What Is a Discretionary Account Comprehensive Guide Examples

Core Description

• A discretionary account is an investment arrangement where a licensed manager makes buying and selling decisions on behalf of the client, without needing pre-trade client approval, while operating within a clearly defined mandate.
• This structure enables timely portfolio management, professional expertise, and efficient execution tailored to the investor’s objectives, risk tolerance, and constraints.
• Discretionary accounts are utilized by individuals, families, institutions, and charitable foundations seeking professional portfolio management with a balance of flexibility, governance, and oversight.

Definition and Background

A discretionary account is a formal investment arrangement in which the client grants written authority to a licensed financial professional—such as a portfolio manager or advisor—to make investment decisions and execute transactions according to agreed guidelines. The manager acts within the parameters outlined in an Investment Policy Statement (IPS), which documents the client’s investment goals, time horizon, risk tolerance, liquidity requirements, and any specific constraints.

The concept originated during the early years of private banking for individuals with significant assets and later expanded to institutional clients. Regulatory frameworks, such as the U.S. Investment Advisers Act of 1940, applied fiduciary duties and established suitability standards, helping define the structure of discretionary portfolio management today.

In the current investment landscape, discretionary management is adopted by individuals with complex financial needs, professionals with limited time, family trusts, non-profit organizations, endowments, and pension funds. The principal benefit is delegating day-to-day investment responsibilities to professionals, allowing for prompt decision-making and continuous alignment with long-term objectives.

Calculation Methods and Applications

Portfolio Construction and Strategy

The foundation of a discretionary account is the mandate, established after a comprehensive Know Your Client (KYC) and suitability assessment. This process defines:

• Target return expectations
• Strategic asset allocation (for example, portion in equities, bonds, alternatives)
• Risk limits (maximum permitted portfolio volatility, drawdown limits, concentration caps)
• Liquidity requirements (cash reserves, near-term distribution needs)
• Investment constraints (for example, ESG screens, specific exclusions, sector or asset class caps)
• Rebalancing rules (based on calendar cycles or triggered by threshold breaches)

Managers may use model portfolios designed for various risk profiles and customize them per client requirements, factoring in considerations such as taxation and currency exposure.

Implementation and Monitoring

Once the account is funded, the manager allocates capital according to the IPS, selecting securities, determining trade timing, and adjusting positions as markets evolve. Trades adhere to “best execution” standards, using tools such as algorithmic trading (VWAP and TWAP) and transaction cost analysis (TCA) to optimize results. Ongoing monitoring and regular rebalancing help maintain the portfolio within agreed boundaries, while minimizing turnover and tax impacts.

Applications in Practice

Discretionary accounts are particularly suitable when:

• Prompt market responses are necessary (for example, during periods of high volatility)
• Investors require ongoing portfolio oversight and systematic rebalancing
• Efficient tax management, including loss harvesting, is a priority
• Clients prefer to avoid the influence of emotional decision-making in investing

For example, a charitable foundation in the United Kingdom may set up a discretionary account with an asset manager to ensure timely investment actions that remain consistent with its spending mandates, ESG criteria, and annual review requirements. (This example is hypothetical and provided for illustrative purposes only.)

Comparison, Advantages, and Common Misconceptions

Discretionary vs. Non-Discretionary Accounts

Advantages

• Timely Execution: Managers can respond quickly to market developments, capturing opportunities or mitigating losses without the need for client authorization on each trade.
• Professional Oversight: Investors benefit from research capabilities, analysis, and institutional-level risk controls.
• Behavioral Benefits: Reduces the chance of impulsive reactions to market swings and market-timing errors.
• Efficiency: Centralized trading and tax management, such as block trades and loss harvesting, may optimize after-tax returns.
• Customization: Portfolios are tailored to client goals, liquidity needs, and investment constraints.

Disadvantages

• Reduced Direct Control: Clients delegate daily investment decisions, which may not be suitable for individuals seeking hands-on involvement.
• Agency Risks: Portfolio managers may misinterpret objectives, overtrade, or deviate from the mandate.
• Costs: Fees can be significant, depending on the provider and account size, and there is no guarantee that net performance will match or exceed benchmarks after fees.
• Transparency: Reporting may only be periodic, which can limit real-time visibility into holdings and strategy.
• Suitability Mismatches: If mandates are poorly defined, portfolios could diverge from client intent.

Common Misconceptions

• “A discretionary account guarantees higher returns.”
  Actual results depend on manager skill, strategy, and market conditions. No investment approach eliminates risk.

• “Delegating discretion means you do not need to monitor the account.”
  Oversight is essential. Clients should review reports, attend review meetings, and ensure compliance with agreed constraints.

• “All fees are included in the headline number.”
  Additional costs, such as trading, custody, or underlying fund expenses, may apply. Request detailed, itemized fee breakdowns.

