Standard V(A) Diligence and Reasonable Basis
Updated April 2024
CFA Institute
The Standard
Members and candidates must:
- Exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions.
- Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action.
Guidance
Diligence requires careful, consistent, and thorough work or effort. To have a reasonable basis for making a decision or taking action requires using sound judgment, understanding, care, and caution appropriate under the circumstances when undertaking an investment action or making a decision; it involves following a rational and well-considered process that is designed to remedy or address an issue or affect an outcome.
The application of Standard V(A) depends on the investment philosophy the member, candidate, or his or her firm is following, the role of the member or candidate in the investment decision-making process, and the support and resources provided by the member’s or candidate’s employer. These factors will dictate the nature of the diligence and thoroughness of the research and the level of investigation required by Standard V(A).
Investment Recommendations and Actions
Members and candidates must make reasonable efforts to consider and address all pertinent issues when arriving at a recommendation.
Clients turn to members and candidates for advice and expect advisers to have more information and knowledge than the clients themselves do. This information and knowledge form the basis from which members and candidates apply their professional judgment in taking investment actions and making recommendations.
At a basic level, clients want assurance that members and candidates are putting forth the necessary effort to support the recommendations they are making. Members and candidates enhance transparency by providing supporting information to clients when making a recommendation or taking action. Communicating the level and thoroughness of the information reviewed before the member or candidate makes a judgment allows clients to understand the reasonableness of the recommended investment actions.
As with determining the suitability of an investment for the client, the necessary level of research and analysis will differ with the product, security, or service being offered. In providing an investment service, members and candidates typically use a variety of resources, including company reports, third-party research, and results from quantitative models. Members and candidates form a reasonable basis for investment recommendations and actions through consideration of a balance of these resources.
The following list includes selected examples of attributes members and candidates may consider when forming the basis for an investment recommendation:
- Global, regional, and country macroeconomic conditions.
- A company’s operating and financial history.
- The industry’s and sector’s current conditions and the stage of the business cycle.
- A pooled fund’s fee structure and management history.
- The output and potential limitations of quantitative models.
- The quality of the assets included in a securitization.
- The appropriateness of selected peer-group comparisons.
Even though an investment recommendation may be well informed, downside risk remains for any investment. Every investment decision is based on a set of facts known and understood at the time. Members and candidates can base their decisions only on the information available at the time decisions are made. The steps taken in developing a diligent and reasonable recommendation will help minimize unexpected negative outcomes.
Information Sources
Members and candidates should make reasonable inquiries into the sources and accuracy of all data used in conducting their investment analysis and forming their recommendations. The sources of the information and data will influence the level of the review a member or candidate must undertake. Information and data taken from certain sources, such as blogs, independent research aggregation websites, or social media, may require a greater level of review than information from more established research organizations.
If members and candidates rely on secondary or third-party research, they must make reasonable and diligent efforts to determine that such research is sound. Secondary research is research conducted by someone else in the member’s or candidate’s firm. Third-party research is research conducted by entities outside the member’s or candidate’s firm, such as a brokerage firm, bank, or research firm. If a member or candidate has reason to suspect that either secondary or third-party research or information comes from a source that may be biased, unreliable, or otherwise deficient, the member or candidate must not rely on that information.
Criteria that a member or candidate may use in forming an opinion on whether research is sound include but are not limited to,
- assumptions used,
- rigor of the analysis performed,
- date/timeliness of the research, and
- evaluation of the objectivity and independence of the recommendations.
Members and candidates may rely on others in their firm to determine whether secondary or third-party research is sound and use the information in good faith unless they have reason to question its validity or the processes and procedures used by those responsible for the research. For example, portfolio managers may not have a choice of which data source to use, because the firm’s senior managers conducted due diligence to determine which vendor would provide information or research services. A member or candidate in this position can use the information in good faith assuming the due diligence process was deemed adequate.
Quantitative Research and Techniques
Standard V(A) applies to quantitatively oriented research models and processes, such as backtesting investment strategies; computer-generated modeling, screening, and ranking of investment securities; the creation or valuation of derivative instruments; and quantitative portfolio construction techniques. Members and candidates must understand the parameters used in models and quantitative research that are incorporated into their investment recommendations. Although they are not required to become experts in every technical aspect of the models, they must understand the assumptions and limitations inherent in any model and how the results are used in the decision-making process.
Members and candidates must make reasonable efforts to test the output of investment models and other preprogrammed analytical tools they use. Such validation must occur before incorporating the process into their methods, models, or analyses.
Individuals who create new quantitative models and services must exhibit a higher level of diligence in reviewing new products than that of the individuals who ultimately use the analytical output. Members and candidates involved in the development and oversight of quantitatively oriented models, methods, and algorithms must understand the technical aspects of the products. A thorough testing of the model and resulting analysis must be completed prior to product distribution.
