Standard III (C) – Suitability

1. When Members and Candidates are in an advisory relationship with a client, they must:

• Make a reasonable inquiry into a client’s or prospective client’s investment experience, risk and return objectives, and financial constraints prior to making any investment recommendation or taking investment action and must reassess and update this information regularly.
• Determine that an investment is suitable to the client’s financial situation and consistent with the client’s written objectives, mandates, and constraints before making an investment recommendation or taking investment action.
• Judge the suitability of investments in the context of the client’s total portfolio.

2. When Members and Candidates are responsible for managing a portfolio to a specific mandate, strategy, or style, they must make only investment recommendations or take only investment actions that are consistent with the stated objectives and constraints of the portfolio.

Members and Candidates in an investment advisory relationship with clients must consider the needs, circumstances, and objectives of clients when determining the suitability of investment action.

In assessing suitability, members should consider:

• The risk profile of an investment relative to the clients’.
• The impact of investment on the portfolio’s diversification.
• The net worth of the client relative to the risk of the investment.

Standard III(C) – Suitability is directed at Members and Candidates who have an advisory relationship with clients. Members responsible for the execution of orders or sell-side analysts may not be in a position to judge the suitability of a specific client for the final client.

Developing an Investment Policy

Members and Candidates in an investment advisory role are required to gather information about a client at the start of their relationship.

The information required includes but is not limited to:

• The financial circumstance of the client.
• Personal data relevant to investment decisions, e.g., age, occupation.
• Risk attitudes.
• Risk tolerance.
• Return objectives.
• Investment constraints.

The information received should form the basis of the client’s investment policy statements (IPS). The IPS should outline the roles and responsibilities of the parties, the investment relationship, and the review/evaluation procedures of the IPS. Members and Candidates can then proceed to create an appropriate strategic asset allocation for the client in combination with long-term capital market expectations.

Understanding the Client’s Risk Profile

One of the most relevant considerations in determining the suitability of a potential investment is a client’s risk tolerance. Members and Candidates should consider the risk associated with each security in isolation and the impact of the addition on the total portfolio risk.

Updating and Investment Policy

A client’s IPS should be updated at least annually and before any material changes to investment actions or recommendations. The needs and objectives of a client may evolve over some time. A review of the client’s investments and their suitability are more effective when a client fully discloses their financial portfolio and investment history.

Diversification

The combination of assets with different risk characteristics may provide a more acceptable risk exposure than having a portfolio invested in one single investment. Members and Candidates are encouraged to maintain a reasonable amount of diversification when managing individual and institutional portfolios.

Addressing Unsolicited Trade Requests 

A Member or Candidate may receive a trade request from a client that is not in line with the investment policy statement. In this circumstance, the member must refrain from making the transaction before addressing his/her concerns with their client first.

If an unsolicited trade is not expected to have a minimal impact on the whole portfolio, the Member or Candidate should inform the investor about how this particular investment action deviates from the IPS. Following the conversation, the Member or Candidate may follow their firm’s policies on unsuitable trade requests.

On the other hand, clients may request trades that may have a material impact on the entire portfolio. In this case, the Member or Candidate should update the client’s IPS. Members or Candidates may have clients who refuse to make changes to their IPS. The Member or Candidate may follow firm policy, which permits the trade to be made in a client-directed account. If no other possibilities exist, the Member or Candidate may have to terminate the relationship with the client.

Managing to an Index or Mandate

Members and Candidates responsible for managing a fund in line with a mandate or index must invest in a manner consistent with the mandate or index.

Compliance Recommendations

Investment Policy Statement

Members and Candidates should put the needs and circumstances of their clients in a written investment policy statement.

Regular Updates

Members and Candidates should perform a periodic review of a client’s IPS, to reflect any changes in their objectives, constraints, or circumstances. An annual review of the IPS is recommended.

Suitability Tests

Members and Candidates should encourage their firms to develop and implement suitability tests that investigate further than the potential return of the investment.

Suitability tests should include:

• Analysis and impact of diversification.
• Comparison of the investment risk and the client’s risk tolerance.
• The fit of the investment in relation to the client’s investment strategy.

Application 1: IPS Update

Joseph Layfield has a financial portfolio worth USD 100,000. His father passed away and left him with a USD 5 Million inheritance. Over two years, Umar Farheed, his investment adviser, has not made any changes to his IPS. Farheed continues to manage Layfield’s portfolio with the same objectives and constraints listed in his initial in his IPS.

