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Discretionary portfolio management

What Is Discretionary Portfolio Management?

Discretionary portfolio management is an investment management approach where a professional, such as a portfolio manager or financial advisor, is granted the authority to make investment decisions on behalf of a client without needing prior approval for each specific transaction. This falls under the broader category of investment management, a key component of portfolio theory. The client initially establishes an investment policy statement with the manager, outlining their investment objectives, risk tolerance, and other relevant parameters. Once this agreement is in place, the portfolio manager can execute trades, rebalance the portfolio, and adjust asset allocation as market conditions evolve, aiming to achieve the client's stated goals. This method is often favored by investors who prefer to delegate the day-to-day oversight of their client accounts.

History and Origin

The concept of professional financial advice and management has roots stretching back centuries, but the formalized structure of discretionary portfolio management as it is known today largely evolved alongside the growth of the financial services industry in the 20th century. Initially, financial professionals often acted more as brokers, executing client orders. However, as markets became more complex and the need for specialized expertise grew, the role of the advisor began to shift. The mid to late 20th century saw a transition from a commission-based sales model to a fee-based advisory model, where advisors provided ongoing guidance and managed portfolios. This evolution facilitated the rise of discretionary accounts, allowing investment professionals to manage assets more dynamically based on agreed-upon strategies rather than transactional instructions.4

Key Takeaways

  • Discretionary portfolio management grants an investment professional the authority to make trading decisions without requiring client approval for each transaction.
  • The relationship is based on a pre-established investment strategy and investment policy statement tailored to the client's financial goals and risk profile.
  • This approach offers efficiency and professional oversight, potentially allowing for quicker responses to market changes.
  • Clients often pay a fee-based structure, typically a percentage of assets under management.
  • Regulatory bodies impose strict rules and fiduciary duty obligations on professionals managing discretionary accounts.

Interpreting Discretionary Portfolio Management

Discretionary portfolio management is interpreted as a relationship built on trust and expertise. For the client, it signifies a decision to delegate the intricacies of investment selection and timing to a qualified professional. The manager's decisions, while independent on a day-to-day basis, are always framed within the pre-defined parameters of the client's investment objectives and risk tolerance. The effectiveness of discretionary portfolio management is typically measured by how well the portfolio achieves its stated goals and its overall performance relative to benchmarks, rather than by individual trade outcomes. It indicates a long-term commitment to a professional managing the investment portfolio.

Hypothetical Example

Consider an individual, Sarah, who has accumulated a sizable retirement nest egg but lacks the time and expertise to manage her investments. She seeks out a financial advisor who offers discretionary portfolio management.

  1. Initial Consultation: Sarah meets with the advisor to discuss her financial situation, retirement goals (e.g., aiming for consistent growth over 20 years), her comfort with risk (moderate), and her current asset holdings.
  2. Investment Policy Statement (IPS): Based on their discussions, the advisor drafts an investment policy statement that outlines a diversified strategy focusing on a mix of equities and fixed income, with specific target allocations and rebalancing guidelines. Sarah reviews and approves this IPS.
  3. Discretionary Authority Granted: Sarah signs an agreement granting the advisor discretionary authority over her retirement account, enabling them to buy and sell securities within the IPS parameters without contacting her for each trade.
  4. Portfolio Management: Over the next year, the market experiences fluctuations. The advisor, observing these changes, decides to slightly reduce the equity exposure and increase fixed income to maintain Sarah's target asset allocation and manage risk, executing these trades promptly. Sarah is informed of these actions through regular account statements and periodic reviews, but no prior approval was needed for each transaction.

This example illustrates how discretionary portfolio management allows for nimble adjustments while adhering to the client's overarching financial plan.

Practical Applications

Discretionary portfolio management is widely applied in various segments of the financial industry, primarily for individuals, families, and institutions that prefer or require professional oversight of their investments.