Although not every model tests for every factor or outcome, members and candidates must ensure that their analyses incorporate a broad range of assumptions sufficient to capture the underlying characteristics of investments. Analysis that fails to consider potentially negative outcomes or levels of risk outside the norm may not accurately measure the true economic value of an investment. In reviewing computer models or the resulting output, members and candidates must include factors and assumptions that are likely to have a substantial influence on an investment’s value to ensure that the model incorporates a wide range of possible input expectations, including negative market events.
Members and candidates must also consider the source and time horizon of the data used as inputs in financial models. The information from databases may not effectively incorporate both positive and negative market cycles. In the development of a recommendation, the member or candidate may need to test the models by using volatility and performance expectations that represent scenarios outside the observable databases.
Selecting External Advisers and Subadvisers
The use of specialized managers to invest in specific asset classes or diversification strategies that complement a firm’s in-house expertise is common. Standard V(A) applies to the level of review necessary in selecting an external adviser or subadviser to manage a specifically mandated allocation. Members and candidates must review such advisers as diligently as they review individual investment opportunities.
Members and candidates who are directly involved with the use of external advisers and subadvisers should develop and use consistent, objective criteria for selecting and evaluating these advisers. Such criteria include but are not limited to,
- reviewing the adviser’s established code of ethics,
- understanding the adviser’s compliance and internal control procedures,
- assessing the quality of the published return information, and
- reviewing the adviser’s investment process and adherence to its stated strategy.
One factor in evaluating external advisers or subadvisers is whether they adhere to recognized industry standards to guide their work. Codes, standards, and guides on best practice published by CFA Institute establish practices for advisers and may be used by members and candidates as criteria for selecting external advisers or subadvisers. The following guides are available at the CFA Institute Research and Policy Center website: the CFA Institute Asset Manager Code™, the Global Investment Performance Standards (GIPS®), and the Model Request for Proposal (for equity, credit, or real estate managers).
Group Research and Decision-Making
Often, members and candidates are part of a group or team that is collectively responsible for producing investment analysis or research. The conclusions or recommendations of a group report represent the consensus of the group but not necessarily the views of a member or candidate, even though the name of the member or candidate is included on the report. In some instances, a member or candidate will not agree with the view of the group. If, however, the member or candidate believes that the consensus opinion has a reasonable and adequate basis and is independent and objective, the member or candidate does not need to dissociate from the report even if it does not reflect his or her opinion.
A clear example of improperly influencing hiring representatives was displayed in the “pay-to-play” scandal involving government-sponsored pension funds in the United States. Managers looking to gain lucrative allocations from the large funds made requested donations to the political campaigns of individuals directly responsible for the hiring decisions. This scandal and similar events have led to new laws requiring additional reporting concerning political contributions and bans on hiring—or hiring delay requirements for—managers who made campaign contributions to representatives associated with the decision-making process.
Compliance Practices
Members and candidates should encourage their firms to consider the following policies and procedures to support the conduct required under Standard V(A):
- Establish policies requiring that research reports, credit ratings, and investment recommendations have a basis that can be substantiated as reasonable and adequate.
- Develop detailed, written guidance that establishes the due diligence procedures for judging whether a particular recommendation has a reasonable and adequate basis.
- Develop measurable criteria for assessing the quality of research, the reasonableness and adequacy of the basis for any recommendation or rating, and the accuracy of recommendations over time.
- Develop detailed, written guidance that establishes minimum levels of scenario testing of all computer-based models used in developing, rating, and evaluating financial instruments. The policy should contain criteria related to the breadth of the scenarios tested, the accuracy of the output over time, and the analysis of cash flow sensitivity to inputs.
- Develop measurable criteria for assessing outside providers, including the quality of information being provided, the reasonableness and adequacy of the provider’s information collection practices, and the accuracy of the information over time. The established policy should outline how often the provider’s products are reviewed.
- Adopt a consistent, objective set of criteria for evaluating the adequacy of external advisers and subadvisers. The policy should include how often and on what basis the allocation of funds to the external adviser or subadviser will be reviewed.
Application of the Standard
- Example 1 (Sufficient Due Diligence)
- Example 2 (Timely Client Updates)
- Example 3 (Group Research Opinions)
- Example 4 (Reliance on Third-Party Research)
- Example 5 (Due Diligence in Subadviser Selection)
- Example 6 (Sufficient Due Diligence)
- Example 7 (Use of Quantitatively Oriented Models)
- Example 8 (Successful Due Diligence/Failed Investment)
- Example 9 (Quantitative Model Diligence)
- Example 10 (Selecting a Service Provider)
- Example 11 (Subadviser Selection)
- Example 12 (Technical Model Requirements)
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