ETH 7 Guidance for Standard V: Investment Analysis, Recommendations, and Actions
Standard V governs the analytical side of the job: how conclusions are reached, how they reach the client, and how the trail is preserved. It splits into three lettered parts, and the whole standard turns on one plain idea. A recommendation is only as trustworthy as the work behind it, the honesty of the way it is described, and the ability to show later how it was formed. Weakness in any one of the three lets the other two down.
The reading treats each part in the same rhythm: the requirement itself, guidance that interprets it, procedures a firm can adopt to stay compliant, and a series of short cases that label conduct as either acceptable or a breach. The sections below keep that order for every subpart.
| Subpart | Core obligation |
|---|---|
| V(A) Diligence and Reasonable Basis | Do thorough, independent work and hold an adequate factual basis before advising or acting |
| V(B) Communication with Clients and Prospective Clients | Disclose services, costs, process, risks, and the factors behind a view, and keep fact apart from opinion |
| V(C) Record Retention | Keep records that support the analysis, the recommendation, and the client communications |
The worked cases throughout are applied judgement scenarios. Read the facts, decide whether the conduct meets the standard, then check your reasoning against the solution.
Standard V(A) sets two linked requirements. Members and candidates must bring diligence, independence, and thoroughness to the way they analyze investments, form recommendations, and take action; and they must hold a reasonable and adequate basis, backed by suitable research and investigation, for whatever analysis, recommendation, or action they produce.
What diligence and a reasonable basis mean
Diligence is careful, consistent, thorough effort. A reasonable basis means applying sound judgment and appropriate care to a rational, well-considered process aimed at the decision at hand. How much work that takes is not fixed. It scales with the investment philosophy being followed, the professional’s role in the decision chain, and the resources the employer supplies. Those three factors together set the depth of research and the level of investigation the standard demands in any given situation.
Recommendations and actions
Clients seek advice precisely because they expect the professional to know more than they do, and that knowledge is what supports any action taken on their behalf. At minimum, clients want confidence that real effort stands behind a recommendation. Sharing the supporting material, and describing how much was reviewed before a judgment was reached, lets a client gauge whether the recommended action is sensible. As with suitability, the necessary depth of analysis varies with the product or service. Professionals typically draw on a mix of company reports, outside research, and quantitative model results, and a defensible basis comes from weighing those sources together rather than leaning on any single one. Attributes worth weighing when building the basis for a view include the following.
- Macroeconomic conditions at the global, regional, and country level.
- A company’s operating and financial track record.
- Where the industry and sector stand today, including the phase of the business cycle.
- What quantitative models generate, along with where those models fall short.
- A pooled fund’s management record and the way its fees are built.
- The quality of the assets bundled inside a securitization.
- Whether the chosen peer group is a fair comparison.
Even a well-supported view carries downside risk, because every decision rests on the facts known at the time. A professional can only act on the information available when the decision is made; diligent process does not remove risk, but it reduces the chance of an avoidable bad outcome.
Judging the sources of information
Professionals should make reasonable inquiries into where their data comes from and how accurate it is, and the source itself sets the level of scrutiny. Material pulled from blogs, research aggregation sites, or social media generally warrants closer checking than material from an established research house. When relying on research produced by others, the reading draws a line between secondary research, done by someone else inside the firm, and third-party research, done by an outside entity such as a broker, bank, or research firm. Either way, the professional must make diligent efforts to confirm the work is sound, and must not rely on it at all where there is reason to think the source is biased, unreliable, or otherwise flawed. Useful tests of soundness include the assumptions applied, the rigor of the analysis, how current the work is, and how objective and independent the conclusions are. A professional may lean on colleagues who vetted a data vendor and use the information in good faith, for instance where senior management already ran due diligence on which vendor to use, unless something surfaces that calls the process into question.
Quantitative models and techniques
The standard reaches quantitatively driven work as well: backtesting strategies, computer screening and ranking of securities, building or valuing derivatives, and quantitative portfolio construction. Users of a model do not have to master every technical detail, but they must grasp its assumptions, its limits, and how its output feeds the decision. They must also make reasonable efforts to test that output before folding a tool into their process. Anyone who builds a new model owes a higher level of scrutiny than the eventual users, and a thorough test of the model and its results must be finished before the product is distributed. Because no single model captures every factor, the analysis should span a broad enough set of assumptions to reflect the real character of the investment, including outcomes worse than normal. A model that ignores negative scenarios or unusual risk can misstate true economic value, so professionals should stress the inputs that most influence value, including adverse market events. They should also weigh the source and time span of the input data, since a database may not contain both good and bad market cycles; where it does not, the model may need to be run with volatility and performance assumptions drawn from beyond the observed record.
Selecting external advisers and subadvisers
Firms often hire specialist managers to cover asset classes or strategies outside their in-house strength, and the standard applies to that selection too. An external adviser or subadviser deserves the same diligence as any direct investment. Those making the choice should apply consistent, objective criteria, such as reviewing the adviser’s own code of ethics, understanding its compliance and internal controls, judging the quality of its reported returns, and confirming that its process matches its stated strategy. Whether the adviser follows recognized industry standards is one more useful marker; the CFA Institute Asset Manager Code, the Global Investment Performance Standards (GIPS), and the Model Request for Proposal can all serve as selection benchmarks.
Group research and consensus
Much analysis is produced by a team, and a group report reflects the group’s consensus rather than every contributor’s personal view, even when a given name appears on it. A member or candidate who disagrees with the consensus does not have to remove their name or dissociate, provided they are satisfied the conclusion rests on a reasonable and adequate basis and is both independent and objective. Confidence in the process, not agreement with the final wording, is the test.
Compliance practices
To support the standard, firms can put several policies in place: require that reports, ratings, and recommendations rest on a basis that can be shown to be reasonable and adequate; write out the due diligence procedures for judging that basis; set measurable criteria for research quality and for tracking the accuracy of recommendations over time; establish minimum scenario testing for every computer model, covering the breadth of scenarios, the accuracy of output over time, and the sensitivity of cash flows to inputs; set measurable criteria for outside data providers and a schedule for reviewing them; and adopt an objective, consistent set of criteria for evaluating external advisers, including how often each allocation is reviewed.
Hawke heads corporate finance at a securities firm. The firm expects the government to soon shut a tax break that lets exploration companies pass drilling costs to a certain class of shareholders, and demand for that share class is high right now. To beat the closing window, the firm lines up several companies to issue new equity at once, but it lacks the resources to research all the issuers properly. Hawke decides to set the offering prices from each company’s rough size and to justify the numbers later, once her staff has time.
Newbury advises high-net-worth clients. A client whose policy statement records an aggressive risk profile asks about the Top Shelf hedge fund, which has reported returns of 20 percent in each of its first three years. The prospectus describes leveraged long and short positions taken in the energy sector. Newbury studies the track record, the principals, the fees, and the risk profile, then recommends the fund and buys a position. Six months later the fund reports a loss of 60 percent of its value and freezes redemptions pending a regulatory review.
Liakos sells derivative strategies. A client is sure that commodity prices will grow more volatile and asks for a strategy to profit from that view on a tight deadline. Liakos hands the request to the firm’s modeling group, which, pressed for time, farms out parts of the work to trusted outside parties. Liakos assembles the pieces as they arrive. Within a month the client is proven right and volatility jumps, yet the position suffers mounting losses. Investigation shows that although each component had been validated on its own, the parts were never tested together, and under extreme conditions some worked against others, sinking the whole strategy.
The labels matter because they point to who did the work, not to how much you can trust it. Secondary research comes from someone else inside your own firm; third-party research comes from an outside house such as a broker or research vendor. In both cases the duty is the same: confirm the work is sound before relying on it, and refuse to use it where the source looks biased or deficient. Being handed research by a colleague does not transfer the responsibility away from the person who uses it.
Standard V(B) sets out what must be communicated. Members and candidates must disclose the nature of the services they provide and the costs the client will bear; disclose the basic format and general principles of their investment process, and promptly flag any change that could materially affect it; disclose the significant limitations and risks of that process; use reasonable judgment about which factors matter and include them in client communications; and keep fact separate from opinion when presenting analysis and recommendations.
How broadly communication is read
Communication here is not limited to the classic written research report. It can travel by any channel, including a spoken recommendation, an electronic message, a social media post, or a broadcast. It ranges from a single word, buy or sell, to a report running past a hundred pages, and may address the market, an asset allocation, a class of investments, or one specific security. Where a recommendation is delivered in shorthand, such as a recommended stock list, clients should be told that fuller analysis is available from whoever produced it. When information goes out electronically or through social media, professionals must take reasonable steps to make sure every client is treated fairly, since some channels are not available to all clients.
Nature of services and costs
The Code and Standards exist in large part to let clients make fully informed decisions, and that starts with a clear picture of the services they will receive and what those services cost. Clients need to know not only what will be provided but what will not, so expectations are set correctly; best practice is to state the nature and scope of the engagement in writing at the outset. On cost, the duty covers the charges the client is expected to pay. It does not require quoting a specific dollar figure. A firm charging a quarterly fee on assets under management cannot state a dollar amount in advance, and no one has to reveal the firm’s own internal cost of delivering the service. The disclosure is ongoing, not a one-time event at the start, so any change in services or costs must be pushed out to every affected client and prospective client on a timely basis. The scope also runs beyond the entity the client deals with directly: costs arising from affiliates, related entities, or third parties used in serving the client are included. A professional may not treat a client’s supposed sophistication as an excuse to withhold this information, though the level of detail can be tailored to each client.
Disclosing the investment process
Clients and prospective clients must be given the basic parameters of the decision-making process, including the important factors that push recommendations in either direction and the significant risks and limits of the process used. Professionals must keep clients current as the process changes, especially where a newly identified risk or limitation appears, because only a client who understands the product can judge whether a change threatens their objectives. Understanding an investment matters most in portfolio context: a stock that would be 90 percent of one investor’s holdings plays a completely different role than the same stock at 2 percent of a diversified portfolio. Where the process uses external advisers to run part of a client’s assets, that use must be disclosed too, so the client sees the full mix of strategies and the manager’s reliance on others.
Risks and limitations
Significant risks and limitations must be disclosed, and clients notified when the risk character of a security or strategy shifts markedly. Which risks count depends on the process and the client’s own situation. General market risk and the risks of complex instruments deemed significant must be covered, and other candidates include counterparty, country, sector, security-specific, and credit risk; the use of leverage is treated as significant almost by default. Limiting factors matter as well, notably liquidity, the ability to exit an investment on time at a reasonable cost, and capacity, the size beyond which new money starts to drag on returns. The duty runs only to risks known at the time. A professional cannot disclose a risk they were unaware of, and a later loss from such a risk may point to a diligence gap under V(A) rather than a breach of V(B).
Important factors, and fact versus opinion
A published report or recommendation should present the basic characteristics of what is being analyzed, so a reader can weigh it and add their own considerations. A report may dwell on some points, touch others lightly, and drop matters judged unimportant, as long as the writer states the limits of the report’s scope. Advice built on quantitative work should be backed by readily available reference material, and any change in methodology disclosed. Above all, opinion must be kept apart from fact. Earnings estimates, a changed dividend outlook, and expected future prices are opinions contingent on events, not facts, and in complex quantitative work the professional must separate fact from statistical conjecture and name the known limits. Overstating the accuracy of any model is a trap, because its output is an estimate of the future, never a certainty.
Manner of disclosure and who it binds
The form of disclosure is left to the professional, provided it is appropriate, accurate, timely, and complete, with written disclosure the best practice. In large firms, disclosures about client charges are often dictated by firm policy, but that does not relieve individuals of responsibility: where a firm’s communication is flawed or insufficient, they should alert the firm, supplement it where possible, and, if they cannot fix it, document their objection and dissociate. In general the standard binds client-facing professionals; those on a service team who do not deal with clients are not required to extend their duty to ensure others make the right disclosures.
