1.

1 ETHICS AND TRUST IN THE

INVESTMENT PROFESSION
1.1.a ETHICS EXPLAINED

Ethics represents a set of moral principles which serve as the foundation for proper conduct. These
principles in turn help guide the individual in balancing between his or her self-interest with the
effect that their actions will have on others. A ‘Code of Ethics’ communicates an organization’s
set of principles and values. These principles are then used as the foundation to construct a set of
‘Standards of Conduct’ which address how to apply the organization’s values in specific
situations. Since there isn’t a law for every specific situation, we need a set of broad principles in
order to guide our conduct in the ‘grey’ areas.

An effective Code of Ethics would place the integrity of the profession and the interests of clients
above all else. In order to earn this trust, industry participants must:

i) Be open and transparent in their business practices.

ii) Take responsible actions.
iii) Adopt ethical business practices.

1.1.b THE ROLE OF ETHICS IN THE INVESTMENT PROFESSION

A ‘profession’ carries a much higher sense of responsibility than just an ordinary job for the
following reasons:

i) A professional possess a specialized skill or knowledge.

ii) There is a duty to serve others.

Consequently, in most professions, members must adhere to the ethical standards set by that
profession. These standards can in turn be principle based (i.e. broad values) or rules based (in
which there is a rule for every specific situation). The CFA Institute’s Codes and Standards are
more principle based and for good reason: the investment industry is so complex and ever so
evolving that it would be impossible to create a rule for every specific scenario. Nevertheless,
irrespective of whether the standards are principles based or rule based, they signal to the public
the level of integrity of the members of the profession. Once a client forms a trust in the
professional, only then can their relationship be sustained.

1.1.c HOW PROFESSIONS ESTABLISH TRUST

A profession is an occupational group that possesses skill, expertise, and knowledge. A

profession’s primary goal is to establish trust with clients and to have an ethical relationship with
society at large (think of doctors as an example). Unlike trade organizations (such as electricians
or plumbers), professionals are expected to uphold the highest ethical standards and are subject to
the rules and potential sanctions which may be imposed by the body of which they are a member
of. Professions establish trust through the following actions:

1. Normalize behavior by making members adhere to a set of codes and standards. In practice,
these codes and standards (which tend to be specific acts) go above and beyond government
regulations (which tend to be more broad based principles).

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2. Benefit society as a whole. For example, when an auditor gives a clean bill of health to the
firms being audited, it gives investors the confidence needed to invest accordingly. Professions
benefit from this as the more trust the public places in the profession, the more independence it
will get from the governments in order to regulate its members. For example, doctors and lawyers
are regulated by their own professional bodies, rather than the government itself.

3. Members place the integrity of the profession and the interests of clients ahead of their own.
Members carry out their fiduciary duty by exercising care, skill and diligence when acting on
behalf of their client. This is understandable since in the investment industry, clients are placing
all their hard earned capital into the hands of the investment professional.

4. All members must undergo extensive examinations in order to prove that they possess the
required knowledge, skill, and high level of ethical standards.

5. All members have access to a body of knowledge and best practices that are continuously
accrued by their organization. For example, the CFA Institute continuously makes available to its
members any new readings that are published. Members are encouraged to keep up to date with
any new changes through continuous education, so that they may sustain their competency.

6. Members will be subject to sanctions if they violate any of the profession’s codes and standards.
This encourages members to be accountable for their actions.

7. Members are expected to be respectful to each other, even though often times, they are in
competition with each other. Furthermore, members are encouraged to volunteer their time to
their organization in order to advance the profession and to inspire and provide guidance to the
new generation of members.

1.1.d ETHICAL STANDARDS IN THE INVESTMENT INDUSTRY

The investment industry is where entities (such as governments and corporations) go to raise
capital. Consequently, the greater the trust that investors (i.e. suppliers of capital) place in the
investment industry, the more capital that may be supplied, which in turn may be used to foster
growth in the economy. In essence, the investment industry is the heart which keeps the blood
pumping throughout the entire economy. Therefore, it is important to instill a high set of ethical
values in order to maintain the level of trust that is needed in the investment industry. Specifically,
a strong set of ethical standards are required for the following reasons:

i) Investors are essentially handing over their hard earned money to someone else in order to
manage it. This entails an incredible amount of trust being placed on the investment profession.

ii) Investment professionals have better access of information. Therefore, in order to gain trust,
this information must be used to benefit the client, rather than the industry insiders.

iii) Unlike other industries that produce tangible products, the investment industry is purely based
on information. As a result, investors must have assurances that the information they are given is
fair, accurate, and complete.

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1.1.e PROFESSIONALISM IN INVESTMENT MANAGEMENT

Relative to the legal and medical professions, investment management is still relatively young as a
profession. As a result, the public’s understanding of the investment profession’s codes and best
practices is still in its infancy. Complicating matters is the fact that not all practitioners in the
investment industry are part of a professional body. For example, you can have 2 investment
advisors in which one is a member of the CFA Institute whereas the other is not. Thus, for the
same profession, you have 2 individuals that are subject to a different set of codes and standards.

Nevertheless, there is a trend towards convergence in the investment profession towards a global
set of standards. This is being brought about through an increase in cross border coordination
among regulators and through the application of new technologies. For instance, best practices in
one market can now easily be duplicated in other markets. Furthermore, the need to attract
international capital leaves many jurisdictions with no choice but to implement measures which
will gain the investor’s trust.

