contemporary issues

CONTEMPORARY ISSUES

Practical Investment Management

Robert A. Strong

CHAPTER TWENTY-THREE

South-Western / Thomson Learning © 2004 23 - 2

Outline

The Chartered Financial Analyst Program Themes Competence Presentation Standards Fiduciary Duties Ethics

Ethics Training and Industry Reform Standards of Practice and the SEC GAO Report on Unscrupulous Brokers Price Manipulation Analyst Objectivity Mandated Ethics Training


Outline

The Dot.com Phenomenon The Industry and the Players The Role of Advertising The Security Analysis Dilemma Changes in Market Mechanics

Derivatives The Definitional Problem Educational Efforts Internal Controls


increasing the technical competence of those in the investment business,

the accurate presentation of investment results,

adherence to fiduciary duty, and

the maintenance of a high ethical standard of conduct.

The Chartered Financial Analyst Program Themes

There are four motivating factorsbehind the CFA program :


As the investment industry grows in complexity, continuing education becomes all the more important.

From a fiduciary perspective, compliance with AIMR reporting requirements is becoming mandatory.

According to a recent poll, more than two-thirds of Americans think that financial advisors put their own interests ahead of those of their clients.

The Chartered Financial Analyst Program Themes


Ethics Training and Industry Reform

One researcher finds that failure to establish trust is the primary reason for the lack of success with cold calling.

Another study found that while 94% of money managers had some form of ethics and professional conduct policy, about half admitted that they did not have any assessment process in place.


The Securities and Exchange Commission has made it a top priority to raise the standards of practice among retail brokers.

Investors can take their broker to court for malpractice. Dramshop cases are those finding that brokers have a responsibility to ensure that clients do not commit financial suicide.

Standards of Practice and The SEC


On the other hand, the corporation should be free from opportunistic gadflies trolling for out-of-court settlements.

The SEC is also taking steps to make the mutual fund prospectus more comprehensive and comprehensible , so as to enable the average investor to make better investment decisions.



Most states also exercise some type of regulatory control over the securities offered for sale within their borders.

The SEC has little patience for misleading advertising too.



A principal conclusion of the report is that “existing disciplinary policies and practices may not adequately ensure investor protection.”

GAO Report on Unscrupulous Brokers

In 1994 Congress instructed the Government Accounting Office (GAO) to review the oversight and disciplinary actions of the SEC and other organizations with regard to unscrupulous brokers.


Price manipulation is illegal. The most common version involves posting false information on the Internet via chat rooms or phony research reports in an attempt to “pump and dump” a stock.

Analyst objectivity : A conflict of interest may arise between the investment banking function of an investment house and its research department.

Ethics Training and Industry Reform


In 1992, Congress reauthorized the CFTC, and ethics training was mandated for futures professionals.

Other organizations are following suit. In 1995 for instance, the SEC issued a regulation prescribing continuing education requirements for stockbrokers.

Mandated Ethics Training

The Commodity Futures Trading Commission (CFTC) is the federal agency overseeing the futures industry.


The Dot.com Phenomenon

One of the factors contributing to the substantial bull market during 1999 is what some people call the dot.com phenomenon, where we

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witnessed the growth of Internet firms, the proliferation of day trading, and sky-high valuations for companies with no earnings.

Since then, the market has declined three years in a row, and many of the darlings of 1999 are bankrupt.


The customer relationship is changing. Internet firms identify potential customers and

build a product specifically for them. People have convenient access to the Internet,

even while they are at work.

Projections of future earnings seem to matter more to the market than profits. All along, there have been very few profitable

Internet companies.

The strategic alliances of Internet firms with traditional companies may be the start of a new trend.




Internet firms spend heavily on advertising, but hope to permanently reduce this expenditure because of repeat business and “stickiness”.

The security analysis dilemma: If the capital market is reasonably efficient, how does it settle upon such huge valuations for firms with no profits and a very unclear future? The price-earnings ratio for Internet firms in mid-

1999 was about eight times as large as the PE for non-Internets.



Insert Table 23-5 here.


Whether Internet valuations are “loopy” or the reflection of a new era in investing is hard to say.

Merrill Lynch sums up things this way:


With these types of investments, we would also argue that the real “risk” is not losing some money - it is missing much-bigger upside. Investing in hyper-growth stocks is not about preserving capital (that’s what bonds are for); it is about making sure that you are on board the train if and when it leaves.


Changes in Market Mechanics

Internet trading reduces trading costs and brings more investors to the marketplace. However, it may also encourage gambling and disregard for professional advice.


Changes in Market Mechanics

Substantial structural changes are also being made to the brokerage systems. Many exchanges are implementing ways to

extend trading hours. Many brokerage firms are also revising their fee

structure and broker compensation scheme. Mergers and alliances are being discussed too.


Derivatives : The Definitional Problem

What is a derivative ?

Like the word speculation, the word derivative is impossible to define succinctly.

One workingman’s definition of derivative is “anything whose value derives from the value of something else.”

An alternative definition may specifically include reference to off-balance sheet items like interest rate caps, swaps or floors.


Derivatives : Educational Efforts

A fact not well understood by everyone is that derivatives are neutral products. They are not inherently good or bad, and their

risk and utility depends on what the user does with them.

Another misconception is the belief that investors with a large investment position have some type of risk-return advantage over the small investor. In fact, someone holding a large position may

be taking a substantial risk.


Derivatives : Internal Controls In 1995, the 233-year-old Barings Bank went

broke because of the actions of a 28-year-old, Singapore-based futures trader named Nick Leeson. Prior to the collapse of the British bank, Leeson

was writing straddles on the Japanese Nikkei index.

In response to the uncomplimentary attention brought to the derivatives industry, the Futures Industry Association assembled a group to seek ways to lessen the likelihood that a similar scandal will happen again.


Review

The Chartered Financial Analyst Program Themes Competence Presentation Standards Fiduciary Duties Ethics

Ethics Training and Industry Reform Standards of Practice and the SEC GAO Report on Unscrupulous Brokers Price Manipulation Analyst Objectivity Mandated Ethics Training


Review

The Dot.com Phenomenon The Industry and the Players The Role of Advertising The Security Analysis Dilemma Changes in Market Mechanics

Derivatives The Definitional Problem Educational Efforts Internal Controls

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