Chapter II Ethics Fiduciary Duty

8/12/2019 Chapter II Ethics Fiduciary Duty

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Chapter II.

FIDUCIARY DUTY: THE ETHICAL

TREATMENT OF THE CLIENT

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Chapter II: Fiduciary Duty: The Ethical

Treatment of the Client

Learning objectives:

Describe the role of a fiduciary and itsimportance in the investment profession.

Distinguish between a fiduciary and an agencyrelationship

Identify and understand fiduciary obligations and

potential conflicts. Comprehend the importance of identifying the

client and ensuring fair treatment of all clients.

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Chapter II outline:

Introduction: What Is a Fiduciary?

Agency versus Fiduciary Relationships

The Role of Laws, Regulations, and ProfessionalStandards

The Importance of Confidentiality

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Chapter II outline (Cont.):

Conflicts in Finding the Right Investments

Conflicts in Trade Management: Best Execution

Conflicts in Trade Management: Soft Dollars

Identification and Fair Treatment of Clients

Conclusion: Disclose!

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Introduction: What is a Fiduciary?

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For example:

Doctorstake the Hippocratic oath to donoharmwhen treating their patients.

Lawyersmust always act in the best interestsof their clients, even if this meansdefending a guilty person.

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An investment professional is a fiduciary entrusted to act in theinterests of clients when providing investment services.

He must place the clients interests above his own and even hisemployers interests.

Investment professionals do have their own interests, thus theprofit motive can make it difficult to fulfill fiduciary obligations.

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What makes profit motive to overshadow fiduciaryobligation:

Finance is complicated: easy to mask

substandard, pricey, or even fraudulent services.Return uncertainty: an advisor can disguise poor

investment advice or unreasonable fees as partof the normal periodic declines in the market.

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The difference of time horizons betweeninvestment professionals and clients: theinvestment professionals might have short terminterests in benefiting from a clients business,but a client may be investing for the long run.

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E.g. : IBG YBGIllbe gone, youllbe gone

a phrase used to characterize excessive risk

taking (CDOs, subprime mortgages)

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Agency theory the closet idea in economics thatcaptures the concept of the fiduciary relationship

between an investment professional and a client.

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In agency theory, the principal hires an agentto act on his or her behalf.

A contract between the principal and the agentis written to align both partiesincentives.

Yet, this contract doesnt perfectly align the

agent/manager and the principal/clientsincentives.

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For example:

The investment professional is paid 20% ofthe return earned on the clients portfolio of

$100,000. He can expend a reasonableamount of time researching investmentoptions and then make investments that earn

his client a 12% return.

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Yet, to earn a 13% return (1% return more)would require much more time trying to findundervalued securities. He hopes to earn onlyan extra $200 (20%x1%x$100,000) for hisefforts, while the client earns $800.

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Thus, the agent is unlikely to spend the extratime, so the client will not receive the extra

$800.Agency theory

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Costs to write incentive contracts:

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Monitor

The principal must monitor or watch over theagent to ensure he is fulfilling his end of thecontract.

Bond

The bond is something of value to the agent thatcould be lost if the agent doesntact in the interestof the principal.


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The Role of Laws, Regulations, and

Professional Standards

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A nonprofit organization that has thelegal authority to enforce securitiesrules and regulations on its memberswhich are primarily brokers andtraders.

FinancialIndustry

RegulatoryAuthority(FINRA)

A designation oriented towardanalysts, portfolio, and activemoney managers.

CharteredFinancial

Analyst (CFA)Institute

A designation oriented towardfinancial planners.

CertifiedFinancial

Planner (CFP)


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The Importance of Confidentiality

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Confidentialityrelates toPrinciple IV

Clients needto trust youwith some of

their mostsensitiveandpersonalinformation

You must keepthe identity of yourcurrent or formerclientsconfidential,

unless they giveyou permission touse their names insolicitingbusiness.


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Conflicts in Finding the Right

Investments

Principle I, Ethical Understanding requiresyou to ensure that you understand your clientsneedsand that in turn your client understands

your recommendations and the feesassociated with your services and theinvestments.

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Investments

Risk

The investment professional must assess therisk that a client is willing to accept.

You can ask a series of questions that revealhow tolerant your clients will be toward short-term fluctuations in the value of their

investments.

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Investments

Holding horizon: How long are theythinking about holding theirinvestments?

Liquidity:Are there circumstances

when they will need to liquidate theirinvestments quickly? Income needs:Are they expecting to

receive regular income? How much? Tax considerations: Do they need tax-

free investments? What does the rest of their portfolio

look like? Do they have mortgages?

Usefulquestions

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Investments

Documentation of Goals

First, you have an obligation to be

diligent in translating the clientswished into

an investment program

competent and knowledgeable about a widerange of investment products and financial

markets

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Investments

Second, you should have a written investmentpolicy statement (IPS) (per CFA Institute) oragreement (per the CFP Board of Standards)

that you construct with your client and use as abasis for periodically reviewing your clientsportfolio.

