Discretionary power

What Is Discretionary Power?

Discretionary power, in the context of investment management, refers to the authority granted by a client to an investment adviser or financial professional to make investment decisions on their behalf without seeking prior approval for each individual transaction. This power allows the adviser to buy, sell, or trade securities within a client's account, provided the actions align with the client's stated investment goals and investment strategy. The broad financial category to which discretionary power belongs is Investment Management, as it directly pertains to how investment professionals manage client portfolios.

The core characteristic of discretionary power is the ability of the advisor to act swiftly on market opportunities or react to adverse conditions without the delay of obtaining client consent for every move. This contrasts with non-discretionary accounts, where the adviser must obtain the client's permission before executing any trade. While offering efficiency, discretionary power also carries significant responsibilities for the adviser, necessitating strict adherence to regulatory standards and client best interests.

History and Origin

The concept of granting discretionary power to financial professionals has evolved alongside the investment advisory industry. In the United States, significant regulatory frameworks emerged in the early 20th century to govern the relationships between investors and those who advise them. A landmark piece of legislation, the Investment Advisers Act of 1940, played a pivotal role in defining and regulating the activities of investment advisers, including the exercise of discretionary authority. This act helped establish a legal framework for the industry, distinguishing investment advisers from brokers and imposing a fiduciary duty on registered advisers. The Act requires that firms or sole practitioners compensated for advising others about securities investments register with the SEC and adhere to regulations designed to protect investors.¹⁵

Over time, as markets became more complex and individual investors sought professional guidance, the use of discretionary accounts became more common. Regulatory bodies like the Financial Industry Regulatory Authority (FINRA) have continuously updated their rules to address the specific responsibilities and limitations associated with discretionary power, emphasizing the need for written authorization, regular review, and suitability of transactions. Early rules, such as NASD Rule 2510, addressed obligations of firms with discretionary power, including prohibitions against excessive transactions and requirements for written authorization.¹⁴ These rules have since been consolidated into FINRA Rule 3260.¹³

Key Takeaways

Discretionary power permits an investment adviser to execute trades in a client's account without requiring prior approval for each transaction.
This authority is granted by the client through a written agreement.
Advisers exercising discretionary power are typically bound by a fiduciary duty, requiring them to act in the client's best interest.
Strict regulation and internal controls are in place to prevent misuse of discretionary power, such as excessive trading or unauthorized transactions.
Discretionary management offers efficiency and responsiveness but demands a high level of trust and clear communication between client and adviser.

Interpreting Discretionary Power

Understanding discretionary power involves recognizing the balance between an adviser's operational flexibility and their profound ethical and legal obligations. When an adviser is granted discretionary power, it does not mean they have carte blanche to do whatever they wish. Instead, their actions must always align with the parameters set forth in the client's investment policy statement, which outlines the client's risk management parameters, investment objectives, and any specific restrictions.

The interpretation also extends to the ongoing performance of the account. Clients should regularly review their account statements, even with discretionary management, to ensure that the adviser's decisions are consistent with their expectations and the agreed-upon strategy. Discretionary accounts are often subject to specific rules and oversight by regulatory bodies to protect investors.

Hypothetical Example

Consider Jane, a retired individual who has hired an investment adviser to manage her portfolio. Jane grants her adviser discretionary power to manage her investments, signing a written agreement that specifies her objective is long-term growth with a moderate risk tolerance, and explicitly states she does not wish to invest in tobacco companies.

One afternoon, the market experiences a sudden downturn. Because the adviser has discretionary power, they can immediately sell certain volatile asset allocation positions and reallocate funds into more defensive holdings without calling Jane for approval for each trade. This allows the adviser to protect Jane's capital more efficiently than if they had to wait for her explicit consent on every transaction. Later, when an opportunity arises in a renewable energy sector that fits Jane's growth objective and ethical preferences, the adviser can quickly purchase shares, taking advantage of favorable pricing before the market adjusts. Throughout this process, the adviser maintains meticulous records and sends Jane regular account statements and disclosure documents detailing all transactions.

Practical Applications

Discretionary power is commonly applied in several areas of finance:

Wealth Management: High-net-worth individuals and families often grant discretionary power to their financial planning firms to manage complex portfolios, including various asset classes and bespoke strategies. This streamlines the decision-making process for both the client and the firm.
Institutional Asset Management: Pension funds, endowments, and other large institutions frequently appoint external asset managers with discretionary power to manage segments of their portfolios, relying on the manager's expertise and agility in the markets.
Trust and Estate Management: Trustees may have discretionary power over trust assets to make investment decisions that benefit the beneficiaries, adhering to the terms of the trust document.
Robo-Advisors: While often automated, some advanced robo-advisory platforms can be seen as exercising a form of discretionary power once the client sets their parameters, as the algorithm makes ongoing adjustments without per-trade approval.

The growth of wealth management services, particularly those offering discretionary mandates, indicates a trend towards professionalized investment oversight. For example, some financial firms have reported strong growth in their wealth management units, driven in part by discretionary services.¹²,¹¹ Regulators like FINRA also have specific rules, such as FINRA Rule 3260, which details requirements for firms and their representatives regarding discretionary accounts and transactions, including preventing unauthorized or excessive trading.¹⁰,⁹

Limitations and Criticisms

Despite its benefits, discretionary power comes with inherent limitations and potential criticisms:

Potential for Abuse: The primary concern is the potential for an adviser to misuse their authority, leading to conflicts of interest or excessive trading (churning) to generate commissions. Regulatory bodies implement strict rules and conduct regular examinations to mitigate these risks. Investors should carefully review their brokerage account statements to identify any unfamiliar or unauthorized activity.⁸,⁷
Loss of Control for the Client: While convenient, clients relinquish direct control over day-to-day investment decisions, which may not suit all investors, especially those who prefer a hands-on approach or want to approve every trade.
Importance of Trust and Due Diligence: Granting discretionary power requires a high degree of trust in the adviser's judgment and integrity. Clients must perform thorough due diligence before selecting an adviser and ensure the adviser's interests are aligned with their own, often by verifying they act under a fiduciary standard. The SEC's investor education website, Investor.gov, provides resources for understanding different types of brokerage accounts and the importance of oversight.⁶,⁵
Suitability Concerns: Advisers must ensure that all transactions made under discretionary power are suitable for the client's financial situation and investment objectives. Failure to do so can lead to regulatory penalties and client disputes.

Discretionary Power vs. Fiduciary Duty

While closely related in the context of investment advice, discretionary power and fiduciary duty are distinct concepts.

Discretionary power refers to the specific authority granted by a client that allows an investment adviser to make trades without obtaining prior client approval for each transaction. It defines the operational mechanism by which investment decisions are executed in an account. Without discretionary power, an adviser operates on a non-discretionary basis, requiring client consent for every trade.

Fiduciary duty, on the other hand, is a legal and ethical obligation for an investment adviser to act in the sole best interest of their client. This duty mandates loyalty, care, and a commitment to avoid conflicts of interest. An adviser operating under a fiduciary duty must always prioritize the client's interests above their own. While many investment advisers who exercise discretionary power are fiduciaries, possessing discretionary power does not inherently create a fiduciary relationship. However, if a firm or individual holds themselves out as providing investment advice and manages discretionary accounts, they are almost certainly subject to fiduciary standards under the Investment Advisers Act of 1940.⁴,³,²,¹ The confusion often arises because the efficient exercise of discretionary power is typically expected to occur within the bounds of a fiduciary relationship, particularly for registered investment advisers.