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UpperMarkTM

Study Handbook

CAIA® Level II

Volume 1

Topic 1: Professional Standards & Ethics

Topic 2: Current & Integrated Topics

Topic 3: Asset Allocation & Institutional Investors

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No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without prior written consent from UpperMark, Inc. While UpperMark attempts to provide accurate information in all of its study materials, the company cannot guarantee the accuracy thereof. Therefore, this book is provided without warranty of any kind, either expressed or implied. It is recommended that candidates use any test preparation product together with the original reading materials suggested in the CAIA Study Guide.1

1 CAIAA does not endorse, promote, review or warrant the accuracy of the products or services offered by UpperMark, nor does it endorse any pass rates claimed by the provider. CAIAA is not responsible for any fees or costs paid by the user to UpperMark nor is CAIAA responsible for any fees or costs of any person or entity providing any services to UpperMark. CAIA®, CAIA Association®, Chartered Alternative Investment AnalystSM, and Chartered Alternative Investment Analyst Association® are service marks and trademarks owned by CHARTERED ALTERNATIVE INVESTMENT ANALYST ASSOCIATION, INC., a Massachusetts non-profit corporation with its principal place of business at Amherst, Massachusetts, and are used by permission.


Copyright 2018 UpperMark, Inc. All rights reserved. i

Preface

UpperMark, Inc. is a leading provider of study materials for the Chartered Alternative Investment Analyst (CAIA) Association®, the sponsoring body of the CAIA® designation. Our company mission is to provide the highest quality products and services to assist CAIA candidates in their successful preparation for the CAIA exams. Our goal is to enhance individual study efforts and enable clients to make the most of their valuable time. We design our products to cover the CAIA curriculum material thoroughly, and we revise them for each CAIA exam to accommodate curriculum changes.

The CAIA Level II curriculum is composed of eight Topics based on the following reading

materials. 1. Standards of Practice Handbook, CFA Institute – this is covered in Topic 1.

• This is the same material covered in CAIA Level I. To facilitate your studies, the material in the Topic 1 chapters is presented in a similar format as in our Level I Study Handbooks.

2. CAIA Level II: Current and Integrated Topics – this is covered in Topic 2.

3. Alternative Investments: CAIA Level II – this is covered in Topics 3-8. The CAIA Level II exam is comprised of 100 multiple-choice questions and three multi-part

constructed-response (essay-type) questions.

• Topics 1 and 2 are tested only in constructed-response format.

• Topics 3-8 are tested in multiple-choice and/or constructed-response format.

Additional information on the format of the exam is provided in the Appendix.

This UpperMarkTM Study Handbook provides a comprehensive and concise account of each

learning objective (L.O.) in Topics 1-3. We have compiled this Study Handbook using the reference materials recommended by the CAIA Association and have organized it as follows.

• Each Chapter/Article in the CAIA Study Guide is presented as a separate chapter.

• Keywords defined in the Study Guide are indicated in bold italics.

• Sub-bullets associated with learning objectives are indicated by underlined, capitalized subheadings (e.g., APPROACHES TO PROJECTING CASH FLOWS).

• The list of keywords and learning objectives from the Study Guide is provided at the end of each chapter.

• Space is provided at the end of each chapter for you to record your Personal Study Notes.

• A set of sample exam questions is provided at the end of each chapter.

The questions for Topics 1 and 2 are short-answer questions intended to prepare you for the constructed-response questions. Constructed-response questions for Topic 1 typically involve descriptions of situations that candidates are asked to analyze and evaluate.

The questions for Topic 3 include multiple-choice and short-answer questions. It is important to keep in mind that writing out a response to a question is generally more challenging than selecting a correct response from a set of responses.


ii Preface

Copyright 2018 UpperMark, Inc. All rights reserved.

• For each set of exam questions, a detailed answer key provides the correct responses, explanations for the responses, and the learning objectives being addressed.

• A set of multi-part constructed-response questions and a comprehensive index are provided at the end of the Handbook. A larger set of practice questions (multiple-choice and constructed-response) is in our TestBank software.

As we prepared this Study Handbook, we found some material in the curriculum warranted

further explanation than provided in the CAIA reference texts. In these cases, we included the supplementary information in a footnote, so you know what material comes from the reference text and what is supplementary.

UpperMark further supports CAIA candidates by offering other exam preparation products

and services, including our TestBank software, Courses, Flashcards, and tailored instruction. Our TestBank is a state of the art testing application with hundreds of sample exam questions. One of the unparalleled features of TestBank is that it gets automatically updated to include new questions as we periodically add them to the database of questions during the exam season. For further information about additional products, please visit our Web site at www.uppermark.com.

We wish you the best as you prepare to succeed on your CAIA Level II exam. Padideh Jalali, Ph.D., CAIA President and CEO UpperMark, Inc.


Copyright 2018 UpperMark, Inc. All rights reserved. i

Table of Contents

TOPIC 1 – PROFESSIONAL STANDARDS AND ETHICS .......................... 1

STANDARDS I, II, AND III .................................................................................................................... 1

Keywords & Learning Objectives ........................................................................................................ 34

Personal Study Notes ............................................................................................................................ 35

Practice Exam Questions ....................................................................................................................... 36

STANDARDS IV, V, AND VI ............................................................................................................... 41

Keywords & Learning Objectives ........................................................................................................ 64

Personal Study Notes ............................................................................................................................ 65

Practice Exam Questions ....................................................................................................................... 66

TOPIC 2 – CURRENT AND INTEGRATED TOPICS ................................... 71

Topic 2 will be available later in October.

