Ethics - V B) Investment Analysis, Recommendations, and Action

Steve Jones is a portfolio manager for Gregg Advisors. Gregg has developed a proprietary model that has been thoroughly researched and is known throughout the industry as the Gregg model. The model is purely quantitative and screens stocks into buy, hold, and sell categories. The basic philosophy of the model is thoroughly explained to clients. The director of research frequently alters the model based on rigorous research—an aspect that is well explained to clients, although the specific alterations are not continually disclosed. Portfolio managers then make specific sector and security holding decisions, purchasing only securities that are indicated as “buys” by the model. Jones thoroughly understands the model and uses it with all of his clients. Jones is: A) not violating the Standards either in purchasing stocks without a thorough research basis or in not disclosing all alterations of the model to clients. B) violating the Standards in purchasing stocks without a thorough research basis and in not disclosing all alterations of the model to clients. C) violating the Standards in purchasing stocks without a thorough research basis, but not in failing to disclose all alterations of the model to clients. D) violating the Standards in not disclosing all alterations of the model to clients, but not in purchasing stocks without a thorough research basis. Your answer: D was incorrect. The correct answer was A) not violating the Standards either in purchasing stocks without a thorough research basis or in not disclosing all alterations of the model to clients. Jones and Gregg are using reasonable judgment in not continually disclosing all of the alterations of the model. It is acceptable to use a pure quantitative model as a sole basis for purchasing stocks, as long as it is thoroughly researched. --------------------------------------------------------------------------------------------------------------- I thought part of this standard was that changes have to be disclosed as they occur, however does that mean, you have to fully disclose EVERY change or in the case of this question, they say that simply informing the clients that changes will be made on a continual basis would suffice… I checked the handbook, it doesn’t seem like touch on this explicitly, it said for a quantitative model based investment strategy, it’s ok to report in capsule format, but the reference has to be available when requested, but my question relates to the changes made to the model, rather than the inner workings of the model…

liaaba, I like this passage from the bottom of p.105 “Members and candidates must adequately illustrate to clients and prospective clients the manner in which the member or candidate conducts the investment decision-making process. The member or candidate must keep existing clients and other interested parties informed with respect to changes to the chosen investment process on an ongoing basis. Only by thoroughly understanding the nature of the investment product or service can a client determine whether changes to that product or service could materially affect the client’s investment objectives.” From your example above, it looks like the model is being fine-tuned on an ongoing basis rather than altered in a way that represents a fundamental change to the investment decision-making process.

hiredguns1 Wrote: ------------------------------------------------------- > liaaba, I like this passage from the bottom of > p.105 > > “Members and candidates must adequately illustrate > to clients and prospective > clients the manner in which the member or > candidate conducts the investment > decision-making process. The member or candidate > must keep existing clients and > other interested parties informed with respect to > changes to the chosen investment > process on an ongoing basis. Only by thoroughly > understanding the nature of the > investment product or service can a client > determine whether changes to that > product or service could materially affect the > client’s investment objectives.” > > From your example above, it looks like the model > is being fine-tuned on an ongoing basis rather > than altered in a way that represents a > fundamental change to the investment > decision-making process. —got it, it’s the subtle difference between fine-tuning and altering the investment process that did the trick in this question

(too late to edit) … hiredguns1 Wrote: ------------------------------------------------------- > From your example above, it looks like the model > is being fine-tuned on an ongoing basis rather > than altered in a way that represents a > fundamental change to the investment > decision-making process. or rather that changes that represent a fundamental change to the investment decision-making process are “well explained” to clients while other specific alterations that may not constitute a fundamental change (e.g. upgrades, improvements- rather than changes to the fundamental process) aren’t communicated, which doesn’t seem like a violation to me.

I still can’t digest this completely, why wouldn’t it be a violation if the base model on which the investment decisions are made, is modified without informing the clients of what exactly was the quant-logic change so that the stock which was on a ‘Sell’ list initially, now, all of a sudden, has become a ‘buy’ recommendation? Care to elaborate, as to why it should be option A and not option D? - Dinesh S

I think it boils down to the materiality of the changes, no?

Not really. Every quant hedge fund and bank has proprietary models that they tweak all the time. Not only can you not disclose the details of these models to your clients, but if you did you would be violating the uniform trade secrets act (probably) and Federal IP laws. You could theoretically go to jail.

It’s the difference between disclosing the PROCESS versus disclosing the actual model allocation or investments.

Which ones of those do you think you disclose? This is one of those questions where a little bit of experience goes a long way. Suppose that you have a quant hedge fund investing in futures contracts. There are parts of that model that are public and parts that aren’t. So a client comes in and you say that you make decisions based completely on a computer program that looks at technical factors, volume, and relationship among groups of commodities. Then you have a portfolio process that combines them in a way to minimize some vol measure. Show them some trades you have made and let them understand the kinds of trades they are going to make, how much risk they are taking, and answer any sort-of general questions. After that, you can tweak the system as much as you want as long as what you have told them does not represent a material change (reasonable people can and do disagree about what represents material all the time). You don’t need to tell them about any details, show them any proprietary signals, tell them the model allocations, or investments except in broad ways or as per your agreement.