Has Farheed violated Standard III(C) – Suitability?

    A. No, he is managing Layfield’s portfolio in line with his IPS.

    B. Yes, he has failed to update Layfield’s portfolio to incorporate Layfield’s change in circumstance.

    C. No, Layfield’s inheritance does not materially change his objectives and needs.

Solution

The correct answer is B.

Layfield receiving his inheritance would be considered a material change in his circumstances. Layfield can assume more risk and can broaden his investment holdings. Farheed has violated Standard III(C) – Suitability by failing to update Layfield’s IPS to reflect his significant change in circumstance.

Application 2: Following an Investment Mandate

Travis Green is a portfolio manager responsible for InvesTank’s high growth fund. He purchases high-income (low-growth) stocks of several utility firms. He believes that these stocks are significantly undervalued and would provide a sizable positive return for the fund.

Would Green’s purchase of high-income stocks violate Standard III(C) – Suitability?

     A. Yes, because he is not following the investment mandate of the fund.

     B. No, because he has the discretion of the stock selection of the fund.

     C. No, because the potential upside to the fund from his selection would benefit the beneficiaries of the fund.

Solution

The correct answer is A.

Green has violated Standard III(C) – Suitability. The purchase of the high-income stocks does not fit the investment mandate (high-growth fund) that Green manages. Green must manage the fund according to the investment mandate of the fund.

Application 3: Investment Suitability – Risk Profile

Astrid Coates specializes in managing public and private university endowments. In an attempt to motivate its employees, Brighter Asset Managers has introduced a bonus compensation scheme that ties its manager’s bonus’ to their performance relative to their peers and certain benchmarks. Thomas College Fund – an endowment fund that Coates manages – has an extremely conservative outlook on its IPS and has the main objective of capital preservation. Coates changes her investment strategy and shifts the initial strategic asset allocation (S.A.A) of Thames College portfolio from: 

                                   80% bonds, 15% equity, 5% alternative investments

To a new allocation of:

                                    40% bonds, 50% equity, 10% alternative investments

She does not inform Thomas College of the change in allocation. Her strategy pays off, and she beats her benchmark and is one of the top managers in her firm. Additionally, Thomas College is impressed with her strategy and encourages her to keep up with the good work.

Has Coates violated Standard III(C) – Suitability?

      A. No, because she delivered good results for Thomas College.

      B. No, because her chosen strategy was in the best interest of Thomas College.

      C. Yes, because her strategy is contrary to the risk profile and objectives of Thomas College.

Solution

The correct answer is C.

Coates has violated Standard III(C) – Suitability by changing the asset allocation of Thomas College’s endowment. Her inclusion of more risky assets (equity and alternative investments) is a departure from the conservative portfolio laid out by the IPS. The performance of the strategy is irrelevant in this case; Coates should always follow the IPS of a client or the mandate of a fund.

Application 4: Investment Suitability – Entire Portfolio

Jared Cameron is a financial advisor to several high-net-worth clients in New York. One of his clients, Sebastian Mattel, is looking for a strategy that would increase the investment income in his portfolio. Cameron suggests that Mattel sell puts at appropriate strike prices on Galaxy Technologies. karensingermd.com Mattel has no holdings of Galaxy Technologies in his portfolio at the moment but would be willing to re-allocate some of his assets to purchase Galaxy stock at the right price. Cameron educates Mattel on the possible outcomes of selling puts, the risks involved, the impact of adding puts to his entire portfolio, and the implications of the put options being exercised. In his IPS there is a strict prohibition of the sale or purchase of derivatives. Mattel is happy for Cameron to update his IPS to include the permission of the sale and purchase of derivative instruments.

Is Cameron in compliance with Standard III(C) – Suitability?

     A. No, because derivatives are complicated instruments and are often high risk.

     B. Yes, because Cameron explained the risks and updated Mattel’s IPS accordingly.

     C. No, because the inclusion of derivatives may not be suitable for Mattel’s portfolio.

Solution

The correct answer is B.

Cameron complies with Standard III(C) – Suitability. He has explained the impact of the inclusion of derivative instruments and in the context of the entire portfolio. Additionally, he has updated Mattel’s IPS to include the permission of derivative instruments in his portfolio.

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.