TOPIC 3 – ASSET ALLOCATION & INSTITUTIONAL INVESTORS ...... 239

CHAPTER 1 – ASSET ALLOCATION PROCESSES AND THE MEAN-VARIANCE MODEL ................................................................ 240

Keywords & Learning Objectives ...................................................................................................... 267

Personal Study Notes .......................................................................................................................... 268

Practice Exam Questions ..................................................................................................................... 269

CHAPTER 2 – TACTICAL ASSET ALLOCATION, MEAN-VARIANCE EXTENSIONS, RISK BUDGETING, RISK PARITY, AND FACTOR INVESTING .................. 271




CHAPTER 3 – THE ENDOWMENT MODEL ................................................................................... 303




CHAPTER 4 – PENSION FUND PORTFOLIO MANAGEMENT ................................................ 329





ii Table of Contents

CHAPTER 5 – SOVEREIGN WEALTH FUNDS .............................................................................. 351




CHAPTER 6 – THE FAMILY OFFICE MODEL ................................................................................ 369




SAMPLE CONSTRUCTED-RESPONSE QUESTIONS

Constructed-Response Question 1 .................................................................................................... 391




APPENDIX – EXAM FORMAT ............................................................................................................... 403

INDEX .......................................................................................................................................................... 405


Copyright 2018 UpperMark, Inc. All rights reserved. 1

Topic 1

Standards I, II, and III

This chapter covers three Standards from the CFA Institute's Standards of Practice Handbook.

1. Standard I, Professionalism.

2. Standard II, Integrity of Capital Markets.

3. Standard III, Duties to Clients.

L.O. A.1 Demonstrate knowledge of Standard I: Professionalism.

Standard I covers four areas.

A. Knowledge of the Law

B. Independence and Objectivity

C. Misrepresentation

D. Misconduct

STANDARD I(A), KNOWLEDGE OF THE LAW 2

The purpose and scope of Standard I(A) is that:

• "Members and Candidates must understand and comply with all applicable laws, rules, and regulations (including the CFA Institute Code of Ethics and Standard of Professional Conduct) of any government, regulatory organization, licensing agency, or professional association governing their professional activities.

• In the event of conflict, Members and Candidates must comply with the more strict law, rule, or regulation.

• Members and Candidates must not knowingly participate or assist in and must dissociate from any violation of such laws, rules, or regulations."

This Standard underscores the importance of knowing and adhering to all applicable laws (i.e., laws that regulate the conduct of members and candidates). The Standard compels members and candidates to have a reasonable, not expert, understanding of applicable laws and regulations of any country and jurisdiction in which they conduct professional activities (e.g., conducting investment research, providing investment advice, or trading financial instruments). Based on their reasonable and good faith understanding, members and candidates must abide by laws and

2 Copyright 2014, CFA Institute. Reproduced and republished from the Standards of Practice Handbook with permission from the CFA Institute. All rights reserved.


2 Topic 1 CFA Institute Standards of Professional Conduct (Standards I, II, and III)


regulations that govern these activities, and any consequences thereof, and that protect their clients' interests.

• Members and candidates should know their firm's procedure for getting compliance guidance.

• During periods of regulatory change, members, candidates, and firms should be attentive to any relevant change and should modify their procedures accordingly. Regulatory change often results from lapses in ethical standards; development of new financial products and processes; and new methods of communication (e.g., mobile applications and web-based social networking platforms).

Key components of this Standard are discussed below.

1. Relationship between the Code and Standards and applicable law

• Members and candidates must adhere to the following.

i. Compliance with applicable laws or regulations related to professional activities.

ii. No conduct that violates the Code and Standards, even if the conduct is technically legal.

iii. Adherence to the Code and Standards when no applicable laws exist or when the Code and Standards are the "more strict" regulation (i.e., they impose greater restrictions or require greater action to protect investors' interests).

• Applicable laws that regulate members' and candidates' responsibilities are the lowest threshold of acceptable actions. Members and candidates who take action to exceed these minimal requirements further support the conduct required of Standard I(A).

2. Participation in or association with violations by others

• Since Standard I(A) does not obligate members and candidates to become legal or regulatory experts, it recognizes that situations may exist in which individuals may be unaware of legal or regulatory breaches. However, the Standard does require that members and candidates not intentionally participate in any violations.

• In situations where illegal or unethical conduct on the part of a client or employer is perceived, members and candidates must separate themselves from the conduct. If confronting the violator directly does not resolve the situation, an intermediate step would be to try to stop the violation by informing a supervisor or firm compliance officer.

• In the event that these efforts prove futile, members and candidates must completely dissociate themselves from the matter. This distancing could involve resigning from a position, requesting a transfer, not accepting authorship of a written report, or declining to advise a specific client or potential client. Members and candidates who make no attempt to stop or dissociate themselves from the activity may be viewed as participating in the activity and thus in violation of Standard I(A).

• Although the Code and Standards do not require that violations be reported to regulatory agencies (except when failing to do so would violate applicable law), members and candidates are urged to report potential violations. While failure to dissociate oneself from unethical conduct is clearly a violation of the Code and Standards, remaining inactive and failing to report such conduct can significantly affect the integrity of capital markets. Guidance should be sought from legal and compliance officers.

3. Investment products and applicable laws

• When handling investment products or services or packages of securities and/or derivatives that are created in one country/region and may be sold in another, those


Topic 1 CFA Institute Standards of Professional Conduct (Standards I, II, and III) 3


responsible for supervising the service or originating and maintaining the products should understand the applicable laws of origination and expected sale in all applicable jurisdictions.

• Members and candidates should also attempt to assess whether firms distributing products/services created by their own firm also adhere to the laws of the countries/regions of distribution.

• In cross-border transactions, members and candidates should perform appropriate due diligence to ensure that they understand the various applicable laws and regulations. This helps to safeguard their reputation and that of their firm.

• Since identifying applicable laws/regulations may be challenging when business is conducted in several jurisdictions (particularly in the case of complex transactions), members and candidates should seek guidance (e.g., from legal counsel inside and outside the firm) to ensure they understand their responsibilities and how to adhere them appropriately.

STANDARD I(A) – PROCEDURES FOR COMPLIANCE FOR MEMBERS & CANDIDATES

Procedures for compliance with Standard I(A) that members and candidates should adhere to include the following.

1. Keep informed – Establish or urge employers to establish a procedure that provides updates on applicable laws, statutes, and regulations. For instance, having the employer's counsel periodically provide the information or participating in professional development or continuing education programs.

2. Review compliance procedures regularly – Ensure or urge employers to ensure that compliance procedures are reflective of current laws and that they adequately inform employees of acceptable conduct.