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Investments

IPS written documentation of your clientsinvestment goals as well as the compensationagreement between you and your client per

CFA.Agreement an arrangement formedbetween a client and financial advisor on

investments and financial goals per CFP

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Investments

IPS/agreement can ensure that your clientsfully understand your recommendations.

IPS/agreement will also help eliminate any

misunderstandings that may occur in the future. IPS/agreement acts as bond put up by theinvestment professional.

Deviation from the IPS/agreement can belegal grounds for contract violation.

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Investments

FeesBe wary of sales fees earned on otherinvestment products such as mutual funds.

When you recommend a fund, you need to askwhether the fund is really appropriate for yourclient, or do you just earn a better sales fee on it

than on other funds?It is fine to earn a sales commission, but not atyour clientsexpense.

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fli i i di h i h


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Investments

are securities that arecreated out of a largeportfolio of securities.

are attractive to investors as theyallow smaller investors to get

diversification without having toinvest in a large portfolio

Each share of a mutualfund represents a share ina well-diversified portfolio

The value of each share of amutual fund depends on the

market value and the number ofshares held of each security in

the fund

Mutual funds

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Conflicts in Trade Management: Best

Execution

Investment professionals make trades onbehalf of clients, including the initial purchaseof investments as well as any subsequent

sales and purchases.These trades cost your clientsmoney

As a fiduciary, you have an obligation to

minimize the cost of trading Principle I, Ethical Understanding, andPrinciple IV, Trust and Fairness.

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Execution

Churning occurs when a broker excessivelybuys and sells securities in a clientsaccountto generate commissions.

not only unethical, but also illegal whether you are churning or not dependson the clientsIPS or agreement

E.g. Clients holding period is 20 years,actively buying or selling every month wouldviolate the IPS and constitute churning.

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Execution

The effective spread the difference betweenthe price of the actual transaction and theamount halfway between the quoted spread.

Traders might actually transact at quotedprices, but they are more likely to transact ata price within the spread

Investment professionals have an obligationto minimize the effective spread for theirclients

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Execution

BEST EXECUTION MINIMIZES EFFECTIVE SPREAD

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Effective

Spread

Ask

Bid

Transaction price

Halfway between bid and ask

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Execution

Note:Payment for order flow the exchange paybrokers a per-share price for routing trades through

their exchange. Brokers make money and minimize the cost oftrading to their investors.

If firms are paid for order flow, they must disclosethis to their investors to ensure that clients are fullyinformed of the trading costs incurred on theirbehalf.

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Execution

Fidelity Investments is a fund manager ofmany mutual funds, in aggregaterepresenting billions of dollars.

In early 2008, it was discovered that Fidelityemployees were offered more than $1.6 millionin gifts paid for by outside brokers courting themassive trading business.

Acceptance of these gifts could compromiseFidelity employees interest in seeking bestexecution for clients. The SEC fined Fidelity $8million for accepting these gifts.

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Conflicts in Trade Management: Soft

Dollars

Soft dollars research and other productsand services that are paid for using tradingcommissions.

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Dollars

Until 1975, all commissions had to be chargedat a fixed rate which made it difficult for brokersto offer discounts to attract larger institutional

customers.Brokers create a way to get around the fixed-rate commissions by bundling research and other

services into the commission rate.

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Dollars

An economic rationale for soft dollars

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More clientssubmit trades toearn commission

credits to

purchase qualityresearch

More clientsmean greaterorder flow andthe ability to

provide qualityexecution

Broker makesinvestment in

quality research tomake credible

promise of qualityexecution



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Dollars

Uses of soft dollars: To purchase in-house proprietary researchfrom a broker, or

To purchase third-party research provided bycompanies such as Standard & Poors,Bloomberg, and Down Jones

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Dollars

The abuse of soft dollars:Suppose clients are charged trading commissions.What if these commission are artificially high

because they are also paying for businessexpenses covered by soft dollars? How would theyknow they are paying for both trades and businessexpenses?

Clients are charged twice.

Violation of Principle IV and especially ofPrinciple I

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Identification and Fair Treatment of


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Identification and Fair Treatment of

Clients

The same fiduciary duty is owed to clientsregardless of the size of their account.

It is okay to provide different services for different

fees and to charge management fees that varyaccording to account size as long as fullydisclosed.

These disclosures relate to Principle IV, Trustand Fairness.

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Disclosure serves two purposes:

It keeps the investment professional honest

It alerts the client to potential areas in whichhe may remain vigilant

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Things that should be disclosed

Fees charged for providing investment services

Sale fees earned on different products Best execution practices

Soft dollar practices

Investment policy statement (IPS) or client

agreement Treatment of clients: fee and service schedules.

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Documents

Chapter II Ethics Fiduciary Duty