Practical Guide

Steps to Open and Manage a Discretionary Account

1. Define Objectives and Mandate
Identify your investment objectives, time horizon, risk tolerance, cash flow needs, and any special requirements (for example, ESG restrictions or sector bans). This forms the basis of your Investment Policy Statement (IPS).

2. Vet and Select a Manager
Assess potential managers based on regulatory standing, investment approach, team experience, historical results, and cost structure. Ask for references and review regulatory filings or disclosures as appropriate.

3. Formalize the Relationship
Sign a discretionary mandate that specifies authority, eligible investments, reporting schedules, benchmarks, and fee structure. Complete KYC checks and fund the account.

4. Ongoing Oversight
Maintain engagement through regular review of performance and risk reports. Verify that allocations, exposures, and strategies remain consistent with your IPS. Update objectives and constraints on at least an annual basis or after significant financial changes.

5. Adjust and Exit if Needed
Communicate any changes to your IPS or investment needs to your manager. To close the account, revoke discretionary authority in writing, settle open trades, and direct the custodian to either liquidate or transfer assets according to your instructions.

Case Study (Hypothetical Example)

Background:
A European university endowment previously managed its capital through a committee that met quarterly. Facing more volatile markets and evolving spending needs, it transitioned to a discretionary account with an asset management firm.

Mandate:
The IPS specified a 60/40 allocation between equities and bonds, capped foreign equities at 20 percent, and mandated a minimum 5 percent cash position to support annual grants. ESG exclusions were also included.

Outcome:
During a sharp market downturn, the manager harvested tax losses and reallocated to undervalued equities without delay—actions that would not have been possible under the previous committee structure. Regular performance reports detailed asset class attribution and risk, referencing relevant benchmarks.

Key Takeaway:
Delegating investment discretion allowed the endowment to react methodically and maintain governance.
(The above scenario is for illustration only and does not constitute investment advice.)

Resources for Learning and Improvement

• SEC Investor.gov (Discretionary Accounts): Comprehensive explanation and key questions for investors.
• IAPD/ADV Filings (iapd.sec.gov): Official disclosures related to U.S.-registered investment advisers.
• FINRA Rule 3260: Guidelines for discretionary authority in U.S. brokerage accounts.
• FCA Handbook (United Kingdom): Guidance on client mandates and oversight standards.
• CFA Institute Standards: Best practices regarding ethics, fiduciary duty, and portfolio management.
• IOSCO Suitability Reports: International guidelines on investor suitability and protection.
• ESMA MiFID II Guidance: European requirements for suitability, client reporting, and trade execution.
• Books:
  • “The Investment Answer” by Daniel Goldie & Gordon Murray
  • “Winning the Loser’s Game” by Charles D. Ellis
• Web Platforms:
  • Morningstar (fee analysis and performance tracking)
  • Investopedia (glossary and tutorials for discretionary accounts)

FAQs

What is a discretionary account in simple terms?

A discretionary account is an investment account where a licensed manager is authorized to make buying and selling decisions in line with your agreed objectives and risk limits, without needing your approval for each trade.

Who can benefit from a discretionary account?

Individuals with complex portfolios, busy professionals, charitable organizations, endowments, and anyone wanting professional management without reviewing every order may benefit from discretionary accounts.

How are fees generally charged?

Fees are usually structured as a percentage of assets under management, typically between 0.5 percent and 1.5 percent annually. Other possible charges include trading commissions, fund expenses, and custody or platform fees.

Can I set limits or restrictions?

Yes, you can include asset exclusions, ESG guidelines, sector or position limits, and other instructions in your IPS, which will determine what the manager can do.

Is my manager a fiduciary?

Investment advisers managing discretionary accounts generally act as fiduciaries and are required to act in the client’s best interest, subject to jurisdictional and regulatory standards.

How do I monitor performance?

You will receive regular portfolio reports that include activity, holdings, returns, risk indicators, and performance measured against agreed benchmarks.

Can I withdraw or add funds at any time?

Subject to account terms and possible settlement requirements, funds can generally be added or withdrawn as needed. Confirm any applicable notification periods or restrictions with your provider.

What happens if I want to close the account?

You may revoke the manager’s discretionary authority, settle any outstanding trades, and transfer or liquidate your assets according to instructions detailed in your client agreement.

Conclusion

A discretionary account enables clients to delegate portfolio management to experienced professionals, maintaining clarity through an explicit, documented mandate. This arrangement provides access to research, prompt trade execution, structured risk management, and greater behavioral discipline, which may be especially beneficial in complex and fast-changing markets. However, the effectiveness of this approach depends on thoughtful mandate design, careful manager selection and monitoring, transparency regarding fees and risks, and ongoing communication. When used prudently, a discretionary account can help align investment portfolios with long-term goals, allowing investors to concentrate on their strategic objectives rather than daily trading decisions. Please note that all investments involve risk, and past performance does not indicate future results.