Standard III(C) Suitability

Standard III(C) requires that members and candidates who are in an investment advisory relationship with clients consider carefully the needs, circumstances, and objectives of the clients when determining the appropriateness and suitability of a given investment or course of investment action. An appropriate suitability determination will not, however, prevent some investments or investment actions from losing value.

In judging the suitability of a potential investment, the member or candidate should review many aspects of the client’s knowledge, experience related to investing, and financial situation. These aspects include, but are not limited to, the risk profile of the investment as compared with the constraints of the client, the impact of the investment on the diversity of the portfolio, and whether the client has the means or net worth to assume the associated risk. The investment professional’s determination of suitability should reflect only the investment recommendations or actions that a prudent person would be willing to undertake. Not every investment opportunity will be suitable for every portfolio, regardless of the potential return being offered.

The responsibilities of members and candidates to gather information and make a suitability analysis prior to making a recommendation or taking investment action fall on those members and candidates who provide investment advice in the course of an advisory relationship with a client. Other members and candidates may be simply executing specific instructions for retail clients when buying or selling securities, such as shares in mutual funds. These members and candidates and some others, such as sell-side analysts, may not have the opportunity to judge the suitability of a particular investment for the ultimate client.

When an advisory relationship exists, members and candidates must gather client information at the inception of the relationship. Such information includes the client’s financial circumstances, personal data (such as age and occupation) that are relevant to investment decisions, attitudes toward risk, and objectives in investing. This information should be incorporated into a written investment policy statement (IPS) that addresses the client’s risk tolerance, return requirements, and all relevant investment limitations (including time horizon, liquidity needs, tax concerns, and legal and regulatory factors). For some clients, the IPS may include unique constraints or preferences, such as incorporating environmental, social, and governance factors during the investment decision-making process. Without identifying such client factors, members and candidates cannot judge whether a particular investment or strategy is suitable for a particular client. The IPS also should identify and describe the roles and responsibilities of the parties to the advisory relationship and investment process, as well as schedules for review and evaluation of the IPS. After formulating long-term capital market expectations, members and candidates can assist in developing an appropriate strategic asset allocation and investment program for the client, whether these are presented in separate documents or incorporated in the IPS or in appendices to the IPS. (Updated October 2017)

One of the most important factors to be considered in matching appropriateness and suitability of an investment with a client’s needs and circumstances is measuring that client’s tolerance for risk. The investment professional must consider the possibilities of rapidly changing investment environments and their likely impact on a client’s holdings, both individual securities and the collective portfolio. The risk of many investment strategies can and should be analyzed and quantified in advance.

The use of synthetic investment vehicles and derivative investment products has introduced particular issues of risk. Members and candidates should pay careful attention to the leverage inherent in many of these vehicles or products when considering them for use in a client’s investment program. Such leverage and limited liquidity, depending on the degree to which they are hedged, bear directly on the issue of suitability for the client.

Updating the IPS should be repeated at least annually and also prior to material changes to any specific investment recommendations or decisions on behalf of the client. The effort to determine the needs and circumstances of each client is not a one-time occurrence. Investment recommendations or decisions are usually part of an ongoing process that takes into account the diversity and changing nature of portfolio and client characteristics. The passage of time is bound to produce changes that are important with respect to investment objectives.

For an individual client, important changes might include the number of dependents, personal tax status, health, liquidity needs, risk tolerance, amount of wealth beyond that represented in the portfolio, and extent to which compensation and other income provide for current income needs. With respect to an institutional client, such changes might relate to the magnitude of unfunded liabilities in a pension fund, the withdrawal privileges in an employee savings plan, or the distribution requirements of a charitable foundation. For both individual and institutional clients, the perspective on investment valuation and strategy factors may change with time. An initial IPS may not include concerns around environmental, social, or governance policies that increased in importance since the start of the advisory relationship. Without efforts to update information concerning client factors, one or more factors could change without the investment manager’s knowledge. (Updated October 2017)

Suitability review can be done most effectively when the client fully discloses his or her complete financial portfolio, including those portions not managed by the member or candidate. If clients withhold information about their financial portfolios, the suitability analysis conducted by members and candidates cannot be expected to be complete; it must be based on the information provided.

The investment profession has long recognized that combining several different investments is likely to provide a more acceptable level of risk exposure than having all assets in a single investment. The unique characteristics (or risks) of an individual investment may become partially or entirely neutralized when it is combined with other individual investments within a portfolio. Some reasonable amount of diversification is thus the norm for many portfolios, especially those managed by individuals or institutions that have some degree of legal fiduciary responsibility.

An investment with high relative risk on its own may be a suitable investment in the context of the entire portfolio or when the client’s stated objectives contemplate speculative or risky investments. The manager may be responsible for only a portion of the client’s total portfolio, or the client may not have provided a full financial picture. Members and candidates can be responsible for assessing the suitability of an investment only on the basis of the information and criteria actually provided by the client.

