Standard V (A) – Diligence and Reasonable Basis

Members and Candidates must:

1. Exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions.
2. Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action.

The application of this Standard depends on the investment philosophy that the Member, Candidate, or firm follows, the role the Member or Candidate plays in the investment recommendation or decision process, and the resources and support offered by the Member or Candidates’ employer. The factors highlighted will determine the rigor of research and the depth of due diligence required.

Members and Candidates must make reasonable efforts to consider all relevant information when arriving at investment recommendations. Members and Candidates may enhance transparency by providing supplementary information that supports their investment recommendations.

Defining Diligence and Reasonable Basis

Clients rely on the expertise and knowledge of Members and Candidates to inform their investment decisions. Consequently, clients require assurance that Members and Candidates make the required effort to support any investment recommendations. Members and Candidates can provide greater transparency to their clients by communicating the breadth of information used and the considerations taken to arrive at investment recommendations.

Some factors to consider while forming the basis of a recommendation include:

• Global and national macroeconomic conditions.
• The company’s historic operating and financial results.
• Industry and sector conditions and stage of the business cycle of the firm.
• Output and limitations of quantitative models.

Secondary and Third-Party Research

Members and Candidates are required to make a reasonable and diligent effort to determine the quality and soundness of external research.

Secondary research is defined as research conducted by someone who works at the same firm as the Member or Candidate. Third-party research is defined as research conducted by entities outside the firm, e.g., investment banks, brokerages.

Factors to consider while evaluating the basis of external research includes:

• Assumptions used.
• The rigor of analysis performed.
• Timeliness of data used.
• Independence and objectivity of the author.

Members and Candidates should encourage the development and adoption of review policies of external research providers to ensure that the quality of the research is maintained at a high standard.

Quantitatively Oriented Research

There has been an increase in the use of quantitative models to arrive at investment recommendations, stock selection, stock screening, and portfolio construction techniques. Members and Candidates are required to know the parameters, assumptions, and limitations of the models they use. In addition, Members and Candidates should incorporate a broad range of assumptions that capture the volatile nature of investments. The omission of negative outcomes or tail events may misrepresent the potential range of values that an investment can take.

Developing Quantitatively Oriented Techniques

Members and Candidates involved in the development or oversight of quantitative models must demonstrate a greater level of diligence than those who use the final model.

Members and Candidates involved in the creation of quantitative models must:

• Understand the technical aspects of products and services.
• Consider the time horizon of the data inputs used.
• Fully understand the assumptions of the model.
• Ensure the model captures a wide range of inputs (including negative market events).

Selecting External Advisers and Sub-advisers

Standard V(A) – Diligence and Reasonable Basis applies to the rigor of evaluation required when selecting an external manager or subadviser to manage a particular investment mandate.

Members and Candidates directly responsible for hiring or working with external managers should ensure that their firm has standardized criteria for reviewing external advisers.

Such criteria would include but are not limited to:

• Reviewing the adviser’s code of ethics.
• Understanding the adviser’s compliance procedures.
• Reviewing the adviser’s investment philosophy and how strictly they comply with the stated mandate.

Group Research and Decision Making

Members and Candidates will often be part of a team that is tasked with producing a research report or investment recommendation. The conclusions of a report may not reflect the sole opinion of a Member or Candidate, but their names would be included in the report.

If the Member or Candidate has a differing opinion from the consensus view but believes that the conclusions are based on a reasonable and adequate basis, the member does not need to dissociate from the report. If, however, the Member or Candidate believes that the conclusions are not founded on a reasonable basis, he or she should decline to have their name identified with the report.

Compliance Recommendations

Recommendation for Members and Candidates

• Conduct a periodic review of the quality of third-party research.
• Review all assumptions.
• Investigate the rigor of the analysis performed.
• Evaluate the independence of independence and objectivity of recommendations.

Recommendation for Firms

Members and Candidates should encourage their firms to:

• Have policies that require investment reports and recommendations have a basis that can be supported as adequate and reasonable.
• Develop guidelines for analysts that establish due diligence procedures to determine whether a recommendation has a reasonable and adequate basis.
• Develop measurable criteria for evaluating the quality of research.
• Develop guideline procedures that establish minimum levels of scenario testing for all computer-based models.
• Develop measurable criteria to assess external research providers.
• Implement a standardized set of criteria for evaluating external advisers.

