AIP Risk Assessment & Regulatory Compliance 4 — Questions and Answers
Question 1: An investment adviser has a personal interest in recommending a particular mutual fund to clients. Under the Investment Advisers Act of 1940, the adviser's fiduciary duty requires which action?
- Refuse to recommend the fund entirely
- Fully disclose the conflict of interest to clients (Correct answer)
- Only recommend the fund to accredited investors
- Submit the conflict to FINRA for approval
Correct answer: Fully disclose the conflict of interest to clients
Under the fiduciary standard, advisers must fully disclose all material conflicts of interest so that clients can make informed decisions.
Question 2: Stress testing a portfolio involves which of the following analytical approaches?
- Estimating daily returns using a normal distribution curve
- Applying extreme but plausible hypothetical scenarios to assess potential losses (Correct answer)
- Comparing portfolio beta to the S&P 500
- Calculating the arithmetic mean of historical returns
Correct answer: Applying extreme but plausible hypothetical scenarios to assess potential losses
Stress testing evaluates portfolio performance under severe but plausible adverse conditions, such as a market crash or credit crisis, to identify vulnerabilities.
Question 3: Under the USA PATRIOT Act, financial institutions must establish a Customer Identification Program (CIP). At minimum, which piece of information must be collected for individual customers?
- Social Security number, date of birth, name, and address (Correct answer)
- Name, address, credit score, and employer information
- Name, investment objectives, and annual income
- Date of birth, employer, and net worth
Correct answer: Social Security number, date of birth, name, and address
CIP requirements for individuals mandate collection of name, date of birth, address, and identification number (typically Social Security number) at a minimum.
Question 4: Which of the following best describes 'liquidity risk' for an investment fund?
- The risk that the fund's NAV will decline due to market volatility
- The risk that the fund cannot meet redemption requests without selling assets at distressed prices (Correct answer)
- The risk that interest rates will rise, reducing bond prices
- The risk that a counterparty will default on a payment obligation
Correct answer: The risk that the fund cannot meet redemption requests without selling assets at distressed prices
Liquidity risk is the risk that a fund cannot satisfy redemption demands promptly without incurring significant transaction costs or selling at below-market prices.
Question 5: FINRA's suitability rule (Rule 2111) includes three components of suitability analysis. Which of the following is one of those components?
- Qualitative suitability
- Reasonable-basis suitability (Correct answer)
- Predictive suitability
- Historical suitability
Correct answer: Reasonable-basis suitability
FINRA Rule 2111 identifies three suitability components: reasonable-basis (the strategy is suitable for at least some investors), customer-specific (suitable for this particular customer), and quantitative (frequency of trades is suitable).
Question 6: An investment firm's compliance officer discovers that a portfolio manager has been front-running client trades. This conduct most directly violates which regulatory principle?
- Best execution requirements only
- Anti-money laundering rules
- The duty of loyalty under fiduciary law and SEC anti-fraud rules (Correct answer)
- FINRA margin requirements
Correct answer: The duty of loyalty under fiduciary law and SEC anti-fraud rules
Front-running — trading ahead of client orders for personal gain — violates the manager's fiduciary duty of loyalty and constitutes securities fraud under SEC anti-fraud provisions.
Question 7: Under Regulation D of the Securities Act of 1933, which of the following investors qualifies as an 'accredited investor' based on net worth?
- An individual with a net worth over $500,000 excluding primary residence
- An individual with a net worth over $1 million excluding the value of the primary residence (Correct answer)
- Any investor who earns more than $100,000 per year
- An institutional investor with assets under management of $5 million
Correct answer: An individual with a net worth over $1 million excluding the value of the primary residence
An accredited investor based on net worth is an individual with a net worth (or joint net worth with a spouse) exceeding $1 million, excluding the value of the primary residence.
AIP Risk Assessment & Regulatory Compliance 4
An investment adviser has a personal interest in recommending a particular mutual fund to clients.
Under the Investment Advisers Act of 1940, the adviser's fiduciary duty requires which action?