Members and candidates may receive requests from a client for trades that do not properly align with the risk and return objectives outlined in the client’s investment policy statement. These transaction requests may be based on the client’s individual biases or professional experience. Members and candidates will need to make reasonable efforts to balance their clients’ trading requests with their responsibilities to follow the agreed-on investment policy statement.

In cases of unsolicited trade requests that a member or candidate knows are unsuitable for a client, the member or candidate should refrain from making the trade until he or she discusses the concerns with the client. The discussions and resulting actions may encompass a variety of scenarios depending on how the requested unsuitable investment relates to the client’s full portfolio.

Many times, an unsolicited request may be expected to have only a minimum impact on the entire portfolio because the size of the requested trade is small or the trade would result in a limited change to the portfolio’s risk profile. In discussing the trade, the member or candidate should focus on educating the investor on how the request deviates from the current policy statement. Following the discussion, the member or candidate may follow his or her firm’s policies regarding the necessary client approval for executing unsuitable trades. At a minimum, the client should acknowledge the discussion and accept the conditions that make the recommendation unsuitable.

Should the unsolicited request be expected to have a material impact on the portfolio, the member or candidate should use this opportunity to update the investment policy statement. Doing so would allow the client to fully understand the potential effect of the requested trade on his or her current goals or risk levels.

Members and candidates may have some clients who decline to modify their policy statements while insisting an unsolicited trade be made. In such instances, members or candidates will need to evaluate the effectiveness of their services to the client. The options available to the members or candidates will depend on the services provided by their employer. Some firms may allow for the trade to be executed in a new unmanaged account. If alternative options are not available, members and candidates ultimately will need to determine whether they should continue the advisory arrangement with the client.

Some members and candidates do not manage money for individuals but are responsible for managing a fund to an index or an expected mandate. The responsibility of these members and candidates is to invest in a manner consistent with the stated mandate. For example, a member or candidate who serves as the fund manager for a large-cap income fund would not be following the fund mandate by investing heavily in small-cap or start-up companies whose stock is speculative in nature. Members and candidates who manage pooled assets to a specific mandate are not responsible for determining the suitability of the fund as an investment for investors who may be purchasing shares in the fund. The responsibility for determining the suitability of an investment for clients can be conferred only on members and candidates who have an advisory relationship with clients.

To fulfill the basic provisions of Standard III(C), a member or candidate should put the needs and circumstances of each client and the client’s investment objectives into a written investment policy statement. In formulating an investment policy for the client, the member or candidate should take the following into consideration:

• Client identification—(1) type and nature of client, (2) the existence of separate beneficiaries, and (3) approximate portion of total client assets that the member or candidate is managing;
• Client expectations—(1) return objectives (income, growth in principal, maintenance of purchasing power) and (2) risk tolerance (suitability, stability of values);
• Client constraints—(1) liquidity needs; (2) expected cash flows (patterns of additions and/or withdrawals); (3) investable funds (assets and liabilities or other commitments); (4) time horizon; (5) tax considerations; (6) regulatory and legal circumstances; (7) investor preferences, prohibitions, circumstances, and unique needs, which may include a framework for incorporating environmental, social and governance factors; and (8) proxy voting responsibilities and guidance; and
• Performance measurement benchmarks.

(Updated October 2017)

The investor’s objectives and constraints should be maintained and reviewed periodically to reflect any changes in the client’s circumstances. Members and candidates should regularly compare client constraints with capital market expectations to arrive at an appropriate asset allocation. Changes in either factor may result in a fundamental change in asset allocation. Annual review is reasonable unless business or other reasons, such as a major change in market conditions, dictate more frequent review. Members and candidates should document attempts to carry out such a review if circumstances prevent it.

With the increase in regulatory required suitability tests, members and candidates should encourage their firms to develop related policies and procedures. The procedures will differ according to the size of the firm and the scope of the services offered to its clients.

The test procedures should require the investment professional to look beyond the potential return of the investment and include the following:

• An analysis of the impact on the portfolio’s diversification,
• A comparison of the investment risks with the client’s assessed risk tolerance, and
• The fit of the investment with the required investment strategy.

(Example 9 and Example 10 added October 2017)

Caleb Smith, an investment adviser, has two clients: Larry Robertson, 60 years old, and Gabriel Lanai, 40 years old. Both clients earn roughly the same salary, but Robertson has a much higher risk tolerance because he has a large asset base. Robertson is willing to invest part of his assets very aggressively; Lanai wants only to achieve a steady rate of return with low volatility to pay for his children’s education. Smith recommends investing 20% of both portfolios in zero-yield, small-cap, high-technology equity issues.

Jessica McDowell, an investment adviser, suggests to Brian Crosby, a risk-averse client, that covered call options be used in his equity portfolio. The purpose would be to enhance Crosby’s income and partially offset any untimely depreciation in the portfolio’s value should the stock market or other circumstances affect his holdings unfavorably. McDowell educates Crosby about all possible outcomes, including the risk of incurring an added tax liability if a stock rises in price and is called away and, conversely, the risk of his holdings losing protection on the downside if prices drop sharply.

