What Is Discretionary Authority?
Discretionary authority in finance grants an authorized individual or entity the power to make investment decisions and execute trades in a client's investment account without seeking prior approval for each transaction. This falls under the broader category of investment management and is a common arrangement between investors and their financial advisors or portfolio managers. When a client grants discretionary authority, they empower their advisor to buy or sell securities at their discretion, adhering to a pre-established investment strategy and the client's stated risk tolerance as outlined in a formal client agreement.
History and Origin
The concept of granting discretionary authority to financial professionals evolved as the investment landscape became more complex, requiring specialized knowledge and timely decision-making. Early forms of wealth management often involved personal relationships and implied trust, but as markets grew, the need for formalizing these arrangements became evident. In the United States, significant regulatory frameworks began to emerge in the early 20th century. The Investment Advisers Act of 1940, for instance, established a comprehensive regulatory structure for investment advisers, requiring many to register with the Securities and Exchange Commission (SEC) and adhere to a fiduciary duty to their clients.5 This act laid foundational principles for how investment advisors operate, including managing accounts where discretionary authority is granted. Over time, self-regulatory organizations like the Financial Industry Regulatory Authority (FINRA) developed specific rules, such as FINRA Rule 3260, to govern discretionary accounts and protect investors from potential abuses.4
Key Takeaways
- Discretionary authority allows a financial professional to execute trades in a client's account without requiring approval for each transaction.
- It is granted through a formal, written client agreement outlining investment objectives and risk parameters.
- This authority is subject to strict regulatory oversight, including rules set by FINRA and the Investment Advisers Act of 1940.
- It is typically sought by investors who prefer to delegate day-to-day investment decisions to an expert.
- While offering convenience, it requires significant trust and robust compliance measures to protect the client.
Interpreting Discretionary Authority
Understanding discretionary authority involves recognizing that while the power to act is delegated, it is not absolute. The financial professional must operate within the predefined boundaries of the client agreement, which typically specifies the client's investment objectives, risk tolerance, and any restrictions on certain types of investments. The advisor is expected to exercise their fiduciary duty, always acting in the client's best interest. This framework allows for timely execution of an investment strategy, as the advisor can respond to market fluctuations without delay. Regular reporting and performance evaluation are crucial for clients to monitor how discretionary authority is being utilized in their portfolio.
Hypothetical Example
Consider Sarah, a busy doctor who wants to invest for retirement but lacks the time or expertise to manage her own portfolio. She decides to work with a financial advisor, Mark.
- Initial Consultation: Sarah and Mark discuss her financial goals, current financial situation, time horizon, and her comfort level with risk. They determine an appropriate asset allocation and an investment strategy focusing on long-term growth with a moderate risk profile.
- Granting Discretionary Authority: Sarah signs a written agreement granting Mark discretionary authority over her investment account. This agreement explicitly states the agreed-upon investment strategy, asset allocation targets (e.g., 60% equities, 40% fixed income), and any specific exclusions (e.g., no investments in tobacco companies).
- Market Activity: A few weeks later, Mark identifies an opportunity to rebalance Sarah's portfolio due to recent market movements, which would bring it back in line with her desired asset allocation. He also finds a new exchange-traded fund (ETF) that aligns perfectly with her growth objective and risk tolerance.
- Execution: Because Mark has discretionary authority, he can immediately execute the trades to sell some overperforming assets, buy the new ETF, and adjust her portfolio without calling Sarah for approval on each specific transaction.
- Reporting: At the end of the quarter, Mark provides Sarah with a detailed report of her portfolio's activity, holdings, and performance, ensuring full transparency of how her discretionary authority was used.
Practical Applications
Discretionary authority is widely applied in various areas of financial services, particularly within wealth management and institutional investing. Individuals often grant this authority to their financial advisors to manage their retirement accounts, brokerage accounts, or trust funds. This is particularly appealing to busy professionals, those with limited investment knowledge, or clients who prefer a hands-off approach to their investments.
Institutional investors, such as pension funds, endowments, and mutual funds, frequently appoint portfolio managers or asset management firms to manage their vast portfolios with discretionary mandates. This allows for swift decision-making in complex and dynamic markets. For example, UBS Global Asset Management offers discretionary mandates to clients, providing professional investment management where a team of experts makes day-to-day investment decisions based on the client's risk profile and objectives.3 This enables the manager to conduct ongoing due diligence and make timely adjustments to portfolio holdings.
Limitations and Criticisms
While beneficial for convenience and professional management, discretionary authority comes with certain limitations and potential criticisms. The primary concern revolves around the potential for abuse of power by the financial professional. Without continuous client approval for each trade, there's an increased risk of issues such as "churning," where a broker-dealer executes excessive trades solely to generate commissions, or unauthorized trading, where transactions occur outside the scope of the agreed-upon investment strategy.
To mitigate these risks, robust regulatory oversight is crucial. FINRA Rule 3260 explicitly prohibits excessive transactions in discretionary accounts and mandates prior written authorization for discretionary power. It also requires prompt written approval of each discretionary order and frequent review of all discretionary accounts by the member firm to prevent unauthorized or excessive trading.2 Despite these regulations, cases of misconduct can still occur, underscoring the importance of careful selection of a financial professional and regular review of account statements by the client. Financial professionals found to have exercised discretion without authorization or engaged in churning can face significant penalties, including fines and suspension.1
Discretionary Authority vs. Non-Discretionary Account
The key distinction between discretionary authority and a non-discretionary account lies in who initiates and approves each trade.
| Feature | Discretionary Authority | Non-Discretionary Account |
|---|---|---|
| Trade Approval | Financial professional makes decisions and executes trades without prior client approval for each transaction. | Client must approve every single trade before it is executed. |
| Client Involvement | Hands-off; client delegates day-to-day decisions. | Hands-on; client maintains direct control over every trade. |
| Speed of Execution | Faster; advisor can react quickly to market changes. | Slower; dependent on client availability for approval. |
| Suitability | Best for clients who trust their advisor and prefer to delegate. | Best for clients who want full control and actively manage their investments. |
In a non-discretionary account, while a financial advisor may offer recommendations, the client retains ultimate control and must provide explicit permission before any securities are bought or sold. This requires more active involvement from the client but provides a higher degree of direct control over individual investment decisions.
FAQs
Q: Who can grant discretionary authority?
A: Any investor who owns an investment account can grant discretionary authority to a qualified and registered financial professional. This typically requires signing a formal, written agreement.
Q: What are the benefits of granting discretionary authority?
A: The main benefits include convenience, professional expertise, and timely execution of trades. It allows experts to manage your portfolio, freeing up your time and potentially optimizing your investment strategy by reacting swiftly to market changes.
Q: Are there limits to discretionary authority?
A: Yes. Discretionary authority is not limitless. It is always governed by the terms of the signed client agreement, which outlines the client's investment objectives, risk tolerance, and any specific restrictions. Financial professionals are also bound by regulatory rules, such as FINRA Rule 3260, to act in the client's best interest.
Q: How is discretionary authority overseen?
A: Regulatory oversight bodies like FINRA and the SEC monitor how discretionary authority is exercised. Member firms are also required to have internal compliance procedures, including supervisor approval of trades and regular reviews of discretionary accounts, to prevent abuses.
Q: Can discretionary authority be revoked?
A: Yes, a client can typically revoke discretionary authority at any time by providing written notice to their financial institution and advisor. The terms for revocation are usually outlined in the initial client agreement.