Ethics and listed securities
What are advisers’ ethical obligations when recommending listed securities to clients?
Australian investors poured in $23 billion into ETFs over the past year, the highest yearly flow on record[1]. Despite volatile markets, new listings of thematic and active ETFs have continued. This has resulted in the record investment and an increase in the number of individuals making those investments. This article, proudly sponsored by GSFM, examines some of the ethical issues pertinent to the use of listed investments in client portfolios.
This year has been characterised by volatile financial markets. Investors are grappling with uncertain portfolio returns, inflation and rising interest rates. Despite this, investment in listed securities continues unabated, particularly into ETFs.
In the year ended 31 October 2022, the market cap of Australia’s exchange traded products (ETPs) – Which is largely comprised of ETFs – had increased 3.1% and a further 38 new products had been launched[2]. This continues the trend of interest in ETPs that has resulted in the consistent growth in both the number of available products and value of those products, despite the vagaries of market movements (figure one).
When it comes to making financial product recommendations, financial advisers are guided by a number of frameworks: the law, the Financial Planners and Advisers Code of Ethics 2019 (Code of Ethics) and requirements and obligations from the licensee. Members of the Stockbrokers and Investment Advisers Association (SIAA) are required to abide by the standards outlined in its Code of Ethical Conduct, which was last updated in June 2022.
When it comes to providing financial product advice, acting in a client’s best interests is fundamental and critical to abiding by the adviser Code of Ethics. Acting in the client’s best interests requires you to know and understand the intricacies of each financial product recommended and whether it is suitable for the respective client. It’s also important to ensure that the client understands any financial product that you recommend to them. The increased interest in ETFs from the investor community, coupled with the enormous number and variety of available product, can sometimes make this challenging.
ETFs – from vanilla to complex
ETFs are financial products traded on a stock exchange and the Australian ETF market is currently worth approximately $135 billion1 (figure two). ETFs can invest in a variety of assets including Australian or global shares, fixed income, commodities and cash. ETFs are managed by a professional fund manager, each with an investment strategy that can range from tracking an index through to actively managed portfolios.
The ETF market continues to grow at a faster rate than other investment products (figure three), growing at three times the rate of LICs, eight times the rate of managed funds and four times faster than the broader Australian wealth management market (7% p.a.)[1].
ETFs can be broadly split into two types of strategies – active and passive. And while both options play a part in an investment portfolio, it is important to understand how each works – and importantly, ensure your client understands how they operate and generate returns before investing in them.
The primary difference between active vs passive ETFs is how the product’s assets are invested and managed. Passive ETFs track an index, generally to replicate the returns of a specific index or market’s performance. Investors need to be aware that this return is generated on a ‘before fees’ basis, although the fee load for passive funds is generally low. They also need to understand that while markets and indices increase in value, so will their investments – and also that the opposite will happen when markets and indices lose value.
For an active ETF strategy, the fund manager applies an active investment approach to achieve a specific return and risk objective. Rather than replicating an index, the fund manager selects the investments in line with its stated policies and guidelines to achieve specific return objectives.
Active and passive ETFs share some characteristics – they are both listed on an exchange and investments in them are made through purchasing units in the same way investors buy shares. Both passive and active ETFs are priced throughout the day in 15 second increments and investors can trade during exchange business hours.
The vanilla strategies that first proliferated when ETFs emerged onto the Australian investment landscape in 2014 have been overtaken by more nuanced products. Of the ETFs listed in the past year, many have been thematic ETFs that track a particular group of companies linked to a trend or niche sector.
According to the Stockspot report, these niche funds have lost Australian investors more than $100 million over the past year. This is, the report suggests, because investors are chasing past returns by investing in a thematic at the peak of its interest.
Even the nomenclature can be confusing. ASIC has just updated its Information Sheet 230[3] (INFO 230) for licensed Australian exchanges that admit exchange traded products (ETPs), including exchange traded funds (ETFs) and structured products. One of the updates relates to naming conventions, to make the underlying product more easily understood by investors, so they can more easily differentiate between simple, passive ETFs and the more complex active subset.
