Fulfilling the purpose of this Standard requires that the actual investments chosen and strategy employed are consistent with the information gathered.
This suitability consideration applies to the total portfolio, not to the individual securities. For example, selling call options is a potentially risky strategy if the underlying stock rallies. However, a covered call strategy, where the underlying stock is already owned when writing calls, mitigates this risk and can serve to enhance income in a stagnant market. An exam question might test whether puts and calls are suitable for a conservative investor - some people will guess "no", but the actual answer is that they may be, depending on the total portfolio
The client/advisor relationship is an ongoing two-way exchange of information. Case studies that apply this Standard will likely examine whether pertinent information was properly exchanged or discussed (full disclosure).
Client to Advisor: Factors in applying suitability include the following:
•Age/Time to Retirement - Generally speaking, an investment strategy should become gradually less aggressive as a client gets older, but time to retirement is also a factor - someone retiring at age 50 would be treated differently than someone who is motivated to work until age 75. Moreover, with life expectancies increasing, clients can live 30-40 years after retiring. Some of their assets must assume a long-term orientation.
•Income Needs - Clients who are drawing meaningful monthly income from an account would probably not want all of it invested in aggressive equity funds. At the same time, an individual with a $1-million account, requiring $50,000 a year, wouldn't necessarily need an average 5% income from the portfolio. It's entirely appropriate to satisfy the withdrawal needs with a combination of current income yield and capital gains.
•Tolerance for Risk - Discussions about previous bad investment experiences and how an investment loss affects a client are absolutely essential.
•Total Net Worth - In cases where a new account is only a 5% to 10% slice of a client's larger financial picture, the approach taken by the advisor can be much different. Given the total picture, what does the client expect from this account? Current income? Aggressive speculation? On the other hand, if the account represents a substantial portion of the client's total savings, an investment plan may need to account for both short-term income and long-term growth, all within the same account.
•Other Unique Factors - For example, given the onerous effect that taxes can have on investment performance, is the degree of tax efficiency a primary consideration to this client? If tax efficiency isn't important (or a complete non-factor for tax-exempt portfolios), the resulting investment approach might change.
Advisor to Client: Appropriate disclosures include the following:
•General Overview of Process - There's no specific formula on what must be covered, as clients have varying degrees of sophistication when it comes to investing, as well as varying ideas of what specifically matters to them. Even for those who care little to discuss the details, some discussion on how investment strategy is developed and the return/risk expectations of a policy is required.
•Major Changes in Process - For example, a change might be necessitated by the growth of the organization. An advisor of small-cap accounts may see growth to the point where market liquidity (ability to move into and out of stocks) is affecting the ability to carry out a previously conceived investment process that favored micro caps (and marketed this process to clients and potential clients). If restricting investments to companies with a market capitalization of $250 million or less is now too narrow and the advisor must expand the range of investments in order to handle the increased asset base, this change in policy would be material. Perhaps the inclusion of companies with a market cap of between $250 million and $500 million is appropriate, or the inclusion of foreign-based stocks is deemed necessary. Whatever is decided, any material change in investment approach could potentially impact a client's decision to retain that manager and must be disseminated prior to implementation.
•Loss of Key Personnel - While the performance record of an investment strategy is the property of the firm, it's also a product of the work of the individual manager who led the development of the process, directed the research, made the investment decisions and so forth. A change in investment personnel can affect the client's decision to affiliate with that firm in the first place, or it can be a nonissue. Either way, the firm is obligated to provide adequate disclosure of key personnel changes. In addition, if the switch in personnel prompts a change in investment approach - for example, from an active strategy to a passive one - the manager may need to modify advisory fees accordingly. A client might be paying a premium fee for a manager's reputation or for the rigor of the research process and should not be required to pay the same premium if he or she is now going to be invested in a mix of passive index funds.
Some examples of the application of standard III(C) follow:
An independent investment advisory was previously an account manager with a hedge fund, with which he still maintains personal and business connections. To attract new clients, the advisor offers below market management fees and provides his new clients with direct access to the hedge fund. The investment advisor puts as many of his new clients in the hedge fund as possible. Standard III(C) has been violated because the risk profile of the hedge fund may not be suitable for every client. Additionally, standard V(A) - Diligence and Reasonable Basis may also have been violated.
Investment Policy Requirements
The chief investment officer (CIO) of a large financial subsidiary wants to improve the diversification and returns of its investment portfolio. The investment policy statement for the subsidiary authorizes highly liquid investments, such as highly rated corporate or government bonds, with a five-year maturity or less. The CIO has discovered an exciting new investment in a private equity fund, which includes a three-year lock-up period but an exit option in stages after that. The CIO invests 4% in the fund, leaving the portfolio well within guidelines for overall equity exposure. The CIO violated both standard III (A) - Loyalty, Prudence and Care, as well as standard III(C).
The fund does not fit the requirements for highly rated, liquid investments. Additionally, the lockup period and laddered exit structure of the fund suggests the investment could last beyond the required maturity limits of no more than five years.
Read more: http://www.investopedia.com/exam-guide/cfa-level-1/ethics-standards/standard-suitability.asp#ixzz1oMtwn2uw