A discretionary account is an account for investing that allows an authorized broker to trade securities on behalf of a client without getting the client’s approval for each trade.
For a discretionary account to be active, the client will sign a discretionary disclosure agreement with the designated broker to document the client’s consent to allow the broker to trade on their behalf.
Discretionary accounts are also known as managed accounts. Many brokerage firms will require clients to maintain a minimum account balance (e.g., $100,000+) to be eligible for and pay a percentage of assets under management (AUM) for the service.
Understanding Discretionary Accounts
Discretionary accounts are investment accounts that individuals may open up that allow a broker to trade on their behalf. The details of the agreement are outlined in the discretionary disclosure and will specify the parameters around the trading in the account.
A client may only want equities above a certain market capitalization threshold. There are other unique cases where an investor may have high regard for environmental, social, and governance (ESG) considerations, and may want to avoid investing in companies with poor environmental impacts, such as some energy and mining companies.
A client may want a specific asset allocation as well; depending on their risk appetite, they may want a certain amount to remain invested in safer fixed-income securities, and another portion allocated to more risky equity securities.
The investment terms are flexible and will change over time. As clients get closer to retirement age, they may want a higher allocation towards safer securities. The client’s unique situation may change over time as well, which requires the brokerage firm to monitor and update the discretionary disclosure agreement.
The client must be upfront in defining the constraints and instructions within the discretionary account, and the brokerage firm will be thorough in determining exactly what their client wants out of their service.
In recent years, a new trend has come out in the form of robo-advisors. While traditional discretionary accounts are managed by human traders and brokers, robo-advisors are automated investment management services that are fulfilled by algorithms and use little human intervention and guidance.
Clients can provide their instructions and constraints to robo-advisors that follow a passive index or other quantitative strategies. The robo-advisors are also able to adhere to constraints, such as having regard for ESG considerations or a specific asset allocation mix.
The benefit for the brokerage firm of using robo-advisors is that they spend less on operating expenses for the human capital needed to run the discretionary accounts, which, therefore, leads to lower fees charged to clients.
Also, the client does not usually need to meet a minimum account balance, unlike in traditional discretionary accounts.
Advantages of Discretionary Accounts
1. Professional investing
Investors without much prior knowledge about investing or the financial markets can get professional investing insights that are customized to their risk-return profile and their personal desires and beliefs.
Unlike other retail investing alternatives that offer generalized mutual funds or exchange-traded funds (ETFs), discretionary accounts are more personalized.
If a client trusts their broker enough to open a discretionary account, they will have peace of mind knowing that the broker will execute trades that will benefit the client.
3. Execution efficiency
The broker will be able to execute trades more efficiently. They will be able to get lower trading costs and can implement trading ideas more effectively when they do not have to get the client’s consent before each trade.
For example, if a broker discovers a trade that is beneficial to all clients, they can execute a large block trade in which the clients will get a favorable deal on the trading costs in aggregate. It is an example of economies of scale in operations for large brokerages.
Disadvantages of Discretionary Accounts
In general, a discretionary account will charge higher fees than a non-discretionary account since it requires the services of a manager to constantly manage the portfolio, monitor risk, and execute trades.
2. Fiduciary risks
Discretionary account managers are held to an ethical standard that they will act in their client’s best interest. However, there may be a substantial conflict of interest at times, and there is a risk that the manager may not be acting in the client’s best interest all the time.
Like most active investing strategies, it is well documented that after fees, discretionary accounts end up underperforming passive investing strategies. They underperform in the broad market index. It is difficult for such strategies to consistently generate alpha, especially when they are charging relatively high fees.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: