Ethical and Professional Standards – CFA Level 1 Essential Review Summary

Ethical and Professional Standards is a major part of the CFA curriculum at all three levels, so it is very important to learn this material well.  The CFA Institute places a high value on ethics, and even uses scores on this section to determine if someone passes or fails when their overall exam result is right at the edge of the Minimum Passing Score.  Be ready to spend a good amount of time learning all the ethics materials.

The ethics questions on the exam will ask you to read through a situation and judge whether the actions described violate certain parts of the Code of Ethics or Standards of Professional Conduct.  Since the questions only have 3 answer choices, you will only be expected to look for a small range of potential violations in an individual question.

Reading 1: Ethics and Trust in the Investment Profession

Reading 1 is a high-level overview of the importance of ethics for investment professionals.  The primary takeaway is that ethical guidelines go beyond what is defined by legal statute.  Ethics are defined as a standard of conduct that can be expressed by law and by more abstract principles that outline expected behaviors.

Reading 2: Code of Ethics and Standards of Professional Conduct

The Code of Ethics is very straightforward. They are intended as general guidelines for appropriate behavior of an analyst. Don’t expect too many tricky questions about these, but become very familiar with the language of the Code.

Code of Ethics

1. Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets.

2. Place the integrity of the investment profession and the interests of clients above their own personal interests.

3. Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities.

4. Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession.

5. Promote the integrity of, and uphold the rules governing, capital market.

6. Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals.

The Standards of Professional Conduct are outlined in detail in the following reading.

Reading 3: Guidance for Standards of Professional Conduct

The Standards of Professional Conduct are the heart of the ethics content on CFA exams.  Most of the questions you see will involve the application of one or more parts of the standards applied to various real-world scenarios that a professional analyst might face.

Standard I – Professionalism

Standard I makes it clear high ethical standards must apply even when an issue hasn’t been identified in writing.  It specifies that investment professionals must have a working knowledge of laws, as well as a framework for resolving ethical dilemmas.

Standard I(A) – Knowledge of the Law

Knowledge of the law specifies that investment professionals must have a working knowledge of all applicable laws and regulations that apply where they do business.  In situations where they are subject to different requirements, they are always to adhere to the strictest ones.  This standard applies to rules at all levels, including national laws, local regulations, and even the CFA Code and Standards.

Standard I(B) – Independence and Objectivity

Independence and Objectivity specifies the importance of avoiding conflicts of interest that may arise from accepting gifts, payments, or other favors from clients or business partners.  It’s very important for an analyst to avoid even the appearance of bias.  Special note is given to travel considerations.  Although a firm may view the offer to fly its investment professionals on a third-party’s chartered jet as a cost-savings measure for the firm, the opportunity for conflict of interest arises.

Standard I(C) – Misrepresentation

This standard states that CFA candidates and charterholders must not knowingly misrepresent information related to investment analysis, recommendations, or professional actions.  A common example of this is guaranteeing investment results. You cannot use information in a misleading way to influence investment decisions and you absolutely cannot promise specific investment returns or superior results in any form of communication.

Standard I(D) – Misconduct

Misconduct primarily addresses issues with honesty and professional behavior. It is more broad than Standard I(A) Knowledge of the Law because it is concerned with any behavior that could negatively impact professional integrity.  This applies to activities as varied as refraining from drinking during business hours to conducting proper due diligence before making investment recommendations. Compliance with this standard means avoiding behaviors that could even affect the perception of one’s integrity.

Standard II – Integrity of Capital Markets

Standard II prohibits any activities used to manipulate investment markets. Maintaining public trust in financial markets is of paramount concern to the CFA Institute, and so this standard is very strict on actions that could distort markets through fraudulent or deceitful behavior.

Standard II(A) – Material Non-Public Information

Standard II(A) prohibits members from acting on, or causing others to act on, information that is not available to the public and could impact market results. Doing so is a form of market manipulation, as it is providing an unfair trading advantage to some market participants over others.

Standard II(B) – Market Manipulation

Market manipulation refers to any activity that fraudulently alters market information for the purpose of influencing investment results.  Two common types of manipulation are information-based and transaction-based.  Information refers to the distribution of false or misleading materials in order to manipulate the behavior of other investors.  Transaction-based manipulations involve creating false impressions of market activity through misleading or fraudulent trading strategies.

Standard III – Duties to Clients and Prospective Clients

Standard III emphasizes the importance of investment professionals placing the interests of their clients before their own or that of their firms.

Standard III(A) – Loyalty, Prudence, and Care

This standard broadly requires CFA members to treat their clients and beneficiaries with the utmost care and concern towards meeting their financial goals.  Members must practice due diligence and exercise caution when handling clients’ finances.

Standard III(B) – Fair Dealing

Fair Dealing means that members must treat all clients and partners fairly so that they are not disadvantaging some people over others.  A member must not take actions that provide unfair advantages or opportunities only to certain clients.

Standard III(C) – Suitability

This standard refers to basing investment actions and recommendations on each client’s specific needs and limitations.  Each client is going to be unique in terms of their abilities and willingness in regards to investment risk, and the CFA member is responsible for adjusting their strategy to best fit that client’s particular situation.

Standard III(D) – Performance Presentation

This requires members to ensure that all communication about investment performance is fair, accurate, and complete. All disclosures related to tax, fees, and prior performance should be included in the presentation of recommendations.

Standard III(E) – Preservation of Confidentiality

Standard III(E) requires CFA members to maintain the confidentiality of current, former, and prospective clients under most circumstances. Exceptions are cases in which sharing of personal information reveals client activity of an illegal nature. 

