READING 1 - Ethic and Trust in the Investment Profession

EXAM FOCUS

From this reading candidates should learn the definitions of ethics and ethical behavior presented by the authors and the arguments presented for having a code of ethics and following ethical principles. Additionally, the arguments for integrating ethics into the decision-making process include testable material.

MODULE 1.1:ETHICS AND TRUST

LOS 1.a: Explain ethics.

CFA Program Curriculum, Volume 1, page 7

Ethics can be described as a set of shared beliefs about what is good or acceptable behavior and what is bad or unacceptable behavior. Ethical conduct has been described as behavior that follows moral principles and is consistent with society’s ethical expectations.

Ethical conduct has also been described as conduct that improves outcomes for stakeholders, who are people directly or indirectly affected by the conduct. Examples of stakeholders in the case of investment professionals include their clients, coworkers, empoloyers, and the investment profession as a whole. Some decisions may bring positive results for you, but negative consequences for stakeholder, such as a coworker. Ethical conduct is behavior that balances your self-interest with the impact on others.

LOS 1.b: Describe the role of a code of ethics in defining a profession.

CFA Program Curriculum, Volume 1, page 9

A code of ethics is a written set of moral principles that can guide behaviors by describing what is considered acceptable behavior. Having a code of ethics is a way to communicate the values, principles, and expectations of an organization or other group of people and provides a general guide to what constitutes acceptable behavior. Some codes of ethics include a set of rules or standards that require some minimum level of ethical behavior.

A profession refers to a group of people with specialized skills and knowledge who serve others and agree to behave in accordance with a code of ethics. A professional code of ethics is a way for profession to communicate to the public that its members will use their knowledge and skills to serve their clients in an honest and ethical manner.

LOS 1.c: Describe professions and how they establish trust.

CFA Program Curriculum, Volume 1, page 9

A profession is an occupational group(e.g., doctors or lawyers) that has requirements of specialized expert knowledge, and often a focus on ethical behavior and service to the larger community or society. Additionally, a profession may have the following characteristics

A code and standards for professional behavior.
A regulatory body to enforce rules concerning professional behavior and monitor the ethical behavior of members.
A focus on the needs of their clients(e.g., students, patients).
A focus on service to society.
A requirement to put client interests first.
A focus on or requirement for continuing education.

Ways that professions establish trust include:

Requiring high standards of expertise, knowledge, and skill.
Establishing standards of ethical behavior.
Monitoring professional conduct.
Encouraging continuing education to maintain and increase competence.
Being focused on client’s needs.
Mentoring and inspiring others in the profession.

LOS 1.d: Describe the need for high ethical standards in investment management.

CFA Program Curriculum, Volume 1, page 12

Investment professionals have a special responsibility because they are entrusted with their clients’ wealth. The responsibility to use their specialized knowledge and skills to both protect and grow client assets makes hight ethical standards all the more important. Investment advice and management are intangible products, making quality and value received more difficult to evaluate than for tangible products such as a laptop computer or restaurant meal. For this reason, trust in investment professionals takes on an even greater importance than in many other businesses.

Failure to act in a highly ethical manner can damage not only client wealth but also impede the success of investment firms and investment professionals because potential investors will be less likely to use their services.

Unethical behavior by financial services professionals can have negative effects for society as a whole. The financial services industry serves as an intermediary between savers and those seeking financing for their business activities . A lack of trust in financial advisors will reduce the funds entrusted to them and increase the cost of raising capital for business investment and growth. When investors cannot rely on the information they receive from financial services professionals, this adds another layer of risk on top of the investment risks that investors face. Even the perception of additional risk will reduce the amounts invested and increase the returns required to attract investor capital.

In addition to reducing the amount of investment overall, unethical behavior - such as providing incomplete, misleading, or false information to investors - can affect the allocation of the capital that is raised. Misallocation of capital to businesses other than those with the most potential for growth and societal benefit reduces the growth of an economy and the well- being of its people. When the allocation of investment capital is constrained or inefficient, the negative consequences extend to all the participants in an economy.

LOS 1.e: Explain professionalism in investment management.

CFA Program Curriculum, Volume 1, page 12

Because clients of investment professionals rely on their expertise, judgement, and ethical principles, many of the characteristics of a profession we have described apply.

Ethical principles are of great importance because clients often do not have significant knowledge about financial securities, fee structures, or sources of potential bias in investment recommendations. Currently, some financial professionals are held to a suitability standard, while others are held to a fiduciary standard. Suitability refers to the match between client return requirements and risk tolerances and the characteristics of the securities recommended. A fiduciary standard is stronger, requiring professionals to use their knowledge and expertise to act in the best interests of the client.

LOS 1.f: Identify challenges to ethical behavior.

CFA Program Curriculum, Volume 1, page 15

One challenge to ethical behavior is that individuals tend to overate the ethical quality of their behavior on relative basis and overemphasize the importance of their own personal traits in determining the ethical quality of their behavior.

It is claimed that external or situational influence are a more important determinant of the ethical quality of behavior than internal(personal) traits that influence behavior. One situational influence is social pressure from others. Loyalty to an employer, supervisor, organization, or coworkers can cause individuals to act in unethical ways as they place more importance on their self-interest and short-term results than on longer-term results and the ethical quality of their decisions and behavior. The prospect of acquiring more money or greater prestige can cause individuals to engage in unethical behavior.

Firms with strict rules - based compliance procedures run the risk of fostering a culture that is so focused on adhering to compliance rules that individuals only ask themselves what they can do. The question of what behavior they should engage in, base on ethical principles and longer - term results, is often not addressed in such situations.

LOS 1.g: Distinguish between ethical and legal standards.

CFA Program Curriculum, Volume 1, page 17

Not all unethical actions are illegal, and not all illegal actions are unethial. In some places it may be illegal to report ones’s employer’s actions against the best interests of clients by sharing what is considered private company information with authorities, but doing so may be considered ethical “whistle-blowing” behavior by some. Acts of civil disobedience that are illegal are also considered by many to be ethical behavior. On the other hand, recommending investment in a relative’s firm without disclosure may not be illegal, but would be considered unethical by many.

Ethical principles often set a higher standard of behavior than laws and regulations. New laws and regulations often result from recent instances of what is perceived to be unethical behavior. Just at the Securities Act of 1933, the Glass-Stragall Act, and the Securities Exchange Act of 1934 followed the perceived bad behavior by investment professionals and bankers leading to the 1929 market crash, the Dodd-Frank Act followed the 2008 financial crisis. New laws and regulations can create opportunities for different unethical behavior. In general, ethical decisions require more judgement and consideration of the impact of behavior on many stakeholders compared to legal decisions.

LOS 1.h: Describe and apply a framework for ethical decision making.

CFA Program Curriculum, Volume 1, page 19

Ethical decisions will be improved when ethical are integrated into a firm’s decision making process. This will allow decision makers and teams to consider alternative actions as well as shorter - and longer-term consequences from various perspectives, improving the ethical aspects of their decisions. To do this is first necessary that the firm adopt a code of ethics to guide the process.

Such integration provides an opportunity to teach, practice, and reinforce ethical decision making. This is an important part of developing an ethical culture. The support of senior management for integrating ethics into the decision - making process is also very important in developing a culture and processes that will result in ethical decision making.

Using a framework for ethical decision making helps individuals identify the important issues involved, examine these issues from multiple perspectives, develop the necessary judgement and decision making skills required, and avoid unanticipated ethical consequences.

The following ethical decision - making framework is presented in the Level I CFA curriculum:

Identify: Relevant facts, stakeholders and duties owed, ethical principles, conflicts of interest.
Consider: Situational influence, additional guidance, alternative actions.
Decide and act.
Reflect: Was the outcome as anticipated? Why or why not?

In the first step, decision makers need to identify the facts they have to work with, and the facts they would like to have, before making a decision. Stakeholders - those affected by the decision - must be identified. These stakeholders may include the employer, clients, coworkers, self, family, and others in the industry, and the duties to each stakeholder should be identified. This part of the process will also help in explicitly identifying potential conflicts of interest among the various stakeholders. At this point the decision makers should be able to identify the ethical principles involved in the decision, although greater clarity about those may also be gained throughout the process.

In the second step, the framework suggests situational factors that may influence decision makers should be identified and considered along with any personal biases that may come into play. At this point, decision maker may seek outside guidance which can come from a mentor, colleagues, or friends who have shown good judgement in the past. Guidance may also be sought from the firm’s legal and compliance departments. This guidance from alternative sources will help to provide a variety of perspectives form which the decision under consideration can be viewed, as well as help in developing alternative that should be considered.

Finally, the alternative actions that have been identified are all considered, taking into account both the short-term and long-term effects of each alternative action and any potential but unanticipated ethical implications.

In the final step, decision makers should evaluate the outcomes of the actions that were taken. In particular, they should consider whether the decisions had their intended results and whether appropriate consideration was given to ethical principles, situational influences, and duties to clients and other stakeholders.

KEY CONCEPTS

LOS 1.a

Ethical behavior is that which conform to a set of rules and moral principles based on shared beliefs about what behavior is acceptable and what behavior is unacceptable.

LOS 1.b A professional code of ethics is a way for a profession to communicate to the public that its members will use their knowledge and skills to serve their client in an honest and ethical manner, and can increase public confidence and trust that members will act ethically.

LOS 1.c

A profession is an occupational group that has requirement of specialized expert knowledge. Professions establish trust by requiring high standards of expertise, setting standards for ethical behavior, and monitoring professional conduct.

LOS 1.d

Investment professionals have a special responsibility to use their specialized expect knowledge and skills to both protect and grow client assets. The fact that investment management is an intangible product makes big ethical standards all the more important in the financial services profession.

LOS 1.e

Some financial professionals are held to a suitability standard, while others are held to a fiduciary standard. Suitability refers to the match between client return requirements and risk tolerances and the characteristics of the securities recommended. A fiduciary standard requires professionals to act in the best interests of the client.

LOS 1.f

Challenges to ethical behavior include overestimating one’s own ethical character, considering only near-term consequences and not long-term consequences of behavior, and letting situational(external) influences, such as peer pressure, unduly affect one’s decisions and behavior.

LOS 1.g

Not all unethical actions are illegal, and not all illegal actions are unethical. Laws are more specific than ethical principles and often address prior unethical behavior. Ethical behavior require more judgement; acts such as civil disobedience may be considered ethical even when they are illegal.

LOS 1.h

A framework for ethical decision making is designed to lead to better decisions by identifying the stakeholders affected and the conflicts of interest among them, considering alternative actions and the relevant situational influences on decision makers, seeking out different perspectives, and evaluating decisions to see if they had unintended consequences.