In a regular meeting with client Seth Jones, the portfolio managers at Blue Chip Investment Advisors are careful to allow some time to review his current needs and circumstances. In doing so, they learn that some significant changes have recently taken place in his life. A wealthy uncle left Jones an inheritance that increased his net worth fourfold, to US$1 million.

Louis Perkowski manages a high-income mutual fund. He purchases zero-dividend stock in a financial services company because he believes the stock is undervalued and is in a potential growth industry, which makes it an attractive investment.

Max Gubler, chief investment officer of a property/casualty insurance subsidiary of a large financial conglomerate, wants to improve the diversification of the subsidiary’s investment portfolio and increase its returns. The subsidiary’s investment policy statement provides for highly liquid investments, such as large-cap equities and government, supranational, and corporate bonds with a minimum credit rating of AA and maturity of no more than five years. In a recent presentation, a venture capital group offered very attractive prospective returns on some of its private equity funds that provide seed capital to ventures. An exit strategy was already contemplated, but investors would have to observe a minimum three-year lockup period and a subsequent laddered exit option for a maximum of one-third of their shares per year. Gubler does not want to miss this opportunity. After extensive analysis, with the intent to optimize the return on the equity assets within the subsidiary’s current portfolio, he invests 4% in this seed fund, leaving the portfolio’s total equity exposure still well below its upper limit.

Paul Ostrowski’s investment management business has grown significantly over the past couple of years, and some clients want to diversify internationally. Ostrowski decides to find a submanager to handle the expected international investments. Because this will be his first subadviser, Ostrowski uses the CFA Institute model “request for proposal” to design a questionnaire for his search. By his deadline, he receives seven completed questionnaires from a variety of domestic and international firms trying to gain his business. Ostrowski reviews all the applications in detail and decides to select the firm that charges the lowest fees because doing so will have the least impact on his firm’s bottom line.

Samantha Snead, a portfolio manager for Thomas Investment Counsel, Inc., specializes in managing public retirement funds and defined benefit pension plan accounts, all of which have long-term investment objectives. A year ago, Snead’s employer, in an attempt to motivate and retain key investment professionals, introduced a bonus compensation system that rewards portfolio managers on the basis of quarterly performance relative to their peers and to certain benchmark indices. In an attempt to improve the short-term performance of her accounts, Snead changes her investment strategy and purchases several high-beta stocks for client portfolios. These purchases are seemingly contrary to the clients’ investment policy statements. Following their purchase, an officer of Griffin Corporation, one of Snead’s pension fund clients, asks why Griffin Corporation’s portfolio seems to be dominated by high-beta stocks of companies that often appear among the most actively traded issues. No change in objective or strategy has been recommended by Snead during the year.

Andre Shrub owns and operates Conduit, an investment advisory firm. Prior to opening Conduit, Shrub was an account manager with Elite Investment, a hedge fund managed by his good friend Adam Reed. To attract clients to a new Conduit fund, Shrub offers lower-than-normal management fees. He can do so because the fund consists of two top-performing funds managed by Reed. Given his personal friendship with Reed and the prior performance record of these two funds, Shrub believes this new fund is a winning combination for all parties. Clients quickly invest with Conduit to gain access to the Elite funds. No one is turned away because Conduit is seeking to expand its assets under management.

(Added October 2017)

Jan de Vries is trustee of the MPG pension fund. The beneficiaries of the pension fund are health workers, such as doctors, nurses, and other medical staff. Recently, the pension fund conducted a survey into the preferences of the beneficiaries. A series of questions directly related to the return impact and risks associated with the incorporation of factors related to environmental, social, and governance (ESG) issues into the investment selection process. The results of the survey showed that the beneficiaries like high pension payouts, but that investment return should be achieved while considering ESG issues.

De Vries introduced an amendment to the IPS to incorporate an ESG framework into the investment-making process. Among the specific factors in the ESG framework is a restriction on investing in producers of products that negatively affect the health of consumers. The changes to the IPS were approved by the MPG pension board and communicated to all retained investment managers.

After receiving communications on the update to the IPS, Alan Van Cleef, an investment manager for the MPG pension fund, purchased stock in a tobacco firm under his investment mandate. He reasoned that tobacco, although not healthy, exhibits an attractive risk–return profile and will contribute to the high pension payouts that the beneficiaries so desire. Van Cleef believes that investment return is his first priority as a manager.

(Added October 2017)

Dongmi Kim is the portfolio manager of a family office. The family office IPS objectives include long-term capital preservation and mitigation of downside risk. Kim is considering two investments in the chemical industry: Park Inc. and Dong Inc. Based solely on financial risk parameters, the Park Inc. investment is the most attractive. On further analysis, Kim finds that Dong Inc. scores much higher than Park Inc. on corporate factors, including environmental, social, and governance criteria.

Kim’s experience led to the belief that companies scoring high on environmental, social, and governance factors typically have higher quality management with a long-term view for the organization. Such factors should ultimately benefit the expected return and risk profile of the investment. On that basis, Kim invests in the Dong Inc. company for the family office.