3. Maintain current copies of laws – Keep or urge employers to keep current reference copies of applicable laws, statutes, and regulations.

4. Know applicable laws – Make reasonable efforts to know the applicable laws for their investment products' countries of origin and distribution.

5. Seek legal advice – Seek legal counsel if unsure of how to respond appropriately in a particular situation. Further, if members and candidates suspect employees in their firm of any breach, they are advised to seek the counsel of their firm's legal department.

6. Document any violation – Record any violation when dissociating from it. Members and candidates should also encourage their firms to take action and urge the parties to stop the illicit conduct. Sometimes dissociation may require resigning from a position.

STANDARD I(A) – PROCEDURES FOR COMPLIANCE FOR FIRMS

Compliance procedures for companies differ depending on the size and type of the operation. Members and candidates should urge their employers to advocate the principles of Standard I(A) by adopting the following policies.

1. Establish and/or implement a code of ethics – that is adhered to by all employees from the top of the firm down. Having an established code of ethics in place enables issues to be resolved more easily. Furthermore, it can prevent the need for employees to resort to whistleblowing




(i.e., reporting violations or illegal acts to an agency or regulatory authority outside the company).3

• Firms may base their codes on the Asset Manager Code of Professional Misconduct, a document published the CFA Institute.

2. Provide employees with materials on applicable laws and regulations – sources of the materials may include the regulatory authorities themselves, letters from the legal department, and other recognized professional publications.

3. Provide written procedures for reporting alleged violations.

Example of application of Standard I(A) 4

Miguel Chavez, a portfolio manager at Econometrix, Inc., has a seat on the board of directors of a technology corporation. At a recent board meeting, he discovers that the tech company's management is about to release misleading financial statements to its shareholders. He believes that his responsibility is to express his concerns and attempt to persuade the board that this decision is unwise. Comment: Mr. Chavez should in fact resign from the tech company's board of directors so

that he is not in any way participating in any violations of regulations or laws. He should further seek the advice of counsel and then inform the necessary parties (e.g., the proper regulators) of the company's state of affairs.

Further examples of applications of Standard I(A) are presented on pages 20-23 of the CFA Institute's Standards of Practice Handbook. For application of Standard I(A) and obeying laws across the globe, the rule of thumb is that, if the applicable law is stricter than the requirements of the Code and Standards, members, CFA charterholders, and candidates in the CFA program must adhere to the applicable law; otherwise, they must adhere to the Code and Standards.

STANDARD I(B), INDEPENDENCE AND OBJECTIVITY

The purpose and scope of Standard I(B) is that:

• "Members and Candidates must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities.

• Members and Candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another's independence and objectivity."

This Standard underscores the importance of investment professionals not participating in or

seeming to participate in any activities that could or do affect their ability to remain impartial when carrying out professional duties (e.g., providing investment advice or acting on investment

3 Employees who blow the whistle on their employers are, however, protected by the law.

4 The examples in these Topic chapters are not taken from the CFA Institute's Standards of Practice Handbook.




decisions). These activities may be as subtle as networking or being involved in professional societies. In addition, the Standard requires that recommendations be made explicitly, without the use of nebulous language, since this had been a practice of analysts who felt pressure from both within and outside their firms to provide favorable reports.

Ways in which individuals or entities strive to influence investment professionals to the

detriment of other clients, either implicitly or explicitly, include offering gifts, providing entertainment, promising job referrals, and allocating oversubscribed IPO shares for professionals' personal accounts.

• While the Code and Standards generally consider "modest gifts and entertainment" as acceptable, members and candidates are urged to decline any offer that may influence them to act in a manner that is contrary to the interests of their clients.

• As a result, the Code and Standards specifically state that accepting shares of oversubscribed IPOs for personal accounts is prohibited, since it provides managers with an investment opportunity not available to their clients.

• Receiving gifts from clients who already pay for investment services is considered more as additional compensation than as attempts to influence. As such, members and candidates are permitted to receive gifts from clients, although they must inform their employers, preferably before accepting the gifts, so that the employers can evaluate the potential influential effects of the gifts.

Sell-side firms (investments banks) advise investors on which stocks to buy or sell based on

recommendations made by their research analysts. Many of these firms also have an investment-banking arm that underwrites corporate securities. There are a number of areas that present a potential source of pressure or conflict of interest for sell-side research analysts.


1. Buy-side clients

• Sell-side analysts may feel pressure from the users of their research. These buy-side clients are typically institutional investors who use the analysts' research results either directly or indirectly through the use of soft commissions. If analysts release negative judgments about a company, portfolio managers with stakes in that company may see their compensation and reputation affected by the drop in stock value resulting from the poor firm rating.

• The Code and Standards place the responsibility on portfolio managers to avoid exerting any pressure on analysts, including not engaging in intimidating or retaliatory behavior toward analysts. Any hint of retaliation may affect analysts' ability to remain impartial.

2. Fund manager and custodial relationships

• Members and candidates may use outside (or "secondary") managers to manage specific asset allocations or use third-party custodians for trading capabilities and reporting requirements. Members and candidates must avoid the appearance of impropriety when hiring these managers and third-party custodians.

• Activities that may be seen as affecting objectivity include accepting gifts, entertainment, and travel funding; and attending educational or marketing events hosted by the secondary fund managers or custodians to inform about their business strategies, investment processes, or custodial services. Each invite to an event should be reviewed to determine whether independence would be affected by attending the event.




3. Investment banking relationships

• The research team of a sell-side firm often works with the investment banking branch of the firm to assess possible future investment banking clients. Although this is a mutually beneficial relationship and may enhance market efficiency, the analysts may feel pressure to inflate their recommendations so that the investment banking team receives sought-after underwriting contracts.

• Therefore, to minimize pressure and conflicts of interest, the firm should establish firewalls

(i.e., information barriers) between these two branches. Vital components of an effective firewall include not tying the analysts' compensation to the investment banking projects to which they contributed and having the two branches submit reports separately. For instance, the investment banking staff should be not able to comment on or change recommendations made by analysts. Some firewalls may prohibit all communication between the two groups.

4. Performance measurement and attribution

• Members and candidates who are performance analysts, responsible for calculating and analyzing performance, may generate reports that indicate managers have strayed from their mandate or may receive requests to change the construction of a composite index due to negative results associated with a particular account or fund. Performance analysts must not permit any influence, internal or external, to affect their independence and objectivity.

5. Public companies

• Analysts may feel pressure from the firms they are researching to provide positive reports and recommendations. The due diligence carried out by the researchers that is necessary for them to make informed recommendations involves reviewing documentation (e.g., annual reports and regulatory filings) and investigating individuals (e.g., the company's managers and customers).

• However, the company being researched can hinder the analysts' investigation and can also retaliate with legal action against researchers who release negative information about them. These factors can make the analyst's task precarious and more difficult.

6. Credit rating agency opinions

• As in their relationships with investment banking services, analysts may feel pressure to issue specific credit ratings on products due to influences from sponsoring companies or other services provided by the agency. Members and candidates at credit rating agencies should aim to prevent any inappropriate influence through application of standards of conduct and by establishing firewalls between the agencies' different business lines. The firewall should specifically prevent analysts' incentives and compensation from being tied to products' credit ratings.

• Furthermore, because of the potential for conflicts of interest in this area, members and candidates using credit ratings may need to independently authenticate them.

7. Influence during the manager selection/procurement process

• Members and candidates may be on different sides of the manager selection process. Some may be representatives of pension funds or endowment investment committee members looking to hire managers, while others may be representatives of their own organizations trying to earn new investment allocations.

• Those involved with hiring should not solicit compensation (e.g., gifts or contributions) that may affect their independence and objectivity, even if the compensation does not




benefit them personally. They should also not accept any compensation (e.g., gifts or donations) that may be perceived to affect their decision-making.

• Those aiming to earn new investment allocations should not offer gifts, contributions, or other compensation to the hiring representative with the intention of tarnishing the representative's independence and objectivity.

• Illicit actions for all members and candidates include soliciting or offering donations to charitable or political organizations.

Illicit influencing of hiring representatives was witnessed in the "pay-to-play" corruption scandal in the U.S., where managers made political campaign contributions to pension fund representatives responsible for the manager selection process, with the hope of gaining lucrative allocations from the pension funds.

This and similar scandals resulted in new laws requiring additional reporting of political contributions and bans or delays on hiring managers that make campaign contributions to hiring representatives.

8. Issuer-paid research

• Independent analysts may be hired by companies to analyze their performance and present the results in research reports. These reports are used by the companies to communicate with the market and with potential investors, particularly when little or no sell-side research of the companies is available.

• Since the analysts are paid by the subject companies, potential conflicts of interest are numerous. Members and candidates must perform thorough, independent, and impartial analysis and must disclose in the reports potential conflicts, including the type of compensation received for the issuer-paid research. This helps to ensure that investors are not misled into believing that the reports were generated by independent sources.

• Analysts must present clear and comprehensive information about the companies; at a minimum, thorough financial statement analyses based on publicly available data, benchmarking with peers, and industry analysis. Analysts must also distinguish between their own opinion and factual data in reports and base recommendations on solid research.

• Regarding compensation for issuer-paid research, best practice is for analysts to charge a flat fee, rather than charging a fee based on the report's recommendations, whether directly or indirectly (e.g., stock warrants that may rise in value if a positive report is produced). This helps to prevent analysts from excluding negative information in their reports.

9. Travel funding

• Members and candidates may occasionally be offered paid travel arrangements from outside companies. This not only provides cost savings, but also opportunities (e.g., private meetings with company executives while travelling together or getting more information about investment options provided by an investment company). However, since paid travel (e.g., using private planes or attending conferences where most expenses are paid for) may influence members and candidates, best practice demands that they use public transportation at their expense or their firm's expense or, if unavailable, accept modest travel arrangements from the outside company for information-gathering purposes (e.g., a company property tour).




STANDARD I(B) – PROCEDURES FOR COMPLIANCE

Procedures for compliance with Standard I(B) that members and candidates should adhere to and urge their firms to do the same include the following.

1. Protect the integrity of analysts' opinions – by helping them to maintain their independence and objectivity. This includes having a policy stating that all reports are based on impartial opinion and also having analysts' compensation structures be independent of their conclusions.

2. Create a restricted list – i.e., a list of companies for which only factual information (as opposed to analysts' judgments) is provided to the public. This list would consist of companies about which analysts have negative opinions that their firms do not want circulated.

3. Restrict cost arrangements – e.g., when traveling to meet with a corporate issuer, members and candidates should not permit the issuer to cover the cost of transportation or accommodations; and members and candidates should sometimes host the issuer themselves.

4. Limit gifts and gratuities – to token items that are clearly not intended to exert pressure. Also, consider setting a limit on the value of gifts that may be accepted based on local customs and indicate whether the limit is per gift or a total annual value.

5. Restrict investments – e.g., employee purchases of equity, equity-related IPOs, and private placement issues. Require employees seek prior approval for participation in IPOs and promptly disclose any investment actions taken after the IPO.

6. Establish review procedures – to ensure compliance with policies on personal investments.

7. Develop formal policy – on the independence and objectivity of research performed by analysts and establish procedures that ensure that analysts are not managed by any branch of the firm that could affect their impartiality.

8. Appoint a senior officer – who is responsible for ensuring compliance with the firm's code of ethics. Firms should provide all employees policy information regarding reporting ethical breaches.

Example of application of Standard I(B)

Lilly Jahan is an equity analyst at a large brokerage firm with an investment banking division that provides underwriting services. Lilly's team works closely with the firm's underwriters and, as a result, the lead analyst instructs the team members to be particularly careful when issuing reports on companies underwritten by the firm. He stresses that unfavorable recommendations about those companies may affect the firms' underwriting division and, therefore, the firm as a whole. Comment: The lead analyst's advice is not appropriate since, if followed, would violate the

requirement for analysts to maintain independence and objectivity in any analysis and recommendation of a company and its securities. Furthermore, investment professionals should not instruct others to perform acts that would violate the Code and Standards.

Further examples of applications of Standard I(B) are provided on pages 33-40 of the CFA Institute's Standards of Practice Handbook.




