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CHAPTER TWENTY-THREE

CONTEMPORARY ISSUES

Practical Investment Management


Robert A. Strong
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

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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

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The Chartered Financial Analyst Program Themes
ADD YELLOW RULES TO THIS CH.
 There are four motivating factors
behind the CFA program :

 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.

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The Chartered Financial Analyst Program Themes

 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.

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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.

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Standards of Practice and The SEC

 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.

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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.

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Standards of Practice and The SEC

 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.

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

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Ethics Training and Industry Reform

 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.

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

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The Dot.com Phenomenon

 One of the factors contributing to


the substantial bull market during
• com 1999 is what some people call the
dot.com phenomenon, where we
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.

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The Industry and the Players
 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.

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The Dot.com Phenomenon
 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.

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The Dot.com Phenomenon

Insert Table 23-5 here.

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The Dot.com Phenomenon
 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.

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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.

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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.

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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.

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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.

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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.

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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

South-Western / Thomson Learning © 2004 23 - 23


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

South-Western / Thomson Learning © 2004 23 - 24

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