These complexities highlight the importance of your advice: to educate clients, set realistic expectations and ensure all financial products in which they invest will help them to achieve their financial objectives. As well as being in the best interest of your clients, this will ensure you meet your obligations under both the law and Code of Ethics.
Ethics and listed securities
The above-mentioned increase in the number and variety of listed securities available has increased demand for listed investments; as a result, the demand for professionals to provide financial advice that includes these investments has also increased.
Members of the Stockbrokers and Investment Advisers Association (SIAA) are required to abide by the standards outlined in its Code of Ethical Conduct, which was most recently updated in June 2022. The code applies to Stockbrokers and Investment Advisers Association Principal Members (organisations) and Practitioner Members (individuals). This code prescribes the ethical conduct of members and is enforceable.
The objective of this code is to:
“Maintain and improve ethical behaviour in the stockbroking and investment advice profession and the conduct of members of the profession with the consumers of their services”
The SIAA code stipulates that for those members who are subject to other codes – such as the adviser Code of Ethics – the two codes must be read in conjunction. It notes that a breach of any of those other codes may be taken into account by the SAIA in considering the compliance by such members with their obligations under their code.
SIAA’s Code of Ethical Conduct has a number of standards that specify enforceable rules and provides guidance on standards of ethical conduct. Figure four provides a summary of that code and outlines both the ethical principles and industry specific issues. As with the standards in the adviser Code of Ethics, the intent is that each should be interpreted broadly, rather than by narrow and strict interpretation.
The Adviser Code of Ethics
The Financial Planners and Advisers Code of Ethics 2019 imposes ethical duties on financial advisers and has been designed to encourage higher standards of behaviour and professionalism across the financial services industry.
The Code of Ethics addresses five core values: trustworthiness, competence, honesty, fairness and diligence. It requires that financial advisers must act at all times and in all cases, in a manner that is demonstrably consistent with Code’s twelve ethical standards, summarised in figure five. These standards are regulated and monitored by ASIC’s approved compliance schemes.
The interplay between two codes
Following is an assessment of the some of the key principles from the SIAA’s Code of Ethical Conduct and the interplay between those and the standards in the adviser Code of Ethics. The following encompasses those topics most pertinent to financial advisers recommending and dealing in listed securities.
Obey the law
The first principle in the SIAA’s Code of Ethical Conduct is to obey the law; this is consistent with the first standard in the adviser Code of Ethics.
Advisers must obey all applicable laws, which include legislation, statutory rules, regulatory and self-regulatory requirements. As readers will know, laws are frequently revised and updated – it is incumbent on you to remain up to date.
Honesty and integrity
That members must act with honesty and integrity, and in the best interests of their clients is consistent with standards two and nine of the Code of Ethics. However, both honesty and integrity are implied across most of the standards.
Respect the Rights of Clients
This requirement focuses on the notion of ‘informed consent’, particularly in relation to recommendations made (in line with Standard 4) and fees charged (consistent with Standard 7).
Competence
The increased number and type of listed securities has increased the need for knowledge and client education about this sector. To recommend listed investments with competence, advisers need to understand the intricacies of all potential investments. This includes the risk and return profile, the underlying investments and the approach taken to managing the investment.
In addition, recommending listed investments requires additional knowledge; advisers need relevant market and product knowledge and importantly, must understand market rules. All relevant information needs to be clearly communicated to clients.
The SIAA code requires members to take reasonable action to ensure that they have sufficient knowledge of stockbroking and investment advice practice, relevant legal requirements, and where relevant, the adviser Code of Ethics. Members are also expected to maintain this competence through continuing professional development; this is consistent with standard ten of the adviser Code, which focuses on the development, maintenance and application of knowledge and skills.
Principal members of the SIAA must provide staff with information, training and supervision that enables them to do their work competently and comply with the law in the performance of their profession; the same expectation is levelled at AFSL holders.