Standard IV – Duties to Employers

Standard IV outlines basic responsibilities by investment professionals for their employers.  While the loyalty to clients must be the paramount concern, a member must still also place their firm’s needs ahead of their own.

Standard IV(A) – Loyalty

As stated in Standard III(A) – Loyalty, Prudence, and Care, members must always be loyal to clients first. However, Standard IV(A) – Loyalty reinforces the fact that members have a responsibility to act in a way that sustains the integrity of their firm. CFA members must refrain from independent activity that conflicts with the best interest of their employer and must be careful not to alert current clients of separation from the employer prior to the departure or taking any documents from the employer.

Standard IV(B) – Additional Compensation Arrangements

Additional Compensation Arrangements requires members to obtain written permission prior to accepting gifts or additional compensation by third-parties.

Standard IV(C) – Responsibilities of Supervisors

While supervisors are not completely responsible for all actions of their subordinates, this standard makes it clear that supervisors must make every effort to ensure that systems are in place to encourage compliance with all legal and ethical standards of the profession.  These systems include proper incentive structures, training on ethical protocol, and the firm’s policies and procedures.

Standard V – Investment Analysis, Recommendations, and Action

Standard V outlines the responsibility of investment professionals regarding the performance of due diligence prior to making recommendations to clients.

Standard V(A) – Diligence and Reasonable Basis

This standard requires that all investment recommendations be based on independent, verifiable information. An analyst should utilize multiple information sources and be thorough in their research before making recommendations to clients.

Standard V(B) – Communication with Clients and Prospective Clients

Members must disclose limitations and risks associated with investment recommendations and activities. The most important part of this standard is that research based on past circumstances can be verified as fact; however, projections of future performances are the basis of opinions and should be stated in any form of communication to clients as “In my opinion, …”

Standard V(C) – Record Retention

This standard requires members to maintain a system for maintaining records of analysis, recommendations, and investment actions that they make.  The CFA Institute recommends retaining 7 years of records, but members should comply with any applicable legal requirements that require longer time periods.

Standard VI – Conflicts of Interest

Standard VI outlines how members should mitigate the influence of conflicts of interest and how to disclose these potential risks to clients.  It would be nearly impossible to avoid any conflicts of interest, so the standard focuses on how to manage that risk and avoid harm to clients through disclosure and controls.

Standard VI(A) – Disclosure of Conflicts

Dictates that CFA members must disclose any and all circumstances which might result in a conflict of independence and objectivity, or interfere with loyalty to clients or employer.

Standard VI(B) – Priority of Transactions

This standard specifies that investment transactions for clients or employers must take precedence over investment transactions for a CFA member. Priority of Transactions clearly indicates that the order of transaction priority is (1) clients, (2) employer, and (3) member. Firms and members must also limit personal investment in IPOs and establish black-out periods.

Standard VI(C) – Referral Fees

This requires CFA members to report to employers and clients any sums received from or paid to recommendations of products or services. This should be done in writing, with both parties signing a written agreement.

Standard VII – Responsibilities as a CFA Institute Member or CFA Candidate

Standard VII explains the responsibilities that CFA members or Candidates should have regarding their profession and the CFA Institute.

Standard VII(A) – Conduct as Participants in CFA Institute Programs

Requires that CFA candidates and charterholders must not engage in any behavior that could harm the integrity or reputation of the CFA Institute or its programs.

Standard VII(B) – Reference to CFA Institute, the CFA Designation, and the CFA Program

Members must follow criteria for designating their membership or involvement in CFA programs.  It prohibits the misleading use or reference to the CFA charterholder or candidate status in order to gain personal or professional favors.

Readings 4 and 5: GIPS

GIPS Structure, Compliance with and Benefits from GIPS

The Global Investment Performance Standards was created to establish a standardized set of ethical practices that guide practitioners in analyzing and presenting historical data as a basis for comparison of investment results. Performance reporting is an important concern to the CFA Institute, so GIPS is designed to ensure that firms are not reporting their returns in misleading ways to garner business. GIPS primarily benefits investment firms and the clients of those firms. Through compliance with GIPS, it is assured that a firm’s historical results are presented consistently and fairly.

GIPS compliance is done at the firm level, and there is no partial compliance with the requirements.  If a firm wants to claim GIPS compliance, they must meet every part of the standards. This includes the returns for any subadvisors the fund may utilize.  Firms also cannot claim compliance for only certain portfolios or composites they manage. GIPS-compliance is voluntary and self-regulated.  Due to the nature of this setup, a strong commitment to ethical integrity is required to maintain GIPS-compliance.

GIPS reporting standards require firms to publish 5 years of investment results (or since inception for younger firms) in order to claim compliance.  After becoming compliant, the published returns must be added to so that eventually the firm has 10 years of GIPS-compliant returns available.  The returns are to be in the form of Composites that include all fee-paying portfolios that the firm manages under similar investment strategies.

Firm compliance with GIPS is to be stated as “Firm A has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS).” Compliant firms must provide a compliant presentation of returns to every potential client.

There are nine sections of GIPS:

  1. Fundamentals of Compliance
  2. Input Data
  3. Calculation Methodology
  4. Composite Construction
  5. Disclosure
  6. Presentation and Reporting
  7. Real Estate
  8. Private Equity
  9. Wrap Fee/Separate Managed Account (SMA) Portfolios

GIPS recommend, but do not require, periodic audits of returns data, whether by internal auditors or independent firms. Thorough audits of all processes instill confidence in investors who rely on GIPS for faith in firm performance.

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