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: Fiduciary Duty: The Ethical
Treatment of the Client
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: Fiduciary Duty: The Ethical
Treatment of the Client
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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Introduction: What is a Fiduciary?
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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Introduction: What is a Fiduciary?
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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Introduction: What is a Fiduciary?
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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Introduction: What is a Fiduciary?
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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Introduction: What is a Fiduciary?
E.g. : IBG YBGIllbe gone, youllbe gone
a phrase used to characterize excessive risk
taking (CDOs, subprime mortgages)
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Agency versus Fiduciary Relationships
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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Agency versus Fiduciary Relationships
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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Agency versus Fiduciary Relationships
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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Agency versus Fiduciary Relationships
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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Agency versus Fiduciary Relationships
Thus, the agent is unlikely to spend the extratime, so the client will not receive the extra
$800.Agency theory
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Agency versus Fiduciary Relationships
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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Conflicts in Finding the Right
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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Conflicts in Finding the Right
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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Conflicts in Finding the Right
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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Conflicts in Finding the Right
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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Conflicts in Finding the Right
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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Conflicts in Finding the Right
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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Conflicts in Finding the Right
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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Conflicts in Finding the Right
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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C fli i d
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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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C fli i T d M B
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Conflicts in Trade Management: Best
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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C fli i T d M B
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Conflicts in Trade Management: Best
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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C fli i T d M B
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Conflicts in Trade Management: Best
Execution
BEST EXECUTION MINIMIZES EFFECTIVE SPREAD
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Effective
Spread
Ask
Bid
Transaction price
Halfway between bid and ask
C fli i T d M B
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Conflicts in Trade Management: Best
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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C fli t i T d M t B t
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Conflicts in Trade Management: Best
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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Conflicts in Trade Management: Soft
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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C fli t i T d M t S ft
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Conflicts in Trade Management: Soft
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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Conflicts in Trade Management: Soft
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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Conflicts in Trade Management: Soft
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Conflicts in Trade Management: Soft
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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Conclusion: Disclose!
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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Conclusion: Disclose!
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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