Standards application in portfolio context - Duties to clien...

Learning Outcomes

This article explains how the CFA Institute Code of Ethics and Standards of Professional Conduct apply when forming and communicating portfolio recommendations in a Level III exam context, including:

• Applying Duties to Clients (loyalty, prudence, care, fair dealing, suitability) to portfolio construction, monitoring, rebalancing, manager selection, and trade implementation while resolving conflicts between client, firm, and employee interests
• Judging suitability at both the total-portfolio and individual-trade level using client objectives, risk profile, and constraints, and recognizing when changes in circumstances require IPS updates or strategy revisions
• Designing, evaluating, and improving client communications for clarity, completeness, and objectivity, ensuring appropriate disclosure of investment process, risks, costs, liquidity constraints, benchmarks, and any conflicts of interest
• Distinguishing advisory, discretionary, and execution-only relationships and determining the correct level of suitability analysis, documentation, and explanation required in each case
• Evaluating portfolio actions, trade allocations, and order sequencing for fair dealing and best execution, especially in situations involving limited investment capacity, block trades, and new issues
• Identifying potential or actual Standard violations in item-set and essay-style case vignettes and structuring concise exam responses that cite the relevant Standard, justify the conclusion, and recommend compliant corrective actions

CFA Level 3 Syllabus

For the CFA Level 3 exam, you are required to apply the Code and Standards in an integrated portfolio management context, with a focus on the following syllabus points:

• Relate Standard III(A)–(C) (Loyalty, Prudence, and Care; Fair Dealing; Suitability) to portfolio construction, monitoring, and rebalancing
• Apply Standard V(B) (Communication with Clients and Prospective Clients) to written and verbal portfolio recommendations
• Evaluate portfolio strategies and client communications for suitability, fair dealing, and adequate disclosure of risks, costs, and conflicts
• Distinguish between advisory, discretionary, and execution-only relationships and the resulting duty to clients
• Analyze case facts to identify ethical breaches and recommend compliant portfolio recommendations and communications

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which CFA Standard most directly requires that portfolio managers base recommendations on a client’s specific objectives, risk tolerance, and constraints?
   1. Standard III(A): Loyalty, Prudence, and Care
   2. Standard III(B): Fair Dealing
   3. Standard III(C): Suitability
   4. Standard V(B): Communication with Clients and Prospective Clients
2. A firm is rebalancing client portfolios after a strategic asset allocation review. It notifies only its largest clients on day one and implements changes for smaller clients several days later, after markets have moved. Which Standard is most clearly at risk?
   1. Standard III(B): Fair Dealing
   2. Standard III(D): Performance Presentation
   3. Standard V(C): Record Retention
   4. Standard VI(B): Priority of Transactions
3. An adviser recommends a high-turnover, high-fee hedge fund as a core holding. The manager’s bonus is linked to assets gathered in this fund. The adviser discloses the expected return but omits discussion of fees, liquidity restrictions, and turnover. Which combination of duties is most clearly violated?
   1. Loyalty, prudence, and care; and suitability
   2. Fair dealing; and performance presentation
   3. Suitability; and record retention
   4. Material nonpublic information; and market manipulation
4. To ensure portfolio communications comply with CFA Standards, a periodic client report describing a new strategy should most appropriately:
   1. Highlight upside scenarios and omit stress scenarios to avoid alarming the client
   2. Present only security-level details and omit asset allocation and risk metrics
   3. Clearly explain objectives, risks, costs, liquidity, benchmarks, and changes in process
   4. Focus on gross returns and delay disclosure of fees and taxes to a separate document

Introduction

Ethical and professional standards provide a basis for disciplined portfolio management. At Level III, you are expected to integrate those standards with client objectives and constraints to design, implement, and explain portfolio strategies. It is not enough to memorize the wording of Standards; you must apply them to complex, often ambiguous portfolio situations.

Key Term: Duties to Clients
The set of obligations CFA members and candidates owe under the Code and Standards, including loyalty, prudence, care, fair dealing, suitability, fair performance presentation, and preservation of confidentiality.