Application 1: Group Research Opinions

Calvin Samuelson is a junior fixed-income analyst at FreeHouse Securities. He is tasked with writing a report on the Fed interest rate expectations over the next two quarters. Samuelson completes his report and submits it to the investment review committee – as mandated by the firm’s procedures.

An excerpt from the reports states:

“With the economic slowdown caused by the COVID-19 pandemic, we expect that the Fed will hold the Fed Funds rate steady at 0.25% over the next two quarters.”

The majority of the investment committee does not agree with Samuelson’s conclusions. The committee overwhelmingly believes that there will be a strong bounce back in economic activity and share concerns about unanticipated inflation. They believe the Fed will react by increasing the benchmark rate by 25bps over the next two quarters.

Samuelson does not agree with the consensus conclusion and believes that there is no reasonable and adequate basis for the committee’s conclusions but proceeds to leave his name on the report.

Has Samuelson violated Standard V(A) – Diligence and Reasonable Basis?

      A. Yes, because his report is supposed to reflect his views and conclusions.

     B. No, because the firm’s internal policies require a consensus opinion.

     C. Yes, because he fails to dissociate from the report when he believes that there is no reasonable basis for the conclusions of the report.

Solution

The correct answer is C.

Samuelson has violated Standard V(A) – Diligence and Reasonable Basis by failing to dissociate from the report. The conclusions of any research report or investment recommendation are inherently subjective.

In this case, the investment committee may have valid reasons for conclusions that differ from Samuelson’s. The firm is permitted to publish a report that substantially different from Samuelson’s findings, provided that there is a reasonable and adequate basis for its conclusions. If Samelson believes there is no reasonable basis for the conclusions, he should dissociate from the report – by declining to have his name on the published report.

Application 2: Reliance on Third-Party Research

Phillip Russo is the CEO of a mid-sized asset management firm. His firm relies heavily on external research to inform the firm’s investment recommendations and actions. Russo’s firm subscribes to a service from a reputable boutique research firm. The research firm has recently been awarded a prize for its stellar research coverage of the North American durable goods sector. Russo is confident in the rigor and quality of the research published by the firm and does not perform any independent due diligence to determine the quality and accuracy of data received. Russo always attributes the source of the research and explains this to his clients.

Which of Russo’s actions are most likely a violation of the CFA Institute’s Standards?

       A. None of his actions violate any standards.

       B. His use of external research to inform the firm’s investment actions.

       C. His failure to perform due diligence on external research.

Solution

The correct answer is C.

Russo has violated Standard V(A) – Diligence and Reasonable Basis by failing to perform due diligence on external research. Russo is permitted to use external research, provided that he attributes the research to its original author or publishing entity.

Application 3: Quantitative Model Diligence

Davidson Matthews is the head quantitative researcher at Core Technology Hedge Fund. Matthews is under increasing pressure to improve the firm’s proprietary trading algorithms. The existing models have produced impressive results in a bull market but below average results in the current bear market.

Matthews reads several notable quantitative research blogs and publications. In one piece of literature, he identifies missing factors that would improve the firm’s stock screening algorithm. He immediately incorporates the missing variables into the stock screening algorithm. Matthews shares the new algorithm with the firm’s traders.

Has Matthews violated Standard V(A) – Diligence and Reasonable Basis?

     A. Yes, because he failed to diligently research the impact of introducing new factors into the model.

     B. No.

     C. Yes, because he is not allowed to draw inspiration from blog posts research publications.

Solution

The correct answer is A.

Matthews has violated Standard V(A) – Diligence and Reasonable Basis by failing to diligently assess the impact of the addition of new variables into the existing model. Matthews is allowed to draw inspiration from blogs and research publications, but he needs to perform the necessary research to determine the effect of these changes on the stock screening algorithm.

Reading 46: Guidance for The Standards of Professional Conduct (I-VII)

LOS 46 (a) Demonstrate a thorough knowledge of the CFA Institute Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations.