Ethics 3

Question 1

Describe the structure of the CFA Institute Professional Conduct Program and the disciplinary review process for the enforcement of the CFA Institute Code of Ethics and Standards of Professional Conduct.

Answer 1

The CFA Institute Professional Conduct Program is covered by the CFA Institute Bylaws and the Rules of Procedure for Proceedings Related to Professional Conduct. The Disciplinary Review Committee (DRC) of the CFA Institute Board of Governors has overall responsibility for the Professional Conduct Program and enforcement of the Code and Standards. The Professional Conduct staff conducts inquiries related to professional conduct. Several circumstances can prompt such an inquiry, such as self-disclosure by a member or candidate, written complaints, and evidence of misconduct. The Professional Conduct staff may decide (1) that no disciplinary sanctions are appropriate, (2) to issue a cautionary letter, or (3) to discipline the member or candidate. In a case where the Professional Conduct staff finds a violation has occurred and proposes a disciplinary sanction, the member or candidate may accept or reject the sanction. If the member or candidate chooses to reject the sanction, the matter will be referred to a panel of DRC members for a hearing. Sanctions imposed may include condemnation by the member’s peers or suspension of the candidate’s continued participation in the CFA Program.

Question 2

Explain the ethical responsibilities required by the Code

Answer 2

• Act with integrity, competence, diligence, and 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.
• Place the integrity of the investment profession and the interests of clients above their own personal interests.
• Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities.
• Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession.
• Promote the integrity and viability of the global capital markets for the ultimate benefit of society.
• Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals.

Question 3

Explain the ethical responsibilities required by the Standards, including the sub-sections of each standard.

Answer 3

I. Professionalism: (A) Knowledge of the Law, (B) Independence and Objectivity, (C) Misrepresentation, and (D) Misconduct.

**II. Integrity of Capital Markets: **(A) Material Nonpublic Information and (B) Market Manipulation.

**III. Duties to Clients: **(A) Loyalty, Prudence, and Care, (B) Fair Dealing, (C) Suitability, (D) Performance Presentation, and (E) Preservation of Confidentiality.

**IV. Duties to Employers: **(A) Loyalty, (B) Additional Compensation Arrangements, and (C) Responsibilities of Supervisors.

V. Investment Analysis, Recommendations, and Actions: (A) Diligence and Reasonable Basis, (B) Communication with Clients and Prospective Clients, and (C) Record Retention.

VI. Conflicts of Interest: (A) Disclosure of Conflicts, (B) Priority of Transactions, and (C) Referral Fees.

**VII. Responsibilities as a CFA Institute Member or CFA Candidate: **(A) Conduct as members and candidates in the CFA Program and (B) Reference to CFA Institute, the CFA designation, and the CFA Program.

Question 4

I(A): Knowledge of the Law.

Answer 4

Members must understand and comply with laws, rules, regulations, and the Code and Standards of any authority governing their activities. In the event of a conflict, follow the more strict law, rule, or regulation. Do not knowingly participate or assist in violations, and disassociate from any known violation.

Members must know the laws and regulations relating to their professional activities in all countries in which they conduct business. Members must comply with applicable laws and regulations relating to their professional activity. Do not violate the Code or Standards even if the activity is otherwise legal. Always adhere to the most strict rules and requirements (law or CFA Institute Standards) that apply.

Members should dissociate or separate themselves from any ongoing client or employee activity that is illegal or unethical, even if it involves leaving an employer (an extreme case). While a member may confront the involved individual first, the member must approach his supervisor or compliance department. Inaction with continued association may be construed as knowing participation.

Question 5

I(B): Independence and Objectivity.

Answer 5

Members and candidates must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Members and candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another’s independence and objectivity.

Do not let the investment process be influenced by any external sources. Modest gifts are permitted. Allocation of shares in oversubscribed IPOs to personal accounts is NOT permitted. Distinguish between gifts from clients and gifts from entities seeking influence to the detriment of the client. In any case, gifts must be disclosed to the member’s employer.

Question 6

I(C): Misrepresentation.

Answer 6

Members and candidates must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities.

Trust is a foundation in the investment profession. Do not make any misrepresentations or give false impressions. This includes oral and electronic communications. Misrepresentations include guaranteeing investment performance and plagiarism. Plagiarism encompasses using someone else’s work (e.g., reports, forecasts, charts, graphs, and spreadsheet models) without giving them credit.

Question 7

I(D): Misconduct.

Answer 7

Members and candidates must not engage in any professional conduct involving dishonesty, fraud, or deceit or commit any act that reflects adversely on their professional reputation, integrity, or competence.

CFA Institute discourages unethical behavior in all aspects of members’ and candidates’ lives. Do not abuse CFA Institute’s Professional Conduct Program by seeking enforcement of this Standard to settle personal, political, or other disputes that are not related to professional ethics.

Question 8

II(A): Material Nonpublic Information.

Answer 8

Members and candidates who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on the information.

Information is “material” if its disclosure would impact the price of a security or if reasonable investors would want the information before making an investment decision. Ambiguous information, as far as its likely effect on price, may not be considered material. Information is “nonpublic” until it has been made available to the marketplace. An analyst conference call is not public disclosure. Selectively disclosing information by corporations creates the potential for insider-trading violations.

**Mosaic theory: **There is no violation when a perceptive analyst reaches an investment conclusion about a corporate action or event through an analysis of public information together with items of nonmaterial nonpublic information.

Question 9

II(B): Market Manipulation.

Answer 9

Members and Candidates must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.

This Standard applies to transactions that deceive the market by distorting the price-setting mechanism of financial instruments or by securing a controlling position to manipulate the price of a related derivative and/or the asset itself. Spreading false rumors is also prohibited.

Question 10

III(A): Loyalty, Prudence, and Care.

Answer 10

Members and candidates have a duty of loyalty to their clients and must act with reasonable care and exercise prudent judgment. They must act for the benefit of their clients and place their clients’ interests before their employer’s or their own interests.

Client interests always come first:
* Exercise the prudence, care, skill, and diligence under the circumstances that a person acting in a like capacity and familiar with such matters would use.
* Manage pools of client assets in accordance with the terms of the governing documents, such as trust documents or investment management agreements.
* Make investment decisions in the context of the total portfolio.
* Vote proxies in an informed and responsible manner. Due to cost benefit considerations, it may not be necessary to vote all proxies.
* Client brokerage, or “soft dollars,” must be used to benefit the client.

Question 11

III(B): Fair Dealing.

Answer 11

Members and candidates must deal fairly and objectively with all clients.

Do not discriminate against any clients when disseminating recommendations or taking investment action. Fairly does not mean equally. In the normal course of business, there will be differences in the time emails, faxes, etc. are received by different clients. Different service levels are okay, but they must not negatively affect or disadvantage any clients. Disclose the different service levels to all clients and prospects, and make premium levels of service available to all who wish to pay for them.

Give all clients a fair opportunity to act upon every recommendation. Clients who are unaware of a change in a recommendation should be advised before the order is accepted.

Treat clients fairly in light of their investment objectives and circumstances. Treat both individual and institutional clients in a fair and impartial manner. Members and candidates should not take advantage of their position in the industry to disadvantage clients (e.g., taking shares of an oversubscribed IPO).

Question 12

III(C): Suitability.

Answer 12

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 investment actions that are consistent with the stated objectives and constraints of the portfolio.

In advisory relationships, be sure to gather client information at the beginning of the relationship in the form of an investment policy statement (IPS). Consider client’s needs and circumstances and thus the risk tolerance. Consider whether or not the use of leverage is suitable for the client.

If a member is responsible for managing a fund to an index or other stated mandate, be sure investments are consistent with the stated mandate.

Question 13

III(D): Performance Presentation.

Answer 13

When communicating investment performance information, members or candidates must make reasonable efforts to ensure that it is fair, accurate, and complete.

Members must avoid misstating performance or misleading clients/prospects about investment performance of themselves or their firms, should not misrepresent past performance or reasonably expected performance, and should not state or imply the ability to achieve a rate of return similar to that achieved in the past.

Question 14

III(E): Preservation of Confidentiality.

Answer 14

Members and candidates must keep information about current, former, and prospective clients confidential unless:
* The information concerns illegal activities on the part of the client or prospective client.
* Disclosure is required by law.
* The client or prospective client permits disclosure of the information.
* If illegal activities by a client are involved, members may have an obligation to report the activities to authorities. The confidentiality Standard extends to former clients as well.

The requirements of this Standard are not intended to prevent members and candidates from cooperating with a CFA Institute Professional Conduct Program (PCP) investigation.

Question 15

IV(A): Loyalty

Answer 15

In matters related to their employment, members and candidates must act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential information, or otherwise cause harm to their employer.

Members must not engage in any activities which would injure the firm, deprive it of profit, or deprive it of the advantage of employees’ skills and abilities. Always place client interests above the interests of the employer. There is no requirement that the employee put the employer’s interests ahead of family and other personal obligations.

Independent practice for compensation is allowed if a notification is provided to the employer fully describing all aspects of the services.

**Leaving an employer: **Members must continue to act in their employer’s best interests until resignation is effective.

Whistleblowing: There may be isolated cases where a duty to one’s employer may be violated in order to protect clients or the integrity of the market, and not for personal gain.

Question 16

IV(B): Additional Compensation Arrangements.

Answer 16

Members and candidates must not accept gifts, benefits, compensation, or consideration that competes with, or might reasonably be expected to create a conflict of interest with, their employer’s interest unless they obtain written consent from all parties involved.

Compensation includes direct and indirect compensation from a client and other benefits received from third parties. Written consent from a member’s employer includes email communication.

Question 17

IV(C): Responsibilities of Supervisors.

Answer 17

Members and candidates must make reasonable efforts to ensure that anyone subject to their supervision or authority complies with applicable laws, rules, regulations, and the Code and Standards.

Members must take steps to prevent employees from violating laws, rules, regulations, or the Code and Standards and make reasonable efforts to detect violations.

Understand that an adequate compliance system must meet industry standards, regulatory requirements, and the requirements of the Code and Standards. Members with supervisory responsibilities have an obligation to bring an inadequate compliance system to the attention of the firm’s management and recommend corrective action. While investigating a possible breach of compliance procedures, it is appropriate to limit the suspected employee’s activities.

Question 18

V(A): Diligence and Reasonable Basis.

Answer 18

Members and candidates must:
* Exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions.
* 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 adhered to, members’ and candidates’ roles in the investment decision-making process, and the resources and support provided by employers.

These factors dictate the degree of diligence, thoroughness of research, and the proper level of investigation required.

**Using secondary or third-party research: **Ensure the research is sound.

**Group research and decision making: **Even if a member does not agree with the independent and objective view of the group, he does not necessarily have to decline to be identified with the report, as long as there is a reasonable and adequate basis.

Question 19

V(B): Communication with Clients and Prospective Clients.

Answer 19

Members and candidates must:
1. Disclose to clients and prospective clients the basic format and general principles of the investment processes used to analyze investments, select securities, and construct portfolios and must promptly disclose any changes that might materially affect those processes.
2. Disclose to clients and prospective clients significant limitations and risks associated with the investment process.
3. Use reasonable judgment in identifying which factors are important to their investment analyses, recommendations, or actions and include those factors in communications with clients and prospective clients.
4. Distinguish between fact and opinion in the presentation of investment analysis and recommendations.

Question 20

V(C): Record Retention.

Answer 20

Members and candidates must develop and maintain appropriate records to support their investment analysis, recommendations, actions, and other investment-related communications with clients and prospective clients.

Members must maintain research records that support the reasons for the analyst’s conclusions and any investment actions taken. Such records are the property of the firm. If no other regulatory standards are in place, CFA Institute recommends at least a 7-year holding period.

Question 21

VI(A): Disclosure of Conflicts.

Answer 21

Members and candidates must make full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity or interfere with respective duties to their clients, prospective clients, and employer. Members and candidates must ensure that such disclosures are prominent, are delivered in plain language, and communicate the relevant information effectively.

The requirement that all potential areas of conflict be disclosed allows clients and prospects to judge motives and potential biases for themselves. Disclosure of broker/dealer market-making activities would be included here. Board service is another area of potential conflict.

The most common conflict that requires disclosure is actual ownership of stock in companies that a member recommends or that clients hold.

Members must give the employer enough information to judge the impact of the conflict. Take reasonable steps to avoid conflicts and report them promptly if they occur.

Question 22

VI(B): Priority of Transactions.

Answer 22

Investment transactions for clients and employers must have priority over investment transactions in which a member or candidate is the beneficial owner.

Client transactions take priority over personal transactions and transactions made on behalf of the member’s firm. Personal transactions include situations where the member is a “beneficial owner.” Personal transactions may be undertaken only after clients and the member’s employer have had an adequate opportunity to act on a recommendation. Note that family member accounts that are client accounts should be treated just like any client account—they should not be disadvantaged.

Question 23

VI(C): Referral Fees.

Answer 23

Members and candidates must disclose to their employer, clients, and prospective clients, as appropriate, any compensation, consideration, or benefit received by, or paid to, others for the recommendation of products or services.

Members must inform employers, clients, and prospects of any benefit received for referrals of customers and clients, allowing them to evaluate the full cost of the service as well as any potential impartiality. All types of consideration must be disclosed.

Question 24

VII(A): Conduct as Participants in CFA Institute Programs.

Answer 24

Members and candidates must not engage in any conduct that compromises the reputation or integrity of CFA Institute or the CFA designation, or the integrity, validity, or security of the CFA Institute Programs.

This Standard applies to conduct that includes:
* Cheating on the CFA exam or any exam.
* Revealing anything about either broad or specific topics tested, content of exam questions, or formulas required or not required on the exam.
* Not following rules and policies of the CFA Program.
* Giving confidential information on the CFA Program to candidates or the public.
* Improperly using the designation to further personal and professional goals.
* Attempting to circumvent security measures for any CFA exam.
* Misrepresenting information on the Professional Conduct Statement (PCS) or the CFA Institute Professional Development Program.

Members and candidates are not precluded from expressing their opinions regarding the exam program or CFA Institute.

Question 25

VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program.

Answer 25

When referring to CFA Institute, CFA Institute membership, the CFA designation, or candidacy in the CFA Program, members and candidates must not misrepresent or exaggerate the meaning or implications of membership in CFA Institute, holding the CFA designation, or candidacy in the CFA Program. Members must satisfy these requirements to maintain membership: (1) sign the PCS annually and (2) pay CFA Institute membership dues annually. If they fail to do this, they are no longer active members. There is no partial designation. It is acceptable to state that a candidate successfully completed the program in three years, if in fact they did, but claiming superior ability because of this is not permitted.

Question 26

Explain the purpose of the Asset Manager Code and the benefits that may accrue to a firm that adopts the Code.

Answer 26

The purpose of AMC is to assist the firm in developing ethical business and risk management practices while gaining the trust of clients.

Question 27

Explain the ethical and professional responsibilities required by the six General Principles of Conduct of the Asset Manager Code.

Answer 27

**The AMC covers:** 1. Loyalty to Clients. 2. Investment Process and Actions. 3. Trading. 4. Risk Management, Compliance, and Support. 5. Performance and Valuation. 6. Disclosures. **General principles of conduct:** * Always act ethically and professionally. * Act in the best interest of the client. * Act in an objective and independent manner. * Perform actions using skill, competence, and diligence. * Communicate accurately with clients on a regular basis. * Comply with legal and regulatory requirements regarding capital markets.

Question 28

Recommend practices and procedures designed to prevent violations of the Asset Manager Code.

Answer 28

**Loyalty to Clients** * Always put the client's interests before your own by designing appropriate compensation arrangements for managers. * Determine how confidential client information should be collected, utilized, and stored. * Determine the amount of which token gifts can be accepted. **Investment Process and Actions** * Take reasonable care when dealing with client accounts. * Don't engage in market manipulation. * Deal fairly with all clients. * Have a reasonable basis for all investment recommendations. **Trading** * Do not trade on material nonpublic information. * Always place client trades before your own. * Use soft dollars to aid the manager in the investment decision-making process. * Seek best execution and allocate trades equitably among all clients. **Risk Management, Compliance, and Support** * Ensure compliance with the Asset Manager Code and legal and regulatory requirements. * Appoint a compliance officer. * Disseminate portfolio information in an accurate manner. * Have an independent third party review client accounts. * Appropriately maintain records. * Hire qualified staff with sufficient resources. * Have a contingency plan in place. **Performance and Valuation** * Report results in an accurate manner using fair market values. Disclosures deal with any kind of material information disclosed to the client, such as conflicts of interest, regulatory disciplinary actions, the investment decision-making process, and strategies including inherent risks, fee schedules, calculation of performance results, proxy voting issues, allocating shares of stock, and the results of any audits.

Question 29

Discuss the objectives and scope of the GIPS standards and their benefits to prospective clients and investors, as well as investment managers.

Answer 29

The Global Investment Performance Standards (GIPS®) contain ethical and professional standards for the presentation of investment performance results. The GIPS are a voluntary set of standards. The LOS focuses on the standards for investment management firms. Asset owners who manage assets for an organization, participants, or beneficiaries and compete for business would also use the GIPS standards for firms. **The objectives of GIPS are to:** * Advance the interests of investors and increase their confidence in the investment industry. * Provide accurate and comparable data to investors. * Create a globally accepted standard for the determination and presentation of investment performance. * Facilitate fair competition among global investment managers. * Encourage self-regulation in the global investment industry. **The scope of the GIPS standards is as follows:** * GIPS compliance can only be claimed on a firmwide basis. * To claim GIPS compliance, a firm must comply with all, not just some, of the applicable GIPS standards requirements. * A claim of GIPS compliance indicates, among other things, that: * A firm's data inputs, processes, and return calculations are compliant. * All the firm's fee-paying segregated accounts and limited-distribution pooled funds have been assigned to at least one composite.

Question 30

Explain the fundamentals of compliance with the GIPS standards, including the definition of the firm and the firm's definition of discretion.

Answer 30

* A firm is held out to clients or potential clients as a distinct business entity. * A distinct business entity is that which is separated from other parts of the firm and retains discretion over asset management. * Judgment is required to determine what qualifies as a distinct business entity. The definition of the firm is used to determine the fair value of total firm assets, which for the defined firm: * include discretionary and nondiscretionary assets. * include fee-paying and non-fee-paying assets. * are net of leverage used. * are only actual (not simulated) assets. * exclude advisory-only assets. * exclude uncalled, but committed, capital. **Other Compliance Fundamentals** * When calculating composite assets (not total firm assets), nondiscretionary assets are not included (i.e., only include discretionary assets when calculating composite performance). * To initially claim compliance with the GIPS standards, the firm must attain compliance for a minimum of five years or for the period since firm inception if the firm has been in existence for less than five years. * Firms must establish, update, and document GIPS policies and procedures. * If the GIPS standards conflict with local laws and regulations, the firm must comply with local laws and regulations and disclose the conflict. * The firm must not present performance-related information that is false or misleading. * The firm must provide an annual GIPS-compliant report to all existing clients for relevant composites. * Benchmarks must reflect the corresponding investment strategy and be total return benchmarks. * The firm must disclose all material errors and disclose corrected reports to current clients and verifiers. * The firm must maintain GIPS compliance data and a list of composites for the last five years.

Question 31

Discuss requirements of the GIPS standards with respect to return calculation methodologies, including the treatment of external cash flows, cash and cash equivalents, and expenses and fees.

Answer 31

PS requires comparable return calculation methods to facilitate comparison of results. In many cases, there are interim external cash flows (ECF), such as client withdrawals (outflows) or additional client contributions (inflows) that can distort return calculations. Ideally, to eliminate these potential distortions, the investment would be valued each time an interim ECF occurs. The subperiod returns must then be geometrically linked to create a true time-weighted rate of return (TWRR): Rtwrr = (1 + R1) × (1 + R2) × (1 + R3) × ...× (1 + Rt). The methods of calculating an approximate return that do not require interim valuations are the Modified Dietz and MIRR methods. The modified internal rate of return (MIRR) is simply an internal rate of return (IRR) that adjusts for the timing of the ECFs. Since both the Modified Dietz and MIRR use the number of days in the month, they are said to be methods that adjust for daily-weighted ECFs. The Modified Dietz and MIRR typically provide similar values. Under the GIPS requirements: * Firms must calculate monthly returns for non-private market investment portfolios. * If a firm calculates daily valuations and returns, the daily return must be geometrically linked to create a monthly true TWRR. * If a firm does not calculate daily returns and the ECFs are not large, approximations to the true TWRR that do not require an interim valuation can be used. * If the ECFs are large, the portfolio must be valued at the time of the ECFs to calculate a subperiod return. * Regardless of how the monthly return is calculated, the monthly return must be geometrically linked to create an annual return. For portfolios other than non-private market investment portfolios, the GIPS requirements are as follows: * Private market investment portfolios values and returns must be calculated quarterly. * Pooled funds not in a composite must be valued and returns calculated at least annually. * The fund must also be valued and a subperiod return calculated at the time of subscriptions or redemptions. **Large Cash Flows** * The definition of a large ECF is determined by each firm for each composite. * Generally, a large ECF is large enough to affect the return calculation. * The firm's policy for the determination of a large cash flow must be documented. There are some investment strategies where the firm controls the timing and size of the ECFs. In these cases, a money-weighted return (MWR) will be more representative of the manager's skill than the TWRR. MWRs can be used instead of TWRRs if: * The firm has control of the timing of ECFs. * The portfolios are closed-end, or fixed life, or fixed commitment, or have a significant amount of illiquid assets. The MWR (which is an IRR calculation) must be calculated and the portfolios valued at least annually. Other return calculation requirements are as follows. * Trade date, not settlement date, prices must be used to calculate returns. * Partial-year returns cannot be annualized. * Total returns, which include income and capital gains/losses, must be used. * For investments that generate income, such as bonds, accrual accounting must be used. * Returns must reflect the manager's allocations to cash and cash equivalents. * Under GIPS, the presented gross-of-fees return must have been calculated after the deduction of transactions costs. * Transactions costs reflect the costs of buying and selling securities. * Examples include brokerage commissions, spreads, and exchange fees. * For private market investments, they can also include legal, advisory, and other fees. * Custody fees should not be included. * Transactions costs can be estimated but only if they are unknown. * In some cases, portfolios pay bundled or all-in fees, which can include trading costs, as well as investment management, custody, administrative, and other fees. * In this case, the presented gross-of-fees return must be reduced by: * The portion of the bundled fee due to transactions costs; or * The entire bundled fee if the transactions costs cannot be separated out.

Question 32

Explain requirements of the GIPS standards with respect to composite construction, including switching portfolios among composites, the timing of the inclusion of new portfolios in composites, and the timing of the exclusion of terminated portfolios from composites.

Answer 32

Regarding the movement of portfolios into and out of composites, the GIPS standards require firms to have policies for: * When portfolios are included in composites. * When portfolios are excluded from composites. * Switching a portfolio from one composite to another. * Cash flows from new investments or liquidations. * The minimum asset level for a composite. The firm's policy should be established on a composite-by-composite basis and applied in a timely, consistent manner. **Portfolio Inclusion** * New portfolios should be included in a composite at the beginning of the next full measurement period. * However, the firm has discretion on the timing of portfolio inclusion because it may take time to invest new funds if the funding is other securities or if illiquid markets are being invested in. * Thus, the firm's documented policy may vary by composite, with some composites allowing for longer periods before portfolio inclusion. **Portfolio Exclusion** * Terminated portfolios should be included in a composite through the last full measurement period in which the firm had discretion. * Clients sometimes direct a firm to stop trading an account or transfer control to a new manager before the portfolio is fully liquidated. **Switching Portfolios** * A portfolio can be switched to a new composite due to actions by the client or by the firm. * A client may change the portfolio's mandate, objective, or strategy. * The firm may redefine the composite such that the portfolio is no longer appropriate for the composite. * Redefining a composite by a firm should be highly unusual. * When a portfolio is switched to a new composite, the portfolio's performance must remain in the old composite's historical performance. **Significant Cash Flows** * Significant (as defined in the firm's documentation) cash flows are those large enough such that they impede the firm from implementing the strategy on a timely basis. * To prevent composite performance from being affected by cash inflows/outflows in the event of significant cash flows, a firm can temporarily exclude the portfolio from the composite or create and report on a temporary new account (outside of the composite). **Minimum Asset Levels** * As portfolios change in size, they may be added to or removed from a composite as per firm policy. * The minimum asset level must be specified in advance, and portfolios that are removed cannot have their prior performance removed from the composite's historical record.

Question 33

Explain requirements of the GIPS standards with respect to composite return calculations, including methods for asset-weighting portfolio returns.

Answer 33

Composite returns must be calculated in one of three ways: 1. Asset-weighting portfolio returns by beginning-of-period values. 2. Asset-weighting portfolio returns by both beginning-of-period values and ECFs. 3. The aggregate method. The first method is perhaps the simplest as each portfolio return is just multiplied by its beginning of the period weight. The second method is similar except that we also adjust for the ECFs. The third method uses total composite values at the beginning and end of the period.

Question 34

Explain requirements of the GIPS standards with respect to presentation and reporting.