Conflicts of Interest
Members must avoid and disclose conflicts of interest where reasonably practicable before or when the service is provided; principal members must minimise the potential adverse impact of conflicts of interest by having adequate arrangements for controlling such conflicts. The SIAA also requires members comply with the adviser’s Code of Ethics; within this, standard three also deals with conflicts of interest, with onus on both licensee and practitioner to manage conflicts of interest.
Cooperation and Whistleblowing
While the requirements for SIAA members are more detailed, they are broadly consistent with standard eleven of the adviser Code of Ethics, which states that advisers have a duty to cooperate with any investigation of a breach or potential breach of this Code by a monitoring body or ASIC
Fair & Orderly Market
Members must compete fairly in the market, including not taking unfair advantage of other members and not engaging in anti-competitive or unconscionable conduct. Members must not knowingly engage or induce another person to engage in conduct that will or is likely to mislead or deceive in the performance of their profession.
There are several important elements to consider with this standard; advisers working with listed securities need to understand and manage these risks, each of which could see them in breach of the law and, at the very least, standard one in the adviser Code of Ethics.
Some of the requirements include:
Insider trading
Inside information refers to confidential information about a company that has not been publicly disclosed and that may impact the value of a ‘financial product’. Financial products are broadly defined under Division 3 of the Corporations Act and includes all securities able to be traded on a financial market.
The information that could be regarded as ‘inside information’ may include advanced knowledge of unexpected increases or falls in revenue or profit, proposed mergers acquisitions, legal actions, or new product development. Even if the transaction is for the benefit of clients, if it is based on insider knowledge, it is a breach of the Corporations Act 2001, section 1043A and therefore a contravention of the first standard in the Code of Ethics.
Individuals with access to insider information can have an unfair advantage in the market if they were to trade using that information and it is an offence for a person to trade using inside information or to communicate inside information to others who are likely to trade based on that information.
Best execution
ASIC’s regulatory guide RG-265 provides guidance on market integrity rules for participants of securities markets. In terms of best execution, RG265 states:
Market participants must take reasonable steps to obtain the best outcome for their clients. For retail clients, it means best total consideration, which market participants may interpret as best price while there are not material differences in transaction costs between licensed markets.
This applies to trades executed via any exchange and there are additional rules applied where trading derivatives. The notion of ‘best total consideration’ means that for buy orders, investors pay as low a price as possible. Conversely, for sell orders, investors should receive the best possible price. Best execution also means paying the lowest possible transaction costs and applies to all listed securities, whether a share, an ETF or a listed investment company.
From the perspective of the Code of Ethics, this addresses acting in the clients’ best interests (standards one and two) and acting with competence (standard nine).
Pump and dump
‘Pump and dump’ is a form of securities fraud. Through misleading information, often shared by people with a following on social media or other platforms, share prices are inflated. As the share price is pushed up (pumped), a group of investors sell (dump) their overvalued shares, often at a considerable profit.
While not new, pump and dump activity has been on the rise, driven by social media and the use of ‘finfluencers’, which this year came under intense scrutiny from ASIC. It’s clearly unethical to engage in pump and dump activity; being able to recognise such schemes comes back to competence (standard nine) and always acting in your clients’ best interests (standard two).
In announcing its 2023 enforcement priorities[4], ASIC noted that while its specific areas to target will change from year to year, in keeping with shifting economic factors and the volatile risk environment, five enduring priorities will remain. The first of those enduring priorities is “Misconduct damaging to market integrity including insider trading, continuous disclosure failures and market manipulation.”
In addition, ASIC has called out misconduct that involves misinformation through social media about investment products, including ‘finfluencer’ conduct as a key target area for 2023.
Case studies
The following case studies are loosely based on ASIC’s enforcement activities or AFCA cases; however, names and other details have been changed for privacy reasons.
Case study one – Unlicensed CFD trading
Adam, from Queensland’s Gold Coast, advertised guaranteed investment returns and traded Contracts for Difference (CFDs) using his client funds, despite being unlicensed. He was the sole director of Gold Advice Pty Ltd, which collapsed after suffering significant losses trading client monies.
According to ASIC, Adam subsequently advertised under a different business name that he could make “50%, 100% or 200% per year in guaranteed returns”. He also claimed via his website that his firm’s investments are “recession proof” and “profit in both rising and falling markets.”