Investment professionals also assist in the smooth functioning of the economy as a whole. For
example, by properly valuing securities, analyst will in effect be helping direct capital to a more
productive use (i.e. leave overvalued assets and fund undervalued assets). Other services provided
by investment professionals, such as tax, estate, and retirement planning will further assist clients
in maximizing their wealth.

1.1.f CHALLENGES TO ETHICAL BEHAVIOR

The first challenge to ethical behavior is that individuals tend to overestimate the morality of their
behavior (i.e. they think that their ethical standards are higher than average). This overconfidence,
as well as other individual biases and beliefs, will often lead to a faulty decision making. Second,
individuals may fail to recognize or underestimate the effects of ‘situational influences’, which are
external factors that may shape our thinking.

For instance, an individual may engage in a conduct simply because it is practiced by others in the
industry, irrespective of whether or not that conduct may be unethical. Monetary gains and
prestige are also powerful situational influences which may detract the individual from ethical
behavior. In addition, an individual’s sense of loyalty to colleagues and his or her employer may
also yield behavior that would place their interests above that of the profession or the firm’s
clients.

It is quite common to fall into these traps as our brains more easily identify with the short term
benefits of situational influences (such as getting a bonus or gaining recognition) rather than the
longer term effects of our decisions (such as maintaining the integrity of the profession and/or the
clients’ best interests).

While a strong compliance system is essential, it alone may not be enough to foster an ethical
atmosphere. For instance, if employees are simply forced to check off specific compliance steps
before taking an action, they may fail to see the bigger picture of how their acts may affect others.
Therefore, ethical conduct must be guided by a set of moral principles; simply following a specific
set of compliance rules may not be enough to connect all the dots.

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1.1.g ETHICAL vs. LEGAL STANDARDS

Legal standards are specific rules that have been put into law, whereas Ethical standards are
broader based principles. While the 2 sets of standards generally lead to the same conduct, they
do not always coincide. For instance, there might be a unique situation that is not covered by a
specific law (and thus not deemed illegal) but would be considered as unacceptable under the
broader scope of Ethical standards.

For example, in some developing countries, there may not be any laws forbidding insiders from
trading on material information that is not yet available to the public. Therefore, if an insider did
indeed trade on this information, the act would not be deemed as illegal, even though it would
clearly be unethical. We can argue then that the moral principles underlying Ethical conduct
represents a higher standard than the specificity that is often associated with Legal rules.

It is also possible to have instances where an act that is deemed as illegal may not necessarily be
viewed as unethical. For example, protesters at pollution sites are often arrested for trespassing
(i.e. the illegal act), even though there is nothing unethical about this practice (as it is based on
morals). As another example, publicizing wrongdoings at a firm (i.e. whistleblowing) would likely
violate the firm’s disclosure rules; even though the act would be deemed as an ethical necessity.

It may be tempting to think that by increasing or introducing a new set of regulations would lead
to more ethical behavior; however, this does not always become the case, primarily for the
following reasons:

i) Laws often lag market practices. For instance, many of the corporate governance laws that are in
place today were introduced after breaches in corporate governance lead to the collapse of some of
the world’s major corporations.

ii) The laws may be vaguely written, which may lead to confusion as to whether an act is deemed
illegal or not. This would provide an opportunity to serve one’s self-interest, as it is unclear as to
what protection other parties are afforded.

iii) New laws may actually lead to a conflict with existing laws.

iv) Since laws are often specific rules, their narrow scope may not cover all the grey areas of
conduct.

v) Laws will often vary between jurisdictions, which may in turn create an opportunity for firms to
conduct the shadier side of their business in the more lenient jurisdiction.

Clearly then, laws and regulation alone are not sufficient to continuously encourage ethical
behavior. As we indicated previously, Ethical standards are a set of principles and values which
cast a wider blanket than what would otherwise be provided by the specific set of rules which
make up the law. To act ethically then, individuals must think beyond the laws and consider the
impact that their actions will have not only on their reputation, but on all the stakeholders that
might be affected (such as clients, colleagues, employer, etc.). Furthermore, at all times,
investment professionals must place the integrity of the capital markets above all else when
prioritizing any conflicts of interest which may exist among the various stakeholder groups.

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1.1.h ETHICAL DECISION MAKING FRAMEWORK

In addition to adopting a Code of Ethics, firms may further foster a culture of integrity by
encouraging employees to adopt the following framework when making ethical decisions:

i) Identify all the relevant facts, the stakeholders to whom a duty is owed to, the ethical principles
that are relevant to the situation, and any conflicts of interest which may exist. If the decision
maker does not realize the full impact of his actions, then he is more likely to harm the stakeholder
groups involved.

ii) Be mindful of any ‘situational influences’ that may be weighing on the decision. For instance,
if a monetary incentive is pending on the decision, then the decision may not necessarily be made
in the client’s best interest. As a result, the decision maker should consider the effects of all the
possible alternative actions and even perhaps discuss the matter with someone who is not exposed
to the same situational influences (i.e. obtain impartial advice). In any case, it would be wise to
examine the differing points of view before a decision is made.

iii) Make a decision and act upon it.

iv) Using a feedback loop, determine whether the outcome fulfilled the ethical requirements. By
analyzing the outcomes of prior decisions, individuals will be able to make better decisions
moving forward.

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