STANDARD I(C), MISREPRESENTATION

The purpose and scope of Standard I(C) is that "Members and Candidates must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities."

This Standard underscores the importance of maintaining the trust of investors and the integrity of capital markets by not knowingly misrepresenting information, omitting relevant information, or providing erroneous information by any means of communication: oral, written (e.g., research reports, underwriting documents, financial reports, newspaper columns, and books), or electronic (e.g., e-mails, internet communications, webpages, and mobile applications).

• A misrepresentation is considered "any untrue statement or omission of a fact or any statement that is otherwise false or misleading".

• "Knowingly" misrepresenting signifies that the misrepresentation is known explicitly or ought to have been recognized, or that the omitted information could alter the investment decision.

• With regard to electronic communication, members and candidates who use webpages should ensure that the information provided on the webpages is current and does not misrepresent anything, and that websites provide full disclosure and are secure.

Members and candidates are prohibited from making guarantees to clients about returns on volatile investments. They can, however, provide information on investments for which losses will be covered by an insuring entity or with guarantees built into the structure of the investment product.


1. Impact on investment practice

• Misrepresentation of any form relating to members' and candidates' professional activities is prohibited. Examples include misrepresenting the qualifications or track record of analysts or firms and the features of an investment opportunity.

• Members and candidates should take care not to misrepresent third-party information (e.g., credit ratings and research).

• They should disclose the use of outside managers and should not represent the work of these managers as their own.

2. Performance reporting

• Performance can be misrepresented by using benchmarks that are not comparable to implemented strategies or not reporting a benchmark's results on a comparable basis to that of a fund or client. Best practice is to use the most appropriate benchmark available. This provides clients with important information for making investment decisions.

• However, a benchmark does not always need to be provided. Some investment strategies may not have a suitable benchmark (e.g., if underlying investments are complex or extremely diverse) and some strategies may use a reference index that is not reflective of the opportunity set of invested assets (e.g., hedge funds that compare their performance on a "cash plus" basis [e.g., LIBOR plus 6%]).

When using reference indices, members and candidates should disclose the reasons for using the index to avoid misrepresentation of performance.

Discussions should be held continuously with clients regarding the appropriate benchmark to be used.




• Reporting misrepresentations can also occur when more than one source provides prices for illiquid or non-traded securities. Shopping for security valuations to obtain the highest price can result in a number of issues: a security's value may be misrepresented, clients' decisions to hold or sell a security may be based on inaccurate information, and clients may be overcharged advisory fees.

To increase clients' confidence in the valuation process and in their ability to make well-informed decisions, members and candidates should consistently provide clients with accurate and reliable security prices.

3. Social media

• Members and candidates should only share information via social media (e.g., online forums) that they are allowed to distribute to clients and potential clients via traditional means of communication. In all forms of communication, members and candidates must be open and honest about the information they distribute.

• All regulations regarding permitted use of social media should always be followed, and all communications via social media must adhere to the Code and Standards.

• Intentional misrepresentation via social media (e.g., of qualifications, professional activities, or investment recommendations) violates this Standard.

4. Omissions

• Models and technical analysis processes are often used to search for new investment opportunities, to produce investment vehicles, and to generate recommendations and ratings. Omitting inputs for these models can misrepresent performance and result in investment decision-makers using misleading information.

The results of these models should not be presented as fact. It should be clear that they represent expected results based on given inputs and analysis.

• Omissions in performance measurement and attribution processes can also misrepresent performance and manager skill. Firms should be encouraged to establish policies for composite development to prevent cherry-picking (i.e., using specific accounts to represent the firm manager's skill).

5. Plagiarism

• Plagiarism involves the use of someone else's material or ideas, either completely or partially, without clearly acknowledging the source or identifying the author of the information. Members and candidates are required to avoid plagiarism in all forms of written and oral statements. Examples of plagiarism include the following.

Presenting the work of another, whether text, graphs, or tables, as one's own or without acknowledging the source.

Using excerpts from the work of others, either verbatim or with minor modifications, without giving due credit.

Attributing quotes to "leading investment analysts" without giving specific names.

Using statistical results derived by others, giving appropriate credit, but not stating any limitations or pertinent qualifying facts associated with the results.

Using proprietary electronic algorithms or spreadsheets without permission from the originator.

Presenting a report as an original when compiled from numerous sources of information, without giving appropriate credit. This practice is considered one of the "most egregious" violations.




• Members and candidates may use third-party outsourced research reports, provided that authorship is not claimed for themselves and with the caveat that they assume responsibility for any misrepresentations arising from their use of the research. The crux of the issue is that investors should know exactly who attained the information presented, whether an individual analyst, another member in the firm, or an external party. It is important that the actual author of a report or piece of information can be held accountable for their work. As such, analysts are advised against using undocumented results.

6. Work completed for employer

• The case in which attribution to an original author is not required is when members and candidates use research or models developed by other employees in their firm, whether the employees are still with the firm or not. Such work is the property of the firm and the firm need not cite current or former employees as authors.

STANDARD I(C) – PROCEDURES FOR COMPLIANCE

Procedures for compliance with Standard I(C) include the following.

1. Making accurate presentations – Members and candidates can be accurate in making presentations to clients regarding their personal and their firm's qualifications if they understand their firm's services and limitations. Firms can help employees to avoid unintentional misrepresentations by providing a written list of the firm's services and qualifications, and designating certain employees to represent and speak on behalf of the firm.

• It is the responsibility of members and candidates to understand their firm's services and qualifications, whether the firm provides appropriate guidance or not.

2. Providing qualification summary – Members and candidates should prepare a resume of their own qualifications and abilities. Firms can help their employers by periodically reviewing their correspondence and files that reference employee or firm qualifications.

3. Verifying outside information – Members and candidates should ensure that any information they distribute from or about a third party does not misrepresent the third party and, thus, harm the reputation of the member or firm. Employers should be encouraged to institute procedures for verifying information of third-party firms.

4. Maintaining webpages – Members and candidates should regularly monitor web sites that they publish to ensure that posted information is current and accurate and that the sites provide full disclosure. Precautions should also be taken to protect the sites' confidentiality and security.

5. Establishing plagiarism policy – Plagiarism can be avoided by doing the following.

i. Keeping copies of all research reports and the materials used to develop the reports.

ii. Giving credit of work, including tables, charts, and ideas, to its source.

iii. Attributing any summarized material to its source.

Example of application of Standard I(C)

Janice St. Mary has recently been hired as an analyst at Sienna Corp., a brokerage and investment advisory firm. During the course of her research, she comes across a financial model that was developed by a former employee of the firm. The premise of the model is




innovative and she feels has the potential to lead to positive results. However, the model has a flaw that causes it to yield nonsensical results. After further examination and research, Janice finds a solution to the flaw and confirms that the model does indeed yield positive results. Her assistant suggests that she can present the model as her own at a firm meeting, since, without her contribution, the model would have remained ineffective. Comment: Even though the model did not yield positive results without Janice's input, the

initial concept was not hers and so she has a responsibility to give credit to the author of the concept. She can, however, take credit for her own contributions that resulted in an improved model.

Further examples of applications of Standard I(C) are provided on pages 47-53 of the CFA

Institute's Standards of Practice Handbook.

STANDARD I(D), MISCONDUCT

The purpose and scope of Standard I(D) is that "Members and Candidates must not engage in any professional conduct involving dishonesty, fraud, or deceit or commit any act that reflects adversely on their professional reputation, integrity, or competence."

This Standard mandates that members and candidates avoid engaging in any activities that may reflect badly on their professional conduct, whether the activities are legal or not.

• Fraudulent professional activities are clear violations of this Standard. More subtle breaches involve having alcoholic drinks during work hours to the extent that professional responsibilities cannot be carried out. On the other hand, personal bankruptcy, as long as it does not involve fraud or deceit, does not necessarily reflect on a person's integrity or trustworthiness.

• Not behaving appropriately or making sufficient effort may also be considered a violation of this Standard, as it may negatively affect an investment professional's reputation and result in their losing the trust of their clients. For instance, investment professionals are expected to perform appropriate due diligence before making any investment recommendations, and should not rely on others to have performed the due diligence.

STANDARD I(D) – PROCEDURES FOR COMPLIANCE

Recommended procedures for compliance with Standard I(D) involve members and candidates encouraging their employers to do the following.

1. Establish and/or implement a code of ethics – to which every employee must adhere, and stress that conduct that reflects poorly on the individual, organization, or profession is not acceptable.

2. Provide employees with a list of potential breaches and associated disciplinary consequences.

3. Check references of prospective employees – to ensure that they are upstanding individuals and are not barred from working in the investment industry due to past violations.




Example of application of Standard I(D)

Mike Cohen is a senior partner at a large brokerage firm, who regularly takes long working lunches with his subordinates. During lunch, he has several alcoholic drinks but discourages his junior employees from doing so, saying that their job performance may be impaired by the alcohol, whereas his experience more than outweighs the potential effects of a few drinks. However, at the firm, most employees and clients prefer not to deal with Cohen in the afternoon due to fairly frequent noticeable changes in behavior and bouts of forgetfulness during those times. Comment: Regardless of what Mike Cohen says about his experience, his drinking at lunch

clearly has an effect on his professional competence at the brokerage firm and so constitutes a violation of Standard I (D). His actions have a negative effect not only on his own integrity, but also on that of the brokerage firm and the industry.

Further examples of applications of Standard I(D) are presented on pages 56-58 of the CFA

Institute's Standards of Practice Handbook. A synopsis thereof is that convictions of even minor offenses might rise to the level of violating Standard I(D) if committed with a frequency suggesting gross disregard for the law.

L.O. A.2 Demonstrate knowledge of Standard II: Integrity of Capital Markets.

Standard II covers two areas.

A. Material Nonpublic Information

B. Market Manipulation

STANDARD II(A), MATERIAL NONPUBLIC INFORMATION

The purpose and scope of Standard II(A) is that "Members and Candidates who possess material, nonpublic information that could affect the value of an investment must not act or cause others to act on the information."

Trading or encouraging others to trade on material, nonpublic information erodes confidence

in capital markets, institutions, and investment professionals, since it causes investors to believe that the markets are fixed in favor of knowledgeable insiders. As a result, investors avoid capital markets, which results in markets that are less efficient and less supportive of strong economies. This Standard maintains that material, nonpublic information should not be used for buying and selling of individual securities or to influence investment actions related to derivatives, mutual funds, or other investments. This helps to promote confidence in market integrity, which is important for the investment profession.

Key components considered in this Standard are discussed below.

1. Material information

• Information is material if disclosure thereof would probably affect the price of a security or if rational investors would want the information before making an investment decision.

• Material information may include information related to earnings, changes in assets, changes in management, mergers, new products or discoveries (e.g., new research efforts),




new equity or debt ratings, legal disputes, bankruptcies, government reports of economic trends, and firm-specific events that affect the firm's security (e.g., changes in dividends, stock splits, defaults on securities, and sales of additional securities).

• In addition to the type of information, the trustworthiness of its source and its effect on price are factors that contribute to whether and the extent to which the information is material. Information is not considered material if the effect of the information on the price of a security is unclear. Material information may become immaterial after some time.

For example, accurate information provided by a corporate insider about a new contract is likely to be material, whereas a speculative assumption by a competitor about the same contract is less reliable and, thus, not material. In addition, information about trials of a new product from personnel involved in the trials is likely to be material, whereas educated conjecture by subject-matter experts not associated with the trials is not likely to be material.

2. Nonpublic information

• Information is nonpublic until it has been distributed to and received in the general marketplace. Disclosure to a small group of analysts or investors does not constitute making the information public.

• Illegal insider trading refers to trading or encouraging others to trade an investment vehicle using material, nonpublic information in breach of a fiduciary responsibility. This practice weakens investor confidence in the fairness and integrity of securities markets and is prohibited by Standard II(A).

• However, investment professionals may use material insider information that is provided legitimately by the source company specifically for conducting due diligence for activities such as mergers, loan underwriting, and credit ratings.

