Ethical and Professional Standards — CFA Level III practice questions

GIPS-compliant composite construction requires:

1. Including every fee-paying, discretionary portfolio that fits the composite's defined strategy, on a timely basis
2. Including only the firm's best-performing portfolios within each defined strategy
3. Including non-fee-paying model portfolios in place of actual client accounts
4. Excluding new portfolios until they complete a full three-year track record

Answer: A — Including every fee-paying, discretionary portfolio that fits the composite's defined strategy, on a timely basis

A) Correct — GIPS requires firms to include all actual, fee-paying, discretionary portfolios managed according to a composite's strategy, added on a timely basis, preventing selective or delayed inclusion. B) Cherry-picking top performers into a composite is precisely the misrepresentation GIPS composite construction rules are designed to prevent. C) Composites must be built from actual client portfolios, not hypothetical or model portfolios, to be GIPS-compliant. D) New qualifying portfolios must be added within a defined, short period, per GIPS timeliness requirements.

A director of research learns that one of her analysts has been accepting undisclosed gifts from a covered issuer, in violation of firm policy and Standard I(B). She reprimands the analyst privately but takes no further action, does not investigate the scope of the conduct, and implements no additional monitoring. Under Standard IV(C), Responsibilities of Supervisors, her response is MOST likely insufficient because supervisors must:

1. Immediately terminate any employee who violates any Standard, with no supervisory discretion permitted
2. Report every violation directly to the employee's clients before conducting any internal review
3. Take no action beyond documenting the incident for the employee's personnel file, since further steps would exceed the supervisor's authority
4. Make a reasonable effort to detect and prevent violations by establishing and enforcing adequate compliance procedures, and follow up to determine the scope of the problem and prevent recurrence, not merely address the isolated incident informally

Answer: D — Make a reasonable effort to detect and prevent violations by establishing and enforcing adequate compliance procedures, and follow up to determine the scope of the problem and prevent recurrence, not merely address the isolated incident informally

A) Standard IV(C) doesn't mandate automatic termination; supervisors have discretion in crafting an adequate, proportionate response, though inaction is also a failure. B) Client notification isn't the first prescribed step; investigating and remediating the compliance failure comes first. C) Merely filing a note without investigating scope or strengthening procedures falls short of 'reasonable supervision,' which is the crux of the violation described. D) Correct — supervisors must reasonably detect, investigate, and prevent recurrence of violations through adequate compliance systems and follow-through, not just a private, one-off reprimand.

In a manager due-diligence process, verifying that a candidate's stated investment process matches the actual holdings and trading behavior in its historical portfolios is called:

1. Performance attribution
2. Operational due diligence
3. GIPS verification
4. Style analysis / process consistency review

Answer: D — Style analysis / process consistency review

A) Attribution decomposes sources of return, not whether stated process matches actual behavior. B) Operational due diligence covers back-office controls, custody, and compliance infrastructure, not investment style consistency. C) GIPS verification tests composite construction compliance, not whether a manager's process matches its holdings. D) Correct — style/process consistency (drift) analysis compares a manager's claimed approach to its realized holdings and factor exposures.

A client's IPS specifies moderate risk tolerance and a 10-year horizon. The client calls asking the advisor to concentrate 90% of the portfolio in a single speculative biotech stock based on a stock tip. Under Standard III(C), Suitability, the advisor's NEXT step should be:

1. Execute the trade immediately, since the client has final say over her own account
2. Refuse to ever discuss the position with the client again
3. Execute half the requested amount without further discussion
4. Discuss the request against the IPS, explain the suitability conflict, and update the IPS only if the client's actual objectives have genuinely changed

Answer: D — Discuss the request against the IPS, explain the suitability conflict, and update the IPS only if the client's actual objectives have genuinely changed

A) The advisor's suitability duty under Standard III(C) applies regardless of the client's enthusiasm for a specific trade. B) An overreaction that abandons the advisory relationship instead of addressing the conflict. C) An arbitrary unilateral compromise that skips the required suitability discussion. D) Correct — the advisor must reconcile the request against the documented IPS and either decline/adjust the trade or formally revise the IPS if objectives have truly changed.

A portfolio manager learns at a charity gala that her client's spouse, a CFO, casually mentions an unannounced earnings shortfall. Under Standard II(A) Material Nonpublic Information, the manager should:

1. May trade if position size is small
2. May share only with existing clients
3. Cannot trade or share the information
4. May trade after a 24-hour delay

Answer: C — Cannot trade or share the information

A) Size doesn't cure the violation. B) Sharing MNPI with anyone still causes trading. C) Correct — Standard II(A) prohibits trading and causing others to trade on MNPI. D) There is no waiting-period exception.

A portfolio manager allocates an attractive IPO across discretionary client accounts pro-rata by AUM but excludes one account because the client is a personal friend who 'always gets in on the next one.' This MOST LIKELY violates:

1. Standard VII(A) Conduct as CFA Candidate, since IPO allocation issues apply only to exam candidates
2. Standard I(B) Independence and Objectivity, because friendship impaired the manager's analytical judgment
3. Standard III(B) Fair Dealing, because an eligible discretionary account was arbitrarily excluded from a pro-rata allocation
4. No violation, since the client was excluded rather than favored

Answer: C — Standard III(B) Fair Dealing, because an eligible discretionary account was arbitrarily excluded from a pro-rata allocation

A) Standard VII(A) governs candidate conduct in the CFA program, unrelated to client-account allocation practices. B) Independence and Objectivity concerns external influences on research and recommendations, not allocation-policy deviations among clients. C) Correct — Fair Dealing requires equitable treatment of all clients according to a defined, objective allocation policy; arbitrarily excluding an eligible account, even one belonging to a friend, breaches that policy. D) Fair Dealing is violated by unequal treatment in either direction; being arbitrarily excluded from a beneficial allocation is just as much a violation as being favored improperly.