Portfolio managers must balance investment opportunities with their duty to act for the benefit of each client, placing client interests above both the firm’s and their own. This article focuses on how Duties to Clients and the Communication with Clients Standard operate when designing and communicating portfolio recommendations. Adherence to these Standards is central to maintaining client trust and avoiding reputational, regulatory, and legal risk.

A recurring Level III theme is the portfolio context: suitability and communication are assessed relative to the client’s total portfolio and written objectives, not simply security by security. This is implemented through the client’s investment policy statement (IPS).

Key Term: Investment Policy Statement (IPS)
A written document that records a client’s risk and return objectives and all relevant constraints, and guides strategic asset allocation and ongoing portfolio decisions.

THE CORE CLIENT DUTIES IN PORTFOLIO RECOMMENDATIONS

The primary Standards involved in portfolio recommendations are:

• Standard III(A) Loyalty, Prudence, and Care
• Standard III(B) Fair Dealing
• Standard III(C) Suitability
• Standard V(B) Communication with Clients and Prospective Clients

These must be applied jointly rather than in isolation.

Key Term: Loyalty, Prudence, and Care
The requirement to act for the benefit of clients, placing their interests ahead of those of the firm or manager, and exercising the judgment and care of a prudent professional.

Fair Dealing and Priority of Transactions

Portfolio managers must treat all clients fairly and objectively and prioritize client interests above their own or their firm’s.

Key Term: Fair Dealing
The requirement to offer each client the same degree of care and opportunity in investment recommendations and actions, consistent with that client’s objectives and circumstances.

Fair dealing does not mean that all clients must hold identical portfolios. Different clients may have different objectives, risk tolerances, tax situations, or ESG preferences, and thus receive different recommendations. What must be fair is:

• The process for originating and updating recommendations
• The timing and method of dissemination
• The allocation of limited investment opportunities and trade executions

Standard III(B) distinguishes two main areas:

• Investment recommendations: when research is completed or views change, clients should have a fair opportunity to act. That means consistent dissemination policies for research notes, model portfolio changes, or allocation shifts.
• Investment action: when implementing trades, clients with similar objectives should be treated equitably in trade sizing and order sequencing.

Key Term: Priority of Transactions
The principle that client transactions take precedence over transactions for the benefit of the firm or employees, and that personal trading must not disadvantage clients.

In practice this implies:

• No selective early access to upgrades/downgrades for favored clients
• No front‑running client trades with personal or proprietary accounts
• Fair allocation of oversubscribed new issues and limited-capacity strategies
• Consistent treatment of clients across distribution channels (e.g., email vs social media vs portal)

Key Term: Best Execution
Seeking the most favorable terms reasonably available for client trades, considering price, speed, likelihood of execution, and overall transaction costs.

Fair dealing is often tested in portfolio-management item sets through:

• Oversubscribed IPOs or private deals allocated disproportionately to a favored client or to firm proprietary accounts
• Social media posts (e.g., a tweet with a recommendation) sent to some followers before the recommendation is sent to all clients
• Rebalancing implemented promptly for some accounts but materially delayed for others without justification

In all such scenarios, consider whether the process gives each relevant client a fair opportunity to benefit, and whether client transactions are prioritized appropriately.

Suitability and Know Your Client (KYC)

Each recommendation must be suitable to the client’s profile and IPS. Standard III(C) requires reasonable inquiry into the client’s financial circumstances, investment experience, risk and return objectives, and constraints, and mandates judging suitability in the context of the client’s total portfolio.

Key Term: Suitability
The obligation to ensure each recommendation or action is appropriate to a client’s objectives, financial situation, and needs, judged in the context of the client’s overall portfolio.

Key Term: Risk Profile
The combination of a client’s risk capacity (ability to bear risk) and risk tolerance (willingness to bear risk), plus any specific risk preferences or aversions.