In examining the case, ASIC found that Adam:
- carried on a financial services business without holding an AFS licence
- had some clients deposit their funds into his personal trading account and traded CFDs without consulting them
- made false or misleading statements as the returns were not guaranteed and there was no genuine basis to make the statement that the trades would be profitable in both rising and falling markets
- gave false or misleading information to ASIC about the number of clients and the extent of losses suffered
- is not adequately trained or competent to provide financial services
- is likely to have contravened a financial services law.
Adam was banned from providing financial services and carrying on a financial services business for 10 years.
As well as the findings against him, Adam was also likely to have breached a significant number of standards in the Code of Ethics, namely:
Case study two: Inappropriate advice
Sally sought financial advice from by Jim at J&J Financial Advice. She had been reading up on ETFs and wanted to invest an inheritance in a portfolio of ETFs. Although she was in her forties, Sally was particularly risk averse; capital protection was more important to her than high levels of returns. She liked the idea that they followed an index and that the fees were low.
Jim recommended three ETFs – Australian equities, global equities and global long/short equity fund – each of which could be classified as ‘active’. Jim did not explain the difference between active and passive ETFs to Sally, and her reading of the Statement of Advice provided by Jim did not change her expectation that she had invested in passive funds. As a result, she was surprised when the price of these ETFs fell significantly further than the relevant market indices.
After 18 months, when the share price for each ETF was significantly lower that the price Sally paid for the investments, she asked Jim to explain. She was surprised to learn that the ETFs did not in fact track an index as she had anticipated, and performance was instead subject to the investment process engaged by each fund manager. She was also surprised by the higher than expected fees charged for the actively managed products.
Sally was not satisfied with Jim’s explanations and made a complaint to AFCA.
AFCA’s case manager was not satisfied that Sally had been sufficiently informed, during the meeting or through the SOA, about the nature of the ETFs recommended to her. At AFCA’s request, the licensee provided a copy of Jim’s file notes from the meeting at which these investments were discussed. Those notes did not record that there was any discussion about the nature or risks associated with the recommended investments.
By recommending financial products inappropriate to Sally’s risk profile and not adequately explaining how these products worked, Jim potentially breached the following standards in the Code of Ethics:
Case study three: Using ‘insider knowledge’
Louise is an authorised representative of ABC Broking, a boutique investment advisory. She has worked with ABC for seven years and has built up a good client base. Her clients invest in primarily listed securities – shares, ETFs, A-REITs and a small number of LICs.
Louise had dinner with her best friend, a C-suite executive of a biotech business, one that had been involved in vaccine development for Covid-19. Over dinner she talked about the company’s success in vaccine development and that as a result, there was possible M&A activity in the near future.
Following this conversation, Louise did some research. She could find no publicly available information available suggested the biotech was the target of an acquisition and wondered whether she should act on it. After all, the company had been successful, so perhaps it was a viable investment with or without M&A activity, despite it being a microcap.
Louise decided to recommend it to some of her longer-term clients, those with a higher risk appetite and an interest in high growth investments. She also made an investment herself.
Several weeks later, the small biotech was acquired by a large, listed entity, which purchased shares at a significant premium to the price paid by Louise and her clients, locking in a swift gain. Although Louise’s actions had a positive impact on her clients (and her own portfolio), as a member of the Stockbrokers and Investment Advisers Association, she potentially breached the following SIAA Standards of Ethical Conduct:
Louise’s actions must also be considered in the context of the adviser Code of Ethics. Her conduct was potentially a breach of:
Ethics in financial advice is about providing sound advice that is in a client’s best interests and will help them achieve their financial objectives. It is also about making sure the client understands the advice and relevant investment recommendations, whether in relation to listed or unlisted securities. Acting ethically, being trustworthy and demonstrating integrity will build trust among consumers and increase their confidence in using financial services. The adviser Code of Ethics (and for those members of the SIAA, the Code of Ethical Conduct) is critical to continue build a positive reputation for the advice industry.
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