Dox, a mining analyst, finishes a report on a minerals company. Working from the company’s latest core samples, he estimates the extent of gold on the property himself and concludes that it holds more than 500,000 ounces. His report closes by treating that 500,000-ounce figure as an established fact and issuing a strong buy on the strength of it.
Maalouf works at a large wealth management firm that charges a percentage of the assets it manages, using a standard valuation and fee method disclosed to each client at the start. Over time the firm quietly moves to valuing accounts at their closing market value each billing period rather than on an average daily balance, and it starts folding cash and cash equivalents into the fee base, which used to be left out. Clients are not told.
Yakovlev builds a quantitative strategy that picks a small number of small-cap stocks, typically 10 to 20 names that tend to be illiquid, and it tests well. His firm seeds it with US$10 million, and after two years it beats its benchmark with a Sharpe ratio near 1.0. As the firm prepares marketing materials for large institutions, Yakovlev warns that capacity is limited: beyond roughly US$3 billion, given current conditions, new money could hurt returns. The veteran head of marketing argues that this technical point will muddy the message and says the materials should feature only the strong track record. Yakovlev lets it go, reasoning that the fund holds just US$100 million, nowhere near US$3 billion.
When a self-described small-cap specialist that capped holdings at US$2 billion in market value grows past US$20 billion in assets and lifts that ceiling to US$8 billion, or starts adding non-US names, it is altering the very process clients hired it for. Telling prospective clients and consultants is not enough. Existing clients, some of whom may have paired the manager with a mid-cap specialist in a multiple-manager setup, must be notified too, because to them the shift can distort their overall allocation.
Standard V(C) tells members and candidates to build and keep suitable records behind their analyses, their recommendations, the actions they take, and their other investment-related dealings with clients and prospective clients. The records are the proof that the work behind V(A) actually happened and that the disclosures behind V(B) were made.
What must be kept
Professionals must keep records that back up how far their research went and why they reached the conclusions or took the actions they did. This covers decisions to buy or sell and, importantly, reviews that lead to no change in a position at all. Which records are needed depends on the professional’s role in the decision process. Typical supporting documentation includes personal notes from meetings with a covered company, that company’s press releases and presentations, the outputs of computer models, the input parameters fed into those models, analyses of how a security affects portfolio risk, the criteria used to select external advisers, notes from client meetings, and outside research reports.
The move to electronic and online communication does not shrink this duty; it widens the list of things to capture. The format of the information never removes the responsibility to keep a record of what was used in analysis or sent to clients. The records that must be retained now take in text messages, emails, posts on blogs, and posts on social media.
Records belong to the firm
As a rule, records created as part of professional work for an employer are the firm’s property, not the individual’s. A member or candidate leaving for a new job cannot carry off the firm’s property, including originals or copies of supporting records, without the former employer’s express consent. They also must not use historical recommendations or reports made at a previous firm when the supporting documentation is not available. To reuse earlier work at a new employer, those supporting records must be rebuilt afresh once there, and they cannot be reconstructed from anything carried over from the old firm without a clear go-ahead from it.
Firm and regulatory requirements
Professionals must know and follow their employer’s policies and the regulatory rules on record retention. Because those rules can lag behind new ways of communicating, extra responsibility falls on the individual to keep everything relevant. Local regulators often set retention time frames, and firms may set their own; meeting those requirements satisfies Standard V(C). Where no regulation or firm policy gives a time frame, CFA Institute recommends keeping records for at least seven years. Responsibility for maintaining supporting records generally rests with the firm rather than the individual, but professionals should still archive their own research notes and documents, on paper or electronically, which also helps the firm meet its preservation obligations.
Blank builds an analytical model while employed at an investment management firm, carefully documenting the assumptions and his reasoning as he goes. The model succeeds, and a competitor hires him to run its research department. Blank carries copies of the records that document the model to his new employer.
Cannan sometimes works from home on weekends and saves client correspondence and finished reports on her home computer. After a downturn she is laid off. While job hunting she uses those saved files to ask former clients for reference letters and to show prospective clients samples of her work.