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Discretionary accounts

What Is Discretionary Accounts?

A discretionary account is a type of investment account where the account holder grants a financial advisor or broker-dealer the authority to make investment decisions and execute trades without seeking prior approval for each transaction. This arrangement is common in investment management, allowing the advisor to act swiftly on behalf of the client to capitalize on market opportunities or adjust the client's portfolio management strategies. The core characteristic of discretionary accounts is the grant of discretionary authority, typically through a written client agreement that outlines the scope of the advisor's power and the client's investment objectives.

History and Origin

The concept of granting discretionary authority to financial professionals evolved alongside the growth of the financial advisory industry. As markets became more complex and the speed of trading increased, investors sought professionals who could manage their assets actively without requiring constant consultation. The formal regulation of these relationships in the United States gained significant traction with the passage of the Investment Advisers Act of 1940. This landmark federal law established comprehensive regulations for investment advisors, emphasizing their fiduciary duty to act in their clients' best interests. The Act and subsequent regulations, such as FINRA Rule 3260, solidified the requirements for establishing and overseeing discretionary accounts, ensuring investor protection while facilitating professional asset management.7,6

Key Takeaways

  • Discretionary accounts empower financial professionals to execute trades without prior client approval for each transaction.
  • A formal, written agreement is mandatory, outlining the scope of authority and investment objectives.
  • These accounts are subject to strict regulatory oversight, including rules from the SEC and FINRA, to protect investors.
  • Financial advisors managing discretionary accounts are typically held to a fiduciary duty, requiring them to prioritize the client's interests above their own.
  • Discretionary authority allows for agile portfolio adjustments in response to market conditions.

Interpreting the Discretionary Account

A discretionary account signifies a deep level of trust and delegation between an investor and their advisor. For the investor, it means entrusting the day-to-day decisions regarding the buying and selling of securities to a professional. The interpretation revolves around the advisor's ability to implement an investment strategy efficiently, adapting to market fluctuations or new opportunities without delay. The discretion granted is not absolute; it is always bound by the parameters set forth in the initial agreement, including the client's stated risk tolerance, liquidity needs, and long-term financial goals.

Hypothetical Example

Consider Jane, a busy professional with a demanding career, who wants her investments actively managed but lacks the time and expertise to make daily trading decisions. She decides to open a discretionary account with a registered investment management firm.

  1. Initial Meeting: Jane meets with a financial advisor at the firm. They discuss her financial situation, risk tolerance (e.g., moderate), investment objectives (e.g., long-term growth for retirement), and preferred asset allocation.
  2. Client Agreement: A written discretionary client agreement is signed. This document explicitly grants the advisor the authority to buy and sell securities on Jane's behalf, adhering to the agreed-upon investment guidelines. It also outlines fees and reporting frequency.
  3. Portfolio Activity: Over the next few months, the advisor identifies an opportunity to rebalance Jane's portfolio due to market shifts. Without needing to call Jane for approval on each specific trade, the advisor executes several buy and sell orders to adjust her holdings, staying within the agreed-upon parameters.
  4. Reporting: Jane receives regular statements detailing all transactions and the current performance of her discretionary account, allowing her to monitor her investments.

Practical Applications

Discretionary accounts are widely used in various facets of the financial industry. They are fundamental to practices like wealth management, where clients delegate the ongoing oversight of their portfolios to professional money managers. In institutional investing, pension funds and endowments often employ external managers with discretionary authority to manage specific asset classes, optimizing for specialized expertise and responsiveness. Furthermore, the regulatory framework governing discretionary accounts ensures that there is clear guidance on how these accounts must be established, supervised, and operated. Regulators, such as the Financial Industry Regulatory Authority (FINRA) and the U.S. Securities and Exchange Commission (SEC), have specific rules outlining the requirements for written authorization, approval, and ongoing review of discretionary accounts to prevent abuses and ensure regulatory compliance. For instance, FINRA Rule 3260 stipulates that a customer must give prior written authorization for a stated individual or individuals to exercise discretionary power in their account, and the account must be accepted by the firm.5

Limitations and Criticisms

Despite the benefits of efficiency and professional management, discretionary accounts come with inherent limitations and potential criticisms, primarily centered on the risk of conflicts of interest and potential for abuse. One significant concern is excessive trading, also known as "churning," where an advisor might engage in frequent, unnecessary transactions primarily to generate commissions rather than to benefit the client's account. Regulatory bodies actively monitor for such practices. Another risk is unauthorized trading if proper controls are not in place, although this is explicitly prohibited by rules like FINRA Rule 3260 which requires written authorization and firm approval for discretionary power.4 The very nature of discretion means that clients delegate control, which necessitates robust risk management frameworks and strong ethical guidelines for advisors to ensure they consistently act in the client's best interest and avoid situations where their interests might diverge from those of their clients.3

Discretionary Accounts vs. Non-Discretionary Accounts

The key distinction between discretionary accounts and non-discretionary accounts lies in the level of control and decision-making authority held by the financial advisor.

In a discretionary account, the client grants their advisor the power to make investment decisions, including the selection, timing, and price of trades, without requiring prior approval for each specific transaction. This arrangement relies on a written agreement that outlines the parameters and objectives. The advisor can execute trades immediately, which can be advantageous in fast-moving markets.

Conversely, in a non-discretionary account, the client retains full control over all investment decisions. The financial advisor can offer recommendations and advice, but no trade can be executed without the client's express approval for each individual transaction. This requires direct communication and consent from the client for every buy or sell order. The confusion often arises because advisors in both types of accounts provide advice; the difference lies solely in the authority to act on that advice.

FAQs

What is the primary benefit of a discretionary account?

The primary benefit of a discretionary account is the efficiency and responsiveness it offers. It allows a financial advisor to make timely investment decisions and execute trades quickly to capitalize on market opportunities or react to changing conditions, without the need to obtain client approval for each transaction.

Are discretionary accounts regulated?

Yes, discretionary accounts are highly regulated by authorities such as the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). These regulations require written authorization from the client, specific guidelines for the advisor's authority, and ongoing supervision by the firm to ensure proper management and prevent abuses.2,1

Can I set limits on what my advisor does in a discretionary account?

Yes. While the advisor has discretion, the scope of that authority is defined in the written client agreement. Clients can set various parameters, such as specific asset classes to invest in or avoid, risk tolerance levels, or restrictions on certain types of securities. The advisor is legally bound to operate within these predefined limits and the client's stated investment objectives.