Standard V(A): Diligence and Reasonable Basis

What does Standard V(A) require?

You must exercise diligence , independence and thoroughness when you analyze investments, make recommendations or take investment actions. You must also have a reasonable basis , supported by appropriate research and investigation, for each of them.

Memorize

How much work counts as enough is not fixed. It depends on the investment (more for a complex or illiquid product), your role in the decision, the firm’s philosophy and the resources it gives you. What never changes is the duty to cover the pertinent issues and to be able to show what you relied on.

Typical ingredients of a basis are macro conditions, a company’s operating and financial history, industry conditions, a fund’s fees and track record, a model’s output and limits, and a fair choice of peers.

Reasonable and adequate basisthe evidence behind a recommendation or action

• Your own research Use it filings, management calls, industry and macro context
• Others' research Memorize
  • Secondary research done by someone else in your firm
  • Third-party research done outside the firm, such as a broker
  • Check assumptions, rigor, timeliness, objectivity and independence
• Quantitative models Use it
  • Understand assumptions and limitations
  • Test before use including extreme scenarios
  • Developers owe a higher level of diligence than users
• External advisers Use it
  • Code of ethics
  • Compliance and internal controls
  • Quality of reported returns
  • Process and adherence to strategy

When can you rely on other people’s research?

Research done by a colleague in your firm is secondary research . Research from a broker, bank or research house is third-party research . In both cases you must make reasonable efforts to confirm it is sound before relying on it.

Check four things: the assumptions used, the rigor of the analysis, how timely it is, and whether its recommendations are objective and independent. Blogs, aggregation sites and social media call for more checking than established research houses.

You may rely in good faith on your firm’s own vetting of a data vendor, unless you have reason to doubt it. If you suspect that a source lacks a sound basis, do not use it. A firm should also review its approved research providers regularly. If it has no such policy, encourage it to adopt one.

What must you do with quantitative models?

Using a model does not remove your duty. You do not have to be an expert in every technical detail, but you must understand the quantitative models you use, including their assumptions and limitations, and how their results fed your decision.

Test a model’s output before you build it into your process, and include extreme positive and negative scenarios. Data from commercial databases may not contain a full market cycle, so a model that never saw a falling market has not been tested for one. People who build models owe a higher level of diligence than people who only use the output, and a thorough test must come before distribution.

How should you vet external advisers and subadvisers?

When you hire an outside manager for part of the portfolio, review the external advisers as diligently as you would review an individual fund or security. Use standard criteria, and check on a schedule afterward, not only before hiring.

The criteria include the adviser’s code of ethics, its compliance and internal controls, the quality of its published returns, and its investment process and adherence to its stated strategy.

What if you disagree with a group report?

Many reports come from teams. The published view is the consensus of the group research , not necessarily the view of each name on the cover. If you believe the consensus has a reasonable and adequate basis and is independent and objective, you need not remove your name, even though it differs from your own opinion. You may record your dissenting opinion in the file.

Dissociation is for a conclusion that lacks a reasonable basis, not for ordinary disagreement.

Where do the lines fall?

Situation	Verdict
An analyst issues a “buy” based only on a company press release and a two-minute call	Violation (no reasonable basis)
A manager uses a vendor’s credit model after reviewing its assumptions and back-tests	Fine
A team member disagrees with the committee’s rating, the process was thorough, and she stays on the report	Fine (may document dissent)
A fund picks a subadviser on past returns alone, without checking its controls	Violation
A quant manager never tests a strategy under falling-market conditions, and it fails in one	Violation (insufficient testing)
A thoroughly researched stock falls 30% after an unexpected event	No violation (the process was sound)

Exam tip “The broker said it was fine” and “the vendor built the model” are never enough on their own. The member must still check.

Which procedures does a firm adopt?

Compliance practices that support V(A):

• a policy that research, ratings and recommendations have a substantiated, reasonable basis, with a supervisory analyst or committee reviewing them before release;
• detailed written guidance on due diligence, with measurable criteria for research quality and for accuracy over time;
• minimum scenario testing for all computer-based models, covering breadth of scenarios, accuracy over time and sensitivity of cash flows to inputs;
• criteria for outside data providers and a stated review frequency;
• standard criteria for external advisers, including how often and on what basis allocations are reviewed.

Go deeper Why a bad result does not prove a violation

Every investment carries downside risk, however good the research. Members can base decisions only on the information available when they make them. A well-run process can still lose money, and a careless one can get lucky. So a regulator or an exam question looks at what was done: sources checked, models understood, risks considered. A loss alone is not the test. Tell clients what you reviewed, or offer to, so they can judge the reasonableness of your work.

Go deeper Due diligence questionnaires and model risk

Firms usually standardize adviser reviews with a due diligence questionnaire that covers ownership, compliance staff, controls, valuation and reporting. Model risk, the chance that a model is wrong or misused, is a core theme in portfolio management risk management. V(A) is the ethical rule behind that discipline: know the model, test it, and do not hide behind it.