Discretionary Investment Management

When an investment team makes buying and selling decisions on behalf of a client at their discretion

What is Discretionary Investment Management?

Discretionary investment management is an investment management style that refers to when an investment team makes buying and selling decisions on behalf of a client at their discretion. The decisions are usually made by a portfolio manager who has the ultimate end-decision for which individual securities to hold in a portfolio.


Discretionary Investment Management


Because discretionary investment managers invest client’s capital at their discretion, there is a high level of trust and ethical considerations that must be considered in such a type of investment management style. Discretionary investment managers need to answer to their clients if they underperform since they will be charging a fee to clients for their services.


Understanding Discretionary Investment Management

Generally, there are two broad types of investment management styles:

  1. Non-discretionary investment management
  2. Discretionary investment management


Non-discretionary investment managers are characterized by conducting all the research and recommendations of the investment process. However, the clients retain the right to make the end investment decision. It is effective since the investment managers do not need to bear the risk of making the wrong decision, and the client retains responsibility for decisions that are made while still receiving professional research and advice.

However, the caveat is that the decisions may be made a lot slower, and not in an efficient manner if the end decision is left to the client. Therefore, discretionary investment management can be more effective in executing investment strategies in a timely manner since the client does not need to be consulted before making an investment decision.

Discretionary investment managers lack complete free rein over decisions, though. The managers must make decisions according to the clients’ wishes, which are usually outlined in an Investment Policy Statement (IPS). The IPS is a detailed document that outlines the clients’ investing preferences and constraints and is highlighted by the client’s risk-return profile. The document will be flexible over time, since client preferences and tolerances may change dynamically over time.


Investor Types

Investment managers will target three types of investors to sell their services to:


1. High net worth individuals 

High net worth individuals are individuals who own a large number of assets, and therefore, can commit a significant amount of capital to invest. Since they are individuals, they receive very tailored services from discretionary investment managers in order to meet their specific needs.

For example, a high net worth individual may wish to invest in companies with a strong focus on Environmental, Social, and Governance (ESG) initiatives, and therefore, the discretionary investment managers may choose to steer away from fossil fuel energy companies or companies in the tobacco industry.


2. Retail investors

Retail investors are everyday investors who, individually, do not possess a significant amount of capital. They receive less personalized services from discretionary investment managers; however, discretionary investment managers can set up different investment vehicles with a tailored strategy that may fit with different groups of investors with various risk preferences.

For example, a manager may set up a mutual fund that focuses on investment-grade fixed-income securities. This mutual fund is tailored for investors with lower risk tolerance, or that are close to retirement. Furthermore, a manager may set up a mutual fund that focuses on small-cap tech equities. This mutual fund is tailored for investors who have higher risk tolerance and would like exposure to the tech industry.


3. Institutional investors

Institutional investors are investors who manage capital on behalf of a fund or institution. Some common examples are:

  • Endowment funds
  • Pension funds
  • Commercial banks
  • Mutual funds
  • Hedge funds
  • Insurance companies


The investors manage a significant amount of capital and may need more tailored investment offerings as well. For example, a pension fund may require a long-term time horizon on investments, while a P&C insurance company may require short-term liquidity in order to make claim payouts.


Benefits of Discretionary Investment Management

Utilizing a discretionary investment manager offers the following benefits:


1. Convenience

Clients do not need to spend time worrying about their investment performance; they can simply just invest their capital with a professional who will monitor their investments on their behalf.


2. Excess returns

When investment managers are given the right incentives, they will try to earn excess returns for clients above their benchmark.


3. Access to professional insight

Investment managers are usually professionals who understand the financial markets and investing more than the average person; in theory, it should lead to better performance than investing personally.


4. Economies of scale

Clients can pool their capital together and access economies of scale in the form of lower trading fees and block trades.


Risks of Discretionary Investment Management

The risks involved in using a discretionary investment manager include:


1. Fees

Discretionary investment managers charge a fee for their services, and it takes a portion out of the end return that a client receives.


2. Underperformance

Due to the unpredictability of financial markets, there is a solid possibility that the investment manager will actually underperform their benchmark.


3. Confidence in the manager

Clients must maintain the utmost confidence in the investment manager to make the best investment decision; however, many clients may become fearful when they begin losing money and want to pull their capital out from the discretionary investment manager, which limits the manager’s ability to execute on their strategies.


Additional Resources

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:

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