</ul>
<div>
<h3>6. Conflicts of Interest</h3>
</div>
<div>
<ul>
	<li><strong>Disclosure of conflicts.</strong>
Extension: disclosure needs to be prominent and easy to understand.</li>
	<li><strong>Priorities of transactions.</strong>
Extension: the candidate must execute transactions in order: first for clients; second for the firm; and third for themselves.</li>
	<li><strong>Referral fees.</strong>
Extension: if an equity investment management firm is compensated for recommending its clients to a specific firm for its fixed income investment, then the equity firm must disclose the nature of this payment when making the recommendation to its clients.</li>
</ul>
<div>
<h3>7. Responsibilities as a Member and Candidate</h3>
</div>
<div>
<ul>
	<li><strong>Conduct.</strong>
Extension: Members can tell potential employers that they passed all three exams on the first attempt, but cannot imply any special abilities as a result of this accomplishment.</li>
	<li><strong>Referencing the designation.</strong>
Extension: There are several ways to inappropriately display the designation or refer to candidacy. Be sure to review these in anticipation of getting one question on the matter.</li>
</ul>
</div>
</div>
</div>
</div>
</div>
</div>
</div>
 

The Seven Standards for Professional Conduct

<ul>
	<li><strong>Brokerage</strong> generically refers to commission expenses or fees generated by the execution of a trade; this expense belongs to the client and not the investment firm.</li>
	<li>Broker entities typically offer other services beyond trade execution, such as research.</li>
	<li><strong>A soft dollar transaction</strong> takes place when the investment management firm uses client generated commissions instead of firm cash to purchase services from a broker.</li>
	<li><em>In general, soft dollar arrangements are allowable</em>, so long as the services purchased with client commissions are used by the investment manager to support investment decision-making.</li>
	<li><em>CFAI Soft Dollar Standards are voluntary.  However, for a firm to claim compliance, it must minimally adhere to certain mandatory practices and is encouraged to follow certain additional recommended practices.</em></li>
	<li>The standards intend to facilitate: full and fair disclosure to clients by investment firms, consistency in presentation so stakeholders can understand firm brokerage practices, standard disclosure and record keeping, and an industry model for ethical brokerage use by investment firms.</li>
	<li>An investment firm seeking to publicly claim compliance must define services purchased with brokerage, confirm that these services are used in the investment decision making process, and isolate mixed use products.
<ul>
	<li><strong>Analyzing Soft Dollar Transactions</strong>
<ul>
	<li>Level 1 – Ask, is the product truly research?</li>
	<li>Level 2 – Is the primary use of the research product to support the investment decision making process?</li>
	<li>Is 100% of the research product’s use involved in the investment decision making process?</li>
</ul>
</li>
	<li><strong>Example</strong> - Elaborating on mixed-use products.  Say a firm wants to acquire a software package that will be used 50% of the time to perform research for 50% of the time for access to clients and prospects for the purpose of attracting and retaining business, then the firm must pay for half of the software out of its own cash and can only use soft dollars to cover 50% of the expense.</li>
</ul>
</li>
</ul>
 

CFA Soft Dollar Standards - Overview

In the previous article, we briefly discussed the <a title="CFA Soft Dollar Standards – Overview" href="https://financetrain.com/cfa-soft-dollar-standards-overview/">idea of soft dollars</a>. In this article we discuss the soft dollar standards provided by CFA. Each standard is followed by one required practice, but this may not be the only requirement for a given standard.
<ul>
	<li><strong>General principles for the investment firm</strong> – always act in the benefit of the client and place those interests before his/her own.</li>
	<li><strong>Investment firm relationship with client</strong> – the firm must disclose soft dollar arrangements to a client before trading a client’s account under these arrangements.</li>
	<li><strong>Selection of broker</strong> – the investment manager must select the broker with best total execution value received by the client.</li>
	<li><strong>Firm determination of qualified research for appropriate soft dollar purchase</strong> – the investment manager must be able to document the basis for his/her determination of qualified research purchased with soft dollars.</li>
	<li><strong>Client directed brokerage</strong> – a client may direct his or her trading business to a specific broker, but soft dollar services from another client may not be used to benefit the client directing brokerage.</li>
	<li><strong>Disclosure terms for investment firms claiming soft dollar compliance</strong> – soft dollar arrangements must be clearly disclosed to all clients and potential clients.</li>
	<li><strong>Record keeping for investment firm</strong> – a firm must document its allocation process for the use of client brokerage to obtain mixed use products.</li>
</ul>