Answer 34

GIPS requires that firms must make every reasonable effort to provide a GIPS report to prospective clients and limited-distribution pooled fund investors. The requirements for Composite Time-Weighted Return Reports include the following: * At least 5 years of performance history upon GIPS adoption: * Unless the firm has been in existence for less than 5 years. * And then extended each year until the firm builds a 10-year GIPS compliant history. * Time-weighted returns for the composite and benchmark. * The amount of firm assets. * The amount of composite assets. * The number of portfolios in the composite if there are six or more. * Internal composite dispersion to show how consistent portfolio performance is within the composite. * The firm can choose which measure to use as long as it fairly represents the composite's internal dispersion. * Historical dispersion for the benchmark and the composite as a whole, using the ex post standard deviation, which must be: * For the previous three years of data on an annualized basis. **Portability** When one firm acquires or joins with another firm, group of managers, or manager, the new firm can link their performance to the previous firm's historical performance if: * Substantially all the investment decision makers are retained by the new firm. * The decision-making process remains substantially intact and independent within the new firm. * The new firm has records that document the previous firms historical performance. * There is no break in the performance record between the new and previous firm. If only the first three conditions are met, then the previous firm's historical performance can be used to represent that of the new firm, but the records may not be linked. If the new firm is GIPS compliant but the previous firm is not, then the new firm has one year to bring its assets into compliance for future reporting. **Advisory-Only Assets and Uncalled, but Committed, Capital** * The firm can report information on advisory-only assets and uncalled, but committed, capital on a separate basis or combined with composite or firm assets. * If reported on a combined basis, the firm must also report on that for the advisory-only and for the uncalled, but committed, assets.

Question 35

Explain the meaning of "discretionary" in the context of composite construction and, given a description of the relevant facts, determine whether a portfolio is likely to be considered discretionary.

Answer 35

Composites must be constructed so that investors are provided a fair and accurate representation of manager performance. The requirements should prevent managers from excluding poorly performing portfolios from composites. A key determinant in whether a portfolio is included in a composite is whether the manager has discretion. If the performance of a portfolio does not reflect a manager's decisions (i.e., the portfolio is nondiscretionary), then that portfolio would be excluded from the calculation of composite returns. Generally speaking, the requirements for what must be included in at least one composite are as follows: * All actual, fee-paying, discretionary segregated accounts. * Pooled funds that are also offered as segregated accounts. In general, the requirements for what must not be included in a composite are as follows: * Nondiscretionary accounts. * Pooled funds that are not also offered as segregated accounts. * Simulated portfolios. Non-fee-paying, discretionary segregated accounts may be included with additional disclosures. **Discretion** * Given its importance, a firm must maintain and apply a clear, written definition of discretion. * A client's investment policy statement (IPS) will specify risk preferences and constraints. * However, none of these automatically make a portfolio nondiscretionary. * Guidance is based on if the manager's ability to use professional judgment is materially constrained. * If the constraint is deemed immaterial, the manager can: * Place the portfolio in a composite with similar, unconstrained portfolios. * If the constraint is deemed material, the manager should: * Group the portfolio with similar, constrained portfolios. * Exclude the portfolio from all composites. * In some cases, there may be restrictions for particular assets. In these cases, a manager may: * Consider the entire portfolio nondiscretionary; or * Remove these assets and place the remainder of the portfolio in a composite; or * Consider the entire portfolio discretionary if the restricted assets are below a certain percentage of the portfolio, as stated in their policy. * In some cases, a portfolio's ECFs might indicate that it is nondiscretionary. **Model Portfolios** * Simulated portfolios cannot be in a composite. * These portfolios are called hypothetical, model, or theoretical portfolios. * They are often based on the backtesting of data. * Their performance can be provided in supplemental information, but not in composite results. * However, sometimes a firm will use its own funds (seed money) to create a new strategy. * The performance for these actual portfolios can be included in existing or new composites. **Non-Fee-Paying Portfolios** * Non-fee-paying portfolios may be included in a composite but, if included, firms are required to disclose the percentage of composite assets represented by non-fee-paying portfolios.

Question 36

Explain the role of investment mandates, objectives, or strategies in the construction of composites.

Answer 36

A critical step in achieving an accurate and comparable representation of a firm's performance is the defining and construction of composites. As per the GIPS standards, composites must: * Be determined by investment mandate, objective, or strategy. * Contain all portfolios that match the composite definition. * Be based on criteria that are documented in the firm's policies and procedures. * Be defined such that clients are able to compare the performance of one firm to another. * Be representative of the firm's products and be consistent with the firm's marketing strategy. Regarding composite construction: * A starting point in composite construction might be competitors' composite classifications and/or the styles requested by potential investors. * A composite definition that is too narrow results in too few portfolios in each, creates unnecessary costs, and potentially jeopardizes client confidentiality. * A composite definition that is too broad results in disparate performance among composite portfolios. * Examples on which to base composite construction include: * Style, sector, strategy, benchmark, risk/return profile, etc.

Question 37

Explain the conditions under which the performance of a past firm or affiliation may be linked to or used to represent the historical performance of a new or acquiring firm.

Answer 37

GIPS requires that firms must make every reasonable effort to provide a GIPS report to prospective clients and limited-distribution pooled fund investors. The requirements for Composite Time-Weighted Return Reports include the following: * At least 5 years of performance history upon GIPS adoption: * Unless the firm has been in existence for less than 5 years. * And then extended each year until the firm builds a 10-year GIPS compliant history. * Time-weighted returns for the composite and benchmark. * The amount of firm assets. * The amount of composite assets. * The number of portfolios in the composite if there are six or more. * Internal composite dispersion to show how consistent portfolio performance is within the composite. * The firm can choose which measure to use as long as it fairly represents the composite's internal dispersion. * Historical dispersion for the benchmark and the composite as a whole, using the ex post standard deviation, which must be: * For the previous three years of data on an annualized basis. **Portability** When one firm acquires or joins with another firm, group of managers, or manager, the new firm can link their performance to the previous firm's historical performance if: * Substantially all the investment decision makers are retained by the new firm. * The decision-making process remains substantially intact and independent within the new firm. * The new firm has records that document the previous firms historical performance. * There is no break in the performance record between the new and previous firm. If only the first three conditions are met, then the previous firm's historical performance can be used to represent that of the new firm, but the records may not be linked. If the new firm is GIPS compliant but the previous firm is not, then the new firm has one year to bring its assets into compliance for future reporting. **Advisory-Only Assets and Uncalled, but Committed, Capital** * The firm can report information on advisory-only assets and uncalled, but committed, capital on a separate basis or combined with composite or firm assets. * If reported on a combined basis, the firm must also report on that for the advisory-only and for the uncalled, but committed, assets.

Question 38

Explain the recommended valuation hierarchy of the GIPS standards.

Answer 38

Fair value is the amount an asset would be sold in an arm's-length transaction between willing and knowledgeable parties. * Fair value should include accrued income for bonds and other income-generating assets. * For cash, income may be accounted for on a cash or accrual basis. * Firms must document their valuation process and methodologies, which should be composite- or pooled fund-specific. * A method lower in the GIPS recommended valuation hierarchy is used only when all methods higher in the hierarchy are unavailable. The fair value hierarchy is: 1. The quoted price for an identical asset in a liquid market on the same day. 2. The quoted price for a similar asset in a liquid market on the same day. 3. The quoted price for identical or similar assets in markets that are not active. 4. A value based on market inputs. 5. A subjective value that is unobservable.

Question 39

Discuss the purpose, scope, and process of verification.

Answer 39

The purpose of verification is to provide greater confidence to investors and to the firm in its claim of GIPS compliance. Verification is based on the GIPS principle of fair presentation and full disclosure. Although not required, verification is recommended and consistent with best practices. Verification can be characterized as the process whereby an independent, outside party assesses the firm's: * Policies and procedures for composite or pooled fund construction and maintenance. * Performance calculation. * Performance presentation. * Distribution of performance. Verification must be carried out in accordance with the GIPS Standards for Verifiers and must be issued firmwide. * Verification cannot be provided for just a single portfolio, composite, or pooled fund. * A firm must meet all the requirements of GIPS; it cannot claim that it is in compliance "except for." * However, a firm can have the verifier perform a detailed performance examination on one or more composites or pooled funds and then state that a performance examination has been issued on that specific composite or fund. The GIPS Standards for Verifiers provides the various procedures that verifiers must follow, which include planning, sample selection, and testing. In planning for the verification process, the verifier must gather information about the firm, including all the firm's products, calculation methodologies, and GIPS policies and procedures. Although verification must be asserted on a firmwide basis, verifiers often use samples of the firm's products to do so. * When choosing samples, the verifier must consider the size of the firm and composites, the firm's internal controls and methods, the number of years being verified, and other factors. * If the verifier discovers deficiencies, larger samples or additional verification procedures may be necessary. Verifiers should also perform testing to determine whether the firm satisfies requirements in areas including the following: * Recordkeeping. * Policies and procedures. * Firm definition. * The thoroughness of the firm's list of composites and limited distribution pooled funds. * Calculation of total firm assets. * Input data such as portfolio inflows and outflows. * The construction and maintenance of composites, including: * The classification of portfolios as discretionary or nondiscretionary. * The assignment of portfolios to appropriate composites. * Portfolios with outlier returns may indicate calculation errors or a misassignment to a composite. * The content of the firm's GIPS Report and any marketing material.