Standard III(C) – Suitability

Standard III(C) – Suitability refers to providing recommendations and transactions that align with a client’s willingness and ability.

Compliance

The essence of Standard III(C) – Suitability lies in the notion that a client’s objectives and financial circumstances are unique. For example, some may favor higher risk with the prospect of higher gains, while others desire to preserve what they have with moderate gains.

CFA members are compelled to carefully consider each client’s needs and financial circumstances before making decisions on their behalf. The key to determining suitability is obtaining knowledge related to clients’ experience with investments and their objectives.

At the start of a client relationship, an investment professional collects information such as financial circumstances, age, profession, and attitudes toward risk. This information should be translated into a written investment policy statement (IPS) that outlines risk assessment, timeline, tax considerations, and unique circumstances.

Each IPS should be updated annually, if not more frequently.  Changes to an individual client’s IPS may include increased or decreased income, change in the number of dependents, or adjusted attitude toward risk.  Examples of IPS updates for institutional clients might be the number of unfunded liabilities in a pension fund, changes in withdrawal policies for employees, or adjustment to credit rating.

Categories:

1. Client Identification – Ex: type of clients, profession, list of individual beneficiaries
2. Investor Objectives – Ex: investment objectives, risk tolerance
3. Investor Constraints – Ex: liquidity needs, expected cash flows, time horizon, tax consideration, legal circumstances, investor preferences, proxy guidance
4. Performance measurement benchmarks

Note. Adapted from 2017 CFA Curriculum (p. 135) by CFA Institute, New York: 2017

Generally speaking, diversification within client portfolios is the most suitable means of investment. Risks associated with individual security are limited when that security is bundled with other similar investments.

Also related to risk assessment, a client may request a transaction outside the recommendation of an agreed-upon IPS.  In these cases, a CFA member has the responsibility to explain risks associated with this investment and balance the portfolio to maintain client parameters.

Violation

An increase in legally required suitability tests should indicate that CFA members are obligated to adopt suitability policies. Beyond the analysis of possible return on investment, a member should investigate the impact of an investment on the overall portfolio diversification and the alignment of an investment with clients’ risk tolerance.

As an example of a possible violation, a manager of a high-income mutual fund should not invest in zero-dividend stock even if s/he believes it to be undervalued unless the stock is within the excepted fund’s mandate as made available within its disclosures.

Question

Abdul Mahjeed manages the portfolio of Anna Papazian, a wealthy client with whom he’s had a professional relationship for more than a decade. Ms. Papazian receives regular communication from Mahjeed’s firm indicating that she should contact her investment professional if there is a change in “life-status.”  Papazian has not contacted the firm, and Mahjeed has not spoken with her in more than two years.  Has Mahjeed fulfilled his obligation with respect to Standard III(C) – Suitability?

1. Mahjeed’s long-standing relationship with Papazian makes him ideally suited to make relevant changes in his client’s investment policy. Therefore, he is not in violation of Standard III(C) – Suitability.
2. Mahjeed’s firm has maintained communication with Papazian, requesting information related to any change in life-status that may impact her portfolio. Therefore, the firm’s burden of responsibility has been met.
3. Mahjeed is in violation of Standard III(C) – Suitability by not regularly assessing knowledge related to his client’s current circumstances and objectives.

Solution

The correct answer is C.

Standard III(C) – Suitability dictates that CFA members must update clients’ IPS information at least every 12 months.  Although Mahjeed has a long-standing client relationship with Papazian, he is not exempt from this duty.  Furthermore, it is not incumbent upon the firm to ensure that clients communicate changes.  Therefore, Mahjeed is in violation of Standard III(C) – Suitability.