Suitability in a portfolio context requires:

• Developing and maintaining an IPS

  • Document risk tolerance (both psychological and financial), return objectives, and constraints (time horizon, liquidity, tax, legal/regulatory, unique circumstances).
  • For private wealth clients, the IPS often reflects multiple goals (retirement, education funding, legacy) with different horizons.
  • For institutions, the IPS reflects the entity’s obligations (e.g., pension liabilities, spending rules for endowments).

• Judging suitability at both levels

  • Portfolio level: Does the resulting asset allocation and risk level align with the IPS and risk profile?
  • Trade/strategy level: Does each new strategy or investment fit within the IPS, including liquidity, time horizon, and diversification?

• Recognizing liquidity and horizon mismatches

  • Illiquid investments (e.g., private equity with multi‑year lockups) may be inconsistent with a client’s need for ready access to funds, even if expected returns are attractive.
  • Short-horizon goals (funding near-term spending) should not rely on highly volatile or illiquid strategies.

Key Term: Unsolicited Trade
A client-directed transaction that originates from the client rather than as a recommendation from the adviser.

Key Term: Execution-Only Relationship
A relationship where the professional only executes client-directed trades without providing investment advice or suitability assessment.

Standard III(C) draws a line between advisory and execution‑only roles:

• Advisory/discretionary relationships: Full suitability duties apply. The manager must decline or caution against investments inconsistent with the IPS and may need to refuse to implement extreme client instructions.
• Execution-only: The primary duty is to execute orders with skill and care and seek best execution. Suitability analysis is not required, but misleading the client into believing advice is being provided would breach other Standards.

Managers must also periodically update the IPS as client circumstances change (retirement, inheritance, changes in employment or health, changes in institutional funding status) and reassess whether the existing strategy remains suitable.

Objectivity and Transparency in Communication

Clients deserve clear, objective communications regarding all recommendations and decisions made for their portfolios. Standard V(B) requires disclosure of:

• The basic format and general principles of the investment process
• Significant limitations and risks associated with that process
• Factors important to analysis and recommendations
• A clear distinction between fact and opinion

Key Term: Communication with Clients
The expectation that all portfolio recommendations and updates be presented factually, impartially, and with sufficient relevant disclosure to enable informed decisions.

Key Term: Material Risk
Any risk that a reasonable client would consider important in evaluating whether to accept a recommendation or strategy, including downside, liquidity, leverage, concentration, and operational risks.

Key Term: Conflict of Interest
A situation in which personal, firm, or other interests could reasonably be expected to impair independence, objectivity, or loyalty to the client.

Key Term: Discretionary Authority
The client’s authorization for the manager to make and implement investment decisions without obtaining prior approval for each trade.

Transparent portfolio communications should:

• Explain the strategy: objectives, asset classes, instruments, benchmarks, typical risk exposures, rebalancing and tactical decision rules
• Disclose key risks and limitations:
  • Market and factor risks, leverage, derivative use
  • Liquidity constraints (lockups, redemption gates, notice periods)
  • Capacity constraints, tracking error ranges, and style drift risk
• Explain costs: management and performance fees, trading costs and expected turnover, tax implications at a level appropriate to the client’s sophistication
• Disclose conflicts: use of proprietary products, revenue sharing, performance fee structures, and personal holdings that may create perceived conflicts
• Distinguish clearly between facts (current allocation, realized returns, contractual fee rates) and opinions or forecasts (expected returns, scenario outcomes)

For example, if you show modeled return distributions or capital market assumptions, you must:

• Explain that these are estimates, not guarantees
• Provide key assumptions (expected returns, volatilities, correlations, time horizon)
• Highlight downside scenarios as well as central outcomes

Opaque or overly promotional narratives (e.g., focusing only on upside or omitting material risks) are inconsistent with objective communication, even if no explicit misstatements are made.