A firm presents 5-year performance for its 'Global Equity' composite but excludes one portfolio whose mandate was terminated mid-period after losses. Under GIPS, this exclusion is:

1. Permitted, since terminated portfolios may always be removed retroactively from history
2. Not permitted, because terminated portfolios must remain in the composite's historical returns through their last full period under management
3. Permitted only if the client consents in writing to the exclusion
4. Irrelevant to GIPS compliance, since composite membership rules apply only to active accounts

Answer: B — Not permitted, because terminated portfolios must remain in the composite's historical returns through their last full period under management

A) GIPS specifically prohibits retroactively removing terminated portfolios from historical composite performance to prevent survivorship-bias manipulation. B) Correct — GIPS requires that terminated portfolios remain in the historical record of the composite through the last full measurement period they were managed, so results cannot be cleaned up after the fact. C) Client consent does not override the GIPS requirement; the standard governs firm-level presentation, not a private waiver. D) GIPS composite construction explicitly addresses how terminated, as well as active, portfolios must be treated historically.

A wealth manager's compensation includes a higher commission for recommending an in-house structured product versus a comparable third-party alternative. All else being suitable and equal, which of the following is REQUIRED, and which is merely encouraged, under Standard VI(A), Disclosure of Conflicts?

1. Required: refusing to ever sell the in-house product; Encouraged: nothing further is needed
2. Required: matching the in-house product's commission to the third-party product before any sale; Encouraged: nothing further is needed
3. Required: obtaining written client consent only if the in-house product underperforms; Encouraged: verbal disclosure at account opening
4. Required: full and fair disclosure of the compensation conflict to the client before the recommendation; Encouraged (but not required): additionally disclosing the general magnitude/structure of the compensation differential

Answer: D — Required: full and fair disclosure of the compensation conflict to the client before the recommendation; Encouraged (but not required): additionally disclosing the general magnitude/structure of the compensation differential

A) Standard VI(A) does not prohibit selling proprietary products outright; it requires disclosure of the conflict, not avoidance. B) Nothing in the Standard requires equalizing compensation between products. C) Disclosure obligations aren't contingent on subsequent underperformance, and informal verbal-only disclosure at an unrelated point in time doesn't satisfy the requirement. D) Correct — the Standard requires clear, prominent disclosure of the conflict before the recommendation; providing further detail on the compensation structure is good practice but not mandated to the same degree.

A portfolio manager plans to leave her firm in two months to start a competing advisory business. While still employed, she begins soliciting several of the firm's largest clients to move their accounts to her new venture upon her departure. This conduct MOST likely violates:

1. Standard III(B), Fair Dealing, because she is not treating all clients equally
2. Standard IV(A), Loyalty, because soliciting clients while still employed misappropriates the employer's business opportunity
3. Standard I(A), Knowledge of the Law, because starting a competing business is itself illegal
4. Standard V(A), Diligence and Reasonable Basis, because she has not researched her new venture sufficiently

Answer: B — Standard IV(A), Loyalty, because soliciting clients while still employed misappropriates the employer's business opportunity

A) Fair Dealing concerns equitable treatment among clients, not solicitation timing relative to employment. B) Correct — Standard IV(A) prohibits using an employer's resources or client relationships to benefit a future competing venture while still employed. C) Starting a competing business is not inherently illegal; the issue is the timing and manner of solicitation, an ethics violation rather than a legal one. D) Diligence and Reasonable Basis concerns investment research quality, unrelated to this loyalty issue.

A pension consultant recommends a manager that has the highest 3-year return in the peer universe. Under Standard V(A) Diligence and Reasonable Basis, this recommendation is:

1. Consistent with Standard V(A), because top-quartile returns alone constitute a reasonable and adequate basis
2. Consistent with Standard V(A), provided the return data is sourced from an independent database
3. Irrelevant to Standard V(A), which applies only to individual security recommendations, not manager selection
4. A violation, because relying solely on trailing short-term returns without further analysis lacks a reasonable and adequate basis

Answer: D — A violation, because relying solely on trailing short-term returns without further analysis lacks a reasonable and adequate basis

A) Standard V(A) requires reasonable and adequate basis, supported by appropriate research; short-term performance ranking alone does not satisfy that diligence standard. B) The credibility of the data source doesn't cure the lack of a substantive analytical basis behind the recommendation itself. C) Standard V(A) applies broadly to investment recommendations and actions, including manager selection, not just individual securities. D) Correct — Selecting a manager based solely on trailing 3-year return, without evaluating process, risk-adjusted performance, and repeatability, fails the reasonable-basis requirement of Standard V(A).

Disclosure requirements?

Conflicts of interest, referral fees, gifts, additional compensation.

A client's IPS specifies 'moderate risk,' but her actual portfolio holds 95% in speculative small-caps. Which Standard governs, and what's the fix?

Standard III(C) Suitability; the advisor must reconcile the mismatch — either rebalance toward the IPS or formally update the IPS if the client's objectives have genuinely changed.

What must a GIPS-compliant firm do upon discovering a material error in a previously issued compliant presentation?

Correct the error and reissue the corrected presentation to all recipients of the erroneous version, per the firm's documented error-correction policy.

Why is it inappropriate to present a gross-of-fees return to a retail prospect without disclosing that fees will reduce their realized return?

Gross returns overstate the client's likely actual experience; GIPS and fair-dealing standards require clear fee disclosure so the client understands the net return they can realistically expect.