CFA Soft Dollar Standards

<ul>
	<li>The Research Objectivity Standards are a set of guiding principles developed by CFAI.</li>
	<li>The ROS are not laws, but a voluntary code of conduct.</li>
	<li><em>Note: The legal requirements of some jurisdictions may overlap with the intent of an ROS standard.</em></li>
	<li>The ROS are aligned with the CFAI’s professional standards of conduct.  Unlike the Soft Dollar Standards, a firm would not publicly claim compliance to ROS.  However, at the member/candidate level, by violating an ROS standard, the individual may also be violating mandatory professional standard of conduct as well.</li>
	<li><strong>Requirements.</strong>  Each standard is followed by one requirement, not necessarily the only one.  CFAI makes further recommendations for compliance.</li>
<ul>
	<li><strong>Research objectivity policy</strong> – must: be written and sent to all employees, contain supervisory procedures, and owned by a senior firm officer.</li>
	<li><strong>Public appearances</strong> – firm speaker must disclose any personal or firm conflicts of interest to the audience.</li>
	<li><strong>Reasonable and adequate basis</strong> – a supervisory analyst or committee must exist in the firm to review and approve all investment recommendations.</li>
	<li><strong>Firewall</strong> – firms must ensure that activities of the investment bank unit do not influence research or recommendations in the investment management unit.</li>
	<li><strong>Analyst compensation</strong> – must be aligned with research accuracy over a period of time; cannot be tied to any investment banking activity.</li>
	<li><strong>Subject companies</strong> – investment firm cannot promise a company with a specific investment recommendation or stock price target.</li>
	<li><strong>Personal investments and trading</strong> – firms must prevent employees from trading in ahead of clients.</li>
	<li><strong>Timeliness of recommendations</strong> – must be issued regularly; quarterly is the guidance, with updates as needed in response to significant events.</li>
	<li><strong>Compliance and enforcement</strong> – firms must keep records of their internal audit activities.</li>
	<li><strong>Disclosure</strong> – firms must disclose all conflicts of interest that affect the firm and covered employees.</li>
	<li><strong>Rating system</strong> – firms must establish a rating system that investors find useful in making decisions.</li>
</ul>
</ul>
&nbsp;

Research Objectivity Standards (ROS)

<strong>Exam Thinking</strong>
<ul>
	<li>Understand the difference between a member/candidate wrongly using material non-public information versus appropriately applying the mosaic theory.</li>
	<li>Know that CFAI may present an explicit standard violation and expect you to identify the most relevant standard that was violated.</li>
	<li>“Written consent” includes email documentation.</li>
	<li>Know that the new standard for a fiduciary is the “Prudent Investor Rule”, which allows the investment manager to minimize risk in a portfolio context (unlike the outdated “Prudent Man Rule”).</li>
</ul>
<strong>Test Preparation Recommendation</strong>
<ul>
	<li>Spend four hours reading the material and taking notes.</li>
	<li>Spend one to two hours creating flash cards.</li>
	<li>Spend four hours taking practice questions.</li>
	<li>Dedicate small parts of every week to reviewing this topic throughout your preparation.</li>
	<li>Expect the exam to bring a few “obscure” questions and isolate time the week before the exam to review official material with this in mind.</li>
</ul>
<a href="https://financetrain.com/series/cfa-level-2-ethics-and-professional-standards/">Ethics and Professional Standards</a> is a great starting section.  You can ease into your study plan with it, but do not underestimate its importance and continuously review the material throughout your preparation to keep concepts fresh.  But remember that it is a mandatory 70%+ section!

CFA Level II Ethics – Exam Thinking and Recommendations

<strong>The old Prudent Man Rule</strong> – rules governing trustee behavior for managing the assets of a trust, stemmed from an 1830 court ruling in the US and has been replaced by the new Prudent Investor Rule.

<strong>Basic Principles</strong>

The basic principles of the Prudent Investor Rule are:<strong></strong>
<ul>
	<li>Diversification is critical to minimizing risk.</li>
	<li>A trust’s tolerance for risk must be determined.</li>
	<li>Trustees can only incur reasonable transaction expenses for management of trust assets.</li>
	<li>The trustee is bound by a fiduciary duty of impartiality to balance the income needs of current income beneficiaries with the long term growth needs of future income beneficiaries.</li>
	<li>Trustees can delegate responsibilities to experts for specialties in which they lack sufficient knowledge.</li>
</ul>
 

The Prudent Investor Rule

CFA Level 2 - Ethics and Professional Standards

This frontmatter description will appear below the title

COURSE

CFA Level 2 - Ethics and Professional Standards

Lessons

R Programming Bundle: 25% OFF