Implementation: Practical Application of Standards

A portfolio manager must demonstrate the following in client communications and recommendations:

• Confirm that the IPS is up to date and reflects current objectives, risk profile, and constraints
• Provide a detailed, client-specific rationale for each major portfolio change or new strategy
• Clearly articulate the benefits and drawbacks, including potential risks and trade-offs versus the existing portfolio
• Disclose costs, liquidity constraints, and any impact on overall portfolio risk and diversification
• Explain how the recommendation fits within the stated mandate, strategy, or style (Standard III(C)(2))
• Disclose any conflicts of interest and how they are managed
• Clarify the level of discretionary authority and what decisions will be taken without prior consultation
• Update clients about material changes in market conditions, capital market expectations, or investment process that could affect objectives or suitability
• Document the analysis, assumptions, and client communications to satisfy record-retention requirements (Standard V(C))

Well-drafted portfolio communications read like a concise justification memo: they tie recommendations back to the IPS, explain the reasoning, make risks and costs explicit, and demonstrate that the manager has acted with loyalty, prudence, and care.

Worked Example 1.1

A manager is rebalancing a client’s portfolio to add alternative assets and increase long-term return potential. The manager emails a one-line notice: “We are reallocating 15% of your equity into private equity for enhanced returns.” The client’s IPS specifies moderate risk tolerance, significant liquidity needs to fund annual spending, and a preference for simple, transparent strategies.

Does this communication and action meet CFA Standards?

Answer:
No. Even if private equity might increase expected return, the manager has not demonstrated suitability or communicated adequately. The reallocation materially changes liquidity and risk characteristics; under Standards III(A) and III(C) the manager must first assess whether multi-year lockups and capital calls are consistent with the client’s liquidity needs and risk profile. Under Standard V(B), the email must explain the rationale, expected benefits, key risks (illiquidity, valuation uncertainty, J-curve effects), fees, and how the change affects overall portfolio risk relative to the IPS. Minimal, one-line communication fails the transparency and suitability requirements.

Worked Example 1.2

A client requests a “yield-maximizing” portfolio. The manager proposes a concentrated allocation to high-yield bonds and leveraged loan funds without discussing increased default risk, volatility, or the potential for severe drawdowns in credit crises, focusing only on higher expected yields.

Is this appropriate under the Standards?

Answer:
No. Under Standard III(C), the manager must judge suitability in the portfolio context, not simply chase the client’s stated preference for yield. Concentrated high-yield exposure may be inconsistent with the client’s risk profile or need for capital preservation. Standard V(B) requires disclosure of all material risks, including credit, liquidity, and correlation risk in downturns. Omitting discussion of these risks breaches both suitability and fair, objective communication duties. The manager should instead explain trade-offs, propose a diversified solution, and document the discussion.

Worked Example 1.3

A corporate treasury portfolio is managed under an IPS that emphasizes high liquidity and capital preservation, limiting investments to short-duration, investment-grade instruments. The manager identifies a private credit fund with a three- to five-year lockup and attractive yields, and allocates 4% of the portfolio to this fund without revising the IPS or consulting the client.

Is this consistent with the Standards?

Answer:
No. The allocation violates Standard III(A) and III(C). The IPS clearly requires high liquidity; a multi-year lockup is inconsistent with the mandate regardless of attractive yield. A prudent manager would recognize that inability to redeem in stressed conditions is a material risk for a treasury portfolio. Making such an allocation without client discussion also breaches loyalty and prudence. The manager should either decline the investment or first discuss with the client, revising the IPS only if the client consciously accepts the trade-off.

Worked Example 1.4

A long-term pension portfolio is managed according to an IPS targeting moderate volatility and diversified equity exposure. The manager’s bonus has recently been tied to quarterly performance relative to peers. To improve short-term rankings, the manager substantially increases exposure to high-beta growth stocks, raising expected volatility beyond IPS limits, without informing the client.

Is this compliant?

Answer:
No. The manager has allowed personal compensation incentives to override client interests. Increasing risk beyond IPS parameters to improve short-term relative returns breaches Standard III(A) (Loyalty, Prudence, and Care) and Standard III(C) (Suitability). The change also should have been communicated under Standard V(B) as a material alteration of risk profile and style. Incentive structures do not justify ignoring the agreed risk tolerance.