3. Mosaic theory

• Analysts use many sources to collect and examine the information that they interpret and disseminate to clients. It is commonly accepted that this process involves use of both public and nonmaterial, nonpublic information. Analysts who adopt this process (generally termed mosaic theory) are not in violation of Standard II(A). However, as a safeguard, analysts should document and save records of all sources and all research documents in case there is a need to verify their reports or validate their sources.

• In order for analysts and clients to make analyses and well-informed decisions about potential investments, there needs to be "accurate, timely, and intelligible" exchange of financial information. This exchange of information, which is vital to the functioning of a fair and efficient market, must include, not only that mandated by regulatory law, but also detailed information about the future growth of a firm and the competitive business environment in which it operates. Analysts must make efforts to collect as much information as possible about a business, which means collecting from corporate insiders and from others (e.g., clients, competitors, and contractors). This process of collecting and examining company information and relaying it to clients is beneficial to all since it improves market efficiency.

4. Social media

• Not all information on social media platforms is considered public. Some platforms require membership to access information. Members and candidates must verify that material information obtained from membership-based platforms can also be accessed from a publicly available source (e.g., webpage, company filing, and press release).




• Using social media to communicate with clients or investors does not violate this Standard. If the information reaches all clients or is open to the public, using social media platforms is comparable to traditional means of communications (e.g., e-mails and press releases).

• As mandated by Standard I(A), members and candidates must complete regulatory filings related to information distributed via social media.

5. Using industry experts

• Members and candidates can hire and compensate outside industry experts with specialized knowledge of different industries. However, they may not request or use material, nonpublic information from these experts; doing so would violate security regulations. In many cases, firms that connect analysts and experts require both parties sign agreements regarding disclosure of material, nonpublic information.

6. Investment research reports

• Renowned analysts may release reports that may be considered material due to their impact on market prices. In theory, Standard II(A) requires these analysts to make the reports public when they distribute them to clients. However, if the analysts used publicly available information and their own expertise to compile the reports, they are not required to release them to the public. Investors can either pay the analysts for the reports or use the public information to try to draw conclusions.

STANDARD II(A) – PROCEDURES FOR COMPLIANCE

Compliance with Standard II(A) will prevent the misuse of material, nonpublic information by creating, maintaining, and imposing written policies and procedures for such prevention. Procedures for compliance with Standard II(A) include the following.

1. Distribute information publicly – Material information should be distributed publicly. If this cannot be done, the information should not be used to make or alter investment decisions, but should be given to designated supervisors and compliance personnel. Members and candidates should not encourage company insiders to privately disclose material, nonpublic information.

2. Adopt compliance procedures – Firms should be encouraged to adopt procedures to prevent the misuse of material, nonpublic information. Improvement of compliance is particularly important in reviewing employee and proprietary trading, reviewing investment recommendations, documenting firm procedures, and overseeing communications between departments in multiservice firms.

• Members and candidates are urged to notify their supervisor and compliance personnel of potential improper use within their firm of material, nonpublic information for securities trading or investment recommendations.

3. Adopt disclosure procedures – Firms should establish disclosure procedures to ensure that material information is distributed in an equitable way (i.e., distributed to interested parties independent of their firm size, types of recommendations they issued in the past, and whether they are buy- or sell-side analysts).

• Members and candidates in investment and research firms should encourage establishment of and compliance with procedures for distributing to clients new and updated investment recommendations. This information may be material and, thus, needs to be communicated to all clients fairly.




4. Issue press releases – If material, nonpublic information is first disclosed at a meeting or communication with analysts, firms should quickly disclose the information publicly in some way (e.g., in a press release). If possible, firms should try to disclose information before such meetings.

5. Establish firewalls – To restrict the exchange of material, nonpublic information within a firm, an information barrier (i.e., a "firewall") can be established. Minimum components of a firewall include the following.

• Control of relevant interdepartmental communications.

• Maintaining restricted, "rumor", and watch lists to review employee trading.

• Documenting the process for restricting the exchange of information within the firm and describing how the process will be implemented.

• Increased oversight or restrictions of proprietary trading when the firm has material, nonpublic information.

6. Formalize interdepartmental communications – This should be done at small and large firms.

7. Physically separate departments – Firm should aim to physically separate departments and files to prevent the exchange of material, nonpublic information. For instance, a bank's research department should be separated from its commercial lending branch, and a brokerage firm's investment banking and corporate finance departments should be separated from its sales and research departments.

8. Prevent overlap of staff – Departments should not share personnel. For instance, a brokerage firm's investment banking and corporate finance arms should not share personnel with its sales and research departments; and a bank's commercial lending department should not share personnel with its trust and research departments. In multi-service firms, personnel should remain on one side of a firewall at any given time to avoid damaging the efficacy of the wall.

9. Establish a reporting system – A supervisor or compliance officer should be designated to determine whether information is material or not and whether it can used to make investment recommendations and decisions or shared with someone "over the wall". Analysts should consult this individual if they need to share such information, and, if sharing is permitted, the compliance officer should oversee the exchange of information.

10. Limit or prohibit personal trading – Firms should consider restricting or prohibiting personal trading by employees and should monitor employees' proprietary and personal trading.

• Employees should periodically report on their own transactions and transactions made for family members.

• A watch list should be used together with a restricted list to control personal trading. The restricted list should include securities about which the firm has or may have material, nonpublic information. It should not be broadly distributed. Instead, the watch list is provided to the few people responsible for compliance and used to monitor transactions in specific securities.

11. Maintain records – Multiservice firms should keep written records of communications between departments. Firms should train staff to be able to identify material, nonpublic information.

12. Establish proprietary trading procedures – Procedures should depend on the types of proprietary trading in which a firm engages. A ban on all proprietary trading is not necessary.

• For instance, a firm that is a market maker may need to act on material, nonpublic information, and this practice would not be a breach of the Standard. However, in these




situations, market makers should only take the opposite position to any unsolicited customer trade.

• In the case of risk-arbitrage trading, a proprietary trading ban is appropriate, particularly since the potential for illegal profits is greater than in market making. Firms should suspend arbitrage activity when a security is on a watch list. If they continue arbitrage activity, they would need to clearly demonstrate satisfactory procedures for preventing trading on material, nonpublic information and a strict review and record of firm trades.

