Research Objectivity Standards

An analyst's recommendation is only worth reading if it is her own honest view. Plenty of things can quietly pull it off course — the firm's investment banking business, the subject company's management, her own shareholdings, or how her bonus is calculated.

The CFA Institute has written standards for exactly this. They are called the Research Objectivity Standards, or ROS.

They are not a statement of good intentions. The workbook describes them as specific, measurable norms for managing and disclosing conflicts of interest.

A firm that adopts them is signalling two things: that it manages conflicts effectively, and that it gives full and fair disclosure of those conflicts to every investor who can see its research.

The principle underneath is simple. The client's best interests always come first — ahead of the investment professional and ahead of the employer.

Why it matters (Chapter 11, section 11.5.1). Objectivity and independence of the analysts doing research is an important attribute for strengthening investor confidence in financial markets. The ROS are intended to be specific, measurable norms for managing and disclosing conflicts of interest that may impede a research analyst's ability to conduct independent research and make objective recommendations. Firms that adopt them demonstrate a commitment to manage conflicts effectively and to provide full and fair disclosure of those conflicts to all investors who have access to their research.

The fundamental principle. A fundamental principle of ethical investment practice is that the best interests of the investing client must always take precedence over the interests of investment professionals and their employers. Every investment professional is personally responsible for ensuring that his or her independence and objectivity is maintained when preparing research reports, making investment recommendations and taking investment action on behalf of clients.

The nine key requirements for firms adopting the ROS:

1. Developing a formal written research objectivity policy.
2. Employees who present and discuss their research and recommendations in public appearances must fully disclose personal and firm conflicts of interest to the host or interviewer and, whenever possible, to the audience.
3. Research reports and recommendations must have a basis that can be substantiated as reasonable and adequate.
4. Firms engaging in or collaborating on investment banking activities must segregate research analysts from the investment banking department.
5. Compensation — salary, bonus and other pay for research analysts — must be aligned with the quality of the research and the accuracy of the recommendations over time, and must not be directly linked to the investment banking or corporate finance activities the analyst collaborated on.
6. Policies and procedures must manage the working relationships research analysts develop with the management of subject companies.
7. Policies and procedures must effectively manage covered employees' personal investments and trading activities.
8. Firms must provide full and fair disclosure of all conflicts of interest to which the firm or its covered employees are subject.
9. Firms must establish a rating system that is useful for investors and for investment decision-making, and that gives investors information for assessing the suitability of the security to their own circumstances and constraints.

Where it sits in the paper. Section 11.5 is headed Best practices for portfolio managers, and research objectivity is the first of them. The second, in section 11.5.2, is the workbook's treatment of soft dollar arrangements, which it says must be avoided as abusive in nature.

No figure attaches to the standards. Section 11.5.1 is a list of obligations with no threshold, no holding period and no monetary limit anywhere in it.

Illustrative figures. Nilgiri Securities has an equity research desk and an investment banking desk. It adopts the ROS and has to change five things.

1. Segregation. The research team moves to a separate floor with its own access control. An analyst may no longer be taken to a pitch meeting for a client the bank is courting.

2. Compensation. The senior analyst's pay was Rs 40,00,000 fixed plus a bonus of 1.5% of fees on any deal she helped win — about Rs 18,00,000 in a good year. Under requirement 5 that link is severed. Her package is rebuilt as Rs 46,00,000 fixed plus a bonus of up to Rs 15,00,000 assessed on research quality and on the accuracy of her recommendations over time.

Her total pay is similar. What she is paid for has changed completely.

3. Public appearances. Before discussing a cement company on a business channel, she must disclose to the host that Nilgiri managed that company's Rs 900 crore share sale nine months ago, and that she personally holds 2,000 shares of it — and, whenever possible, disclose both to the audience.

4. Personal trading. Her 2,000 shares go into a monitored account under a written personal-trading policy.

5. The rating system. The desk's old labels, Positive and Cautious, are replaced by a documented scale with defined price-target horizons, so that a reader can judge whether the recommendation suits her own circumstances and constraints.

None of this makes the analyst honest. It removes the machinery that made dishonesty profitable — and, under requirement 8, tells every reader where the remaining conflicts lie.

Chapter 11, section 11.5.1 (Research objectivity), sits under best practices for portfolio managers and is examined as a list.

Expect a question naming the body that developed the standards (the CFA Institute), a which-of-these-is-a-key-requirement question, and the fundamental principle — that the client's best interests take precedence over those of the professional and the employer. The two requirements most often tested are the segregation of research analysts from investment banking and the rule that analyst compensation must not be directly linked to investment banking activity. The workbook also stresses that every investment professional is personally responsible for her own independence, which is a favourite true-or-false line.

• The ROS are the CFA Institute's, not SEBI's. They are a best practice a firm adopts voluntarily, which the workbook recommends. A question calling them a SEBI regulation is wrong.
• Compensation is not banned from being variable. It must be aligned with research quality and recommendation accuracy over time, and not directly linked to investment banking work the analyst collaborated on.
• Disclosure in public appearances runs to the host or interviewer and, whenever possible, the audience. Telling only the channel is not enough.
• The client comes before both the professional and the employer. The employer is expressly named in the principle, which is what makes it more than a platitude.
• Responsibility is personal as well as institutional. The firm adopts the policy; the individual professional still has to ensure her own independence and objectivity.
• A rating system is a requirement, not a marketing choice. It has to be useful for investment decision-making and let investors judge suitability to their own constraints.
• Do not confuse the ROS with the soft dollar discussion in the next section, which the workbook treats as abusive and to be avoided.