Worked Example 1.5

A private client with a balanced, diversified portfolio insists on investing 30% of assets in her employer’s stock after reading positive news, despite an IPS that limits single-security exposure to 10%. She instructs the adviser to execute the trade immediately.

How should the adviser respond under the Standards?

Answer:
The adviser must first explain why this unsolicited trade is unsuitable: it creates excessive concentration and increases correlation with the client’s human capital. Under Standard III(C), the adviser should discuss risks and potential alternatives (e.g., a smaller position). If the client persists, the adviser may either: (i) execute the trade but document the discussion and consider whether to revise the IPS to reflect the client’s explicit preference; or (ii) if the trade would make the portfolio clearly inconsistent with the adviser’s fiduciary responsibilities, decline the instruction or consider terminating the relationship. Blindly executing without discussion would breach suitability and loyalty.

Exam Warning

Before making changes to a client’s portfolio, do more than just issue a generic notice or rely on standard templates. Clients must receive specific, relevant explanations in plain language about how each recommendation aligns with their goals and what risks and costs may be involved.

In essay questions, candidates often lose marks by:

• Discussing only security-level attractiveness and ignoring the IPS and portfolio context
• Failing to mention liquidity, horizon, or concentration constraints when evaluating alternative strategies
• Writing vague statements such as “client is conservative” without linking to asset allocation, volatility, or drawdown implications
• Ignoring communication duties (e.g., not explaining that a major change in process or benchmark must be disclosed)

When you see a case vignette, always anchor your analysis in the IPS and Standards III(A)–(C) and V(B), then build out the portfolio and communication implications.

Summary

Upholding CFA Standards when making portfolio recommendations is more than a formality. Suitability, fair dealing, and transparent client communication together build the trust that is essential for long-term client relationships and successful practice. Each client must be treated as a unique principal, with recommendations and explanations suited to their circumstances and documented in a robust IPS. Every communication regarding portfolio decisions should be factual, impartial, and disclose all material facts and risks, including costs and conflicts.

In a Level III exam context, you are expected not only to spot breaches but also to design compliant portfolio solutions and communications: aligning asset allocation and strategies with the IPS, explaining changes clearly, and ensuring processes for fair dealing and trade allocation are in place. Applying the Standards consistently in this way demonstrates genuine professional judgment.

Key Point Checklist

This article has covered the following key knowledge points:

• The Duties to Clients require loyalty, prudence, care, fair dealing, suitability, fair performance presentation, and confidentiality in all actions
• Suitability requires a thorough, up-to-date understanding of client objectives, risk profile, and constraints, documented in a written IPS, before making portfolio recommendations
• Suitability must be judged in the context of the client’s total portfolio and time horizon, not solely at the individual security level
• Fair dealing demands equal opportunity for all relevant clients in access to recommendations, timing of communications, and allocation of limited investment opportunities
• Priority of transactions and best-execution obligations require that client trades take precedence over firm and personal trades and be executed on the most favorable reasonable terms
• All portfolio communications must be fair, objective, and transparent, with clear explanations of strategy, risks, costs, benchmarks, and any conflicts of interest
• Illiquid, leveraged, or complex strategies require heightened suitability and communication analysis, particularly when liquidity needs are significant
• Unsolicited trades that are unsuitable must be discussed and documented; in extreme cases, the adviser may need to decline to implement them or reconsider the relationship
• Proper documentation and record retention support compliance, facilitate performance reporting, and are often tested indirectly in Level III constructed-response questions

Key Terms and Concepts

• Duties to Clients
• Investment Policy Statement (IPS)
• Loyalty, Prudence, and Care
• Fair Dealing
• Priority of Transactions
• Best Execution
• Suitability
• Risk Profile
• Unsolicited Trade
• Execution-Only Relationship
• Communication with Clients
• Material Risk
• Conflict of Interest
• Discretionary Authority