  • Wealth Management: High-net-worth individuals and families often utilize discretionary management for comprehensive wealth management, delegating investment decisions to focus on other aspects of their lives.
  • Institutional Investors: Pension funds, endowments, and foundations frequently engage discretionary managers to handle their large and complex portfolios, benefiting from specialized expertise and efficiency.
  • Trusts and Estates: Trustees, who have a fiduciary duty to manage assets prudently for beneficiaries, often employ discretionary managers to adhere to the trust's mandate.
  • Advisory Firms: Many independent financial advisory firms and broker-dealer operations offer discretionary services as a core offering, particularly in fee-based advisory relationships.
  • Regulatory Compliance: The Financial Industry Regulatory Authority (FINRA) has specific rules, such as FINRA Rule 3260, governing discretionary accounts, which require written authorization from the client and the firm's approval, along with strict oversight to prevent excessive trading.3

Limitations and Criticisms

While offering significant benefits, discretionary portfolio management also has limitations and faces criticisms. A primary concern is the potential for conflicts of interest, especially if the manager's compensation is linked to trading activity rather than overall portfolio performance. However, regulatory bodies like FINRA and the SEC have rules in place, alongside the broad principle of fiduciary duty, that aim to mitigate these risks by requiring advisors to act in the client's best interest.2

Another criticism often leveled against discretionary management is the perceived lack of direct control for the client. While an investment policy statement provides a framework, individual trades are made without client consultation, which may not suit investors who prefer direct involvement. Furthermore, discretionary services typically come with higher fees compared to non-discretionary or self-managed accounts, which can erode returns over time. For instance, academic research has explored whether systematic (algorithmic) investment strategies outperform discretionary (human-managed) approaches in certain contexts, suggesting that the "human touch" does not always guarantee superior performance.1 It is essential for clients to thoroughly understand the fee structure and the extent of the manager's authority before entering such an agreement.

Discretionary Portfolio Management vs. Non-Discretionary Portfolio Management

The key differentiator between discretionary and non-discretionary portfolio management lies in the level of authority granted to the investment professional.

In discretionary portfolio management, the client gives the portfolio manager the authority to make investment decisions and execute trades on their behalf without seeking approval for each transaction. The manager operates within the parameters set out in the initial investment policy statement, allowing for quicker and more flexible responses to market conditions. This approach is suitable for investors who prefer to outsource the day-to-day management of their portfolio.

In contrast, non-discretionary portfolio management, also known as advisory management, requires the investment professional to obtain the client's explicit consent for every trade or investment decision. The advisor provides recommendations, but the final decision-making power rests entirely with the client. This model is preferred by investors who wish to retain full control over their investment decisions and be actively involved in the management of their portfolio, even if it means slower execution.

FAQs

What does "discretionary" mean in investing?

In investing, "discretionary" refers to the authority given to an investment professional to make trading decisions, such as buying or selling securities, without first seeking the client's approval for each individual transaction. This authority is granted after the client agrees to an overarching investment strategy and risk profile.

Is discretionary portfolio management regulated?

Yes, discretionary portfolio management is heavily regulated. In the United States, regulatory bodies like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) impose strict rules on firms and individuals offering these services. These regulations cover requirements for written client authorization, supervisory oversight, and adherence to fiduciary duty, ensuring the manager acts in the client's best interest.

What are the main benefits of a discretionary account?

The main benefits include professional management, which can lead to more timely and informed investment decisions, especially in volatile markets. It saves the client time and effort by eliminating the need to approve every trade. Discretionary management can also facilitate effective diversification and rebalancing, aligning the portfolio with the client's long-term financial goals without constant client input.

What are the potential drawbacks of discretionary portfolio management?

Potential drawbacks include higher fees compared to self-directed accounts, as you are paying for the manager's expertise and active management. Clients also give up direct control over individual trading decisions, which may not suit everyone. There's also the potential for conflicts of interest, although strict regulations and fiduciary duty aim to mitigate this risk.

Who is discretionary portfolio management suitable for?

Discretionary portfolio management is typically suitable for investors who have accumulated significant capital, prefer to delegate investment decisions to a professional, and are comfortable with a fee-based service. It is particularly beneficial for busy individuals, those lacking investment expertise or time, or institutional clients who require sophisticated, ongoing financial planning and management.