13. Communicate with employees – Firm employees should be given written compliance policies and receive appropriate training so they can identify material, nonpublic information and know to either make informed decisions or consult a supervisor or compliance officer if necessary.

• Policies should reinforce that many countries prohibit the use of material, nonpublic information.

Example of application of Standard II(A)

Maria Di Scala, a CAIA member, is having dinner with some friends at a local restaurant. At the table next to hers is the CEO of a large pharmaceutical firm dining with some of his upper management team. The CEO is expressing his concerns about the FDA failing to approve one of their medications and the group is discussing how they plan to counter the negative effects of the news once the information is released the following week. Maria feels that, since this information was acquired in a public place, it is not considered private and so she can act on it. As a result, after leaving the restaurant, she leaves a message for her broker giving him a heads-up about the forthcoming announcement and instructing him to sell any shares of the pharmaceutical firm that are owned by her clients.

Comment: As a CAIA member, Maria should know that the information she overheard in the restaurant is material and nonpublic, regardless of where it was acquired. Therefore, by acting on it as she did, she violated Standard II(A).

Further examples of applications of Standard II(A) are provided on pages 68-73 of the CFA


STANDARD II(B), MARKET MANIPULATION

The purpose and scope of Standard II(B) is that "Members and Candidates must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants."

This Standard compels members and candidates to maintain investor confidence and the integrity of capital markets by not manipulating the market in any way. Market manipulation is an intentional attempt to interfere with market prices or trading volume or to create and/or distribute false or confusing information with the intention of misleading those who depend on that information.

• Market manipulation may cause investors to have less trust in the fairness of capital markets, which can result in less investor participation, higher risk premiums, and less market




efficiency. The lower efficiency of local markets may, in turn, negatively impact the domestic and global economy.

• Opportunities for market manipulation increase with the advent of new products and technologies and more sophisticated means of communication.

Market manipulation can be information-based or transaction-based.

1. Information-based manipulation – This includes distributing false information to stimulate trading by other market participants. The practice of pumping and dumping is an example of information-based manipulation that involves enticing others to buy a security so that its price increases and then later dumping the security (i.e., selling it) at the falsely inflated price.5

2. Transaction-based manipulation – This includes distorting market prices to imply trading activity in securities or gaining a controlling position in a security for the purpose of manipulating the security or an associated derivative security.

Members and candidates may legitimately buy or sell thinly traded securities (i.e., illiquid

securities for which little or no trading takes place for days) in an attempt to exploit a pricing inefficiency or disparity in information. These legitimate strategies do not breach Standard II(B). As long as the action is not intended to manipulate or deceive, it is not considered a violation.

Example of application of Standard II(B)

Natasha Portman is a financial analyst who has created a web site that she uses to provide financial advice to the public. In her research, she has discovered a small company about which there is little public information, but she believes its value will soar fairly quickly and so she purchases some of its penny stock. After a few months, with the stock price around the same levels, she starts to vehemently promote the company on her website. She believes that her recommendations will convince her growing website users to invest in the company. After some time, trading on the stock increases, as does its price. However, Natasha is concerned that it will not be able to maintain the growth and so she sells all her shares. She then also removes the buy recommendation from her website.

Comment: Natasha manipulated unwitting investors to purchase the stock, driving up both demand and price. It is expected that after she removes her recommendation from her website, demand will decrease and the stock price will fall. As a result, many investors will lose their investments as they were deceived by what amounts to a pump and dump scheme. Natasha's actions violated Standard II(B).

Further examples of applications of Standard II(B) are provided on pages 76-80 of the CFA


5 Jonathan Lebed, a 15-year-old American high-school student, engaged in a pump and dump market manipulation scheme by using the Internet to promote stocks. In particular, he bought thinly-traded low-price stocks and then promoted them on numerous message boards. When other investors bought the stocks, causing the prices to increase, Lebed sold his shares for profits ranging from $11,000 to $27,000 a trade. The SEC filed a civil suit against him, which was later settled.




L.O. A.3 Demonstrate knowledge of Standard III: Duties to Clients.

Standard III covers five areas.

A. Loyalty, Prudence, and Care

B. Fair Dealing

C. Suitability

D. Performance Presentation

E. Preservation of Confidentiality

STANDARD III(A), LOYALTY, PRUDENCE, AND CARE

Standard III(A) states that "Members and Candidates:

• have a duty of loyalty to their clients and must act with reasonable care and exercise prudent judgment.

• must act for the benefit of their clients and place their clients' interests before their employer's or their own interests."

Investment professionals have a duty of loyalty to the client whose personal assets they

manage or, in the case of a trust or pension plan, to the beneficiaries thereof. Investment actions must be carried out for the sole benefit of the client and with the same level of prudence, judgment, and care that would be applied to managing their own interests.

• Exercising prudence when managing a client's portfolio entails following the investment parameters set by the client and balancing risk and return.

• Acting with care entails acting carefully to avoid harm to clients.

• Standard III(A) establishes a minimum benchmark for the duties of loyalty, prudence, and care that are required of all members and candidates, regardless of job title, local laws, or cultural differences. This gives clients confidence in the responsibilities undertaken by investment professionals.

• However, this Standard does not replace legal, regulatory, or fiduciary obligations by which members and candidates are bound. As stated in Standard I(A), members and candidates must adhere to the strictest requirements set by regulators or the Code and Standards.

• Members and candidates who have direct or indirect access to a client's funds are said to have custody of client assets. These investment professionals assume an additional responsibility. Those with custody of client assets must manage the assets in their control according to the terms of the governing documents.

This Standard underscores the importance of client interests. The intent of the Standard is to

ensure loyalty, prudence, and care in all situations in which investment professionals deal with clients. Key components of this Standard include the following.

1. Understanding the application of loyalty, prudence, and care

• Standard III(A) establishes a minimum benchmark for the duties of loyalty, prudence, and care. It requires members and candidates to fulfill explicit or implicit obligations in client agreements to the best of their abilities and with loyalty, prudence, and care.


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