An Overview of Discretionary Accounts and Its Pros and Cons
Discretionary Accounts belong to auxiliary services at many brokers and investment firms, but what is discretionary trading? What are the discretionary responsibilities of brokers and portfolio managers?
We will provide an overview of discretionary accounts, cover the pros and cons, and offer low-cost alternatives for the retail sector. The past decade yielded several disruptors, ensuring clients have accessibility and choices to the previously custom-tailored solutions for high-net-worth clients.
What is a Discretionary Account?
A discretionary account is an investment account with an authorized broker, where the client gives a portfolio manager discretionary authority to buy and sell assets. The client will provide the broker with a power-of-attorney (POA) but can dictate portfolio parameters. For example, the client can state to transact in equities above a certain market capitalization, select an investment theme like ESG (environment, social, and governance), only blue chip stocks, or an asset allocation percentage, like 70% equities, 20% bonds, 10% cash.
A discretionary account is a type of fiduciary account where a third party oversees assets and must act in the best interest of their clients. It is also an area where a conflict of interest may appear, and a portfolio manager could follow in the best interest of their broker. For example, brokers and investment firms offering discretionary accounts also employ analysts, and most portfolio managers follow their recommendations, which can indirectly conflict with what is best for clients.
Minimum capital requirements exist, and well-established brokers often charge sums between $25,000 and $250,000+ as they collect performance fees, usually between 1% and 2%, making smaller portfolios an uneconomic choice. Therefore, they cater to the upper tier of clients.
Retail brokers offer an alternative for smaller portfolios, often for as little as $100, via MAM/PAM accounts. The drawback is that a professional background for portfolio managers is usually not required, meaning skilled retail investors and traders can manage accounts for their peers. Brokers provide necessary metrics, including a risk and volatility assessment, allowing investors to make an informed decision. Performance fees are generally higher and closer to profit-sharing than a performance fee.
Some brokers provide in-house thematic portfolios, offering retail traders an accessible alternative to a discretionary account. Robo-advisories began disrupting the scene over the past decade, with low minimum deposit requirements as low as $1.
What is the discretionary vs. nondiscretionary account difference?
A discretionary account is an account managed by a third party. The definition of nondiscretionary is a self-managed account where the investor makes all decisions.
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Discretionary Account Types
Investors have a limited choice of discretionary account types. Most belong to the discretionary broker account category, where investors authorize portfolio managers to transact in their portfolios for a performance fee.
Two variations exist: one with a predetermined investment mandate, where clients set preferences and limits, and one without one that grants portfolio managers unlimited freedom to manage portfolios. Different fee structures are available, which depend on the broker, investment firm, and portfolio manager.
The discretionary authority definition of government requires brokers offering discretionary accounts to register with regulators.
Alternative discretionary account types include:
- Thematic portfolios managed by brokers
- MAM/PAMM accounts at retail brokers where most account managers are retail investors managing portfolios for their peers
- Robo-advisories, provided by professional firms or retail investors, offer investors access to numerous strategies.
- Copy-trading services where investors can select as many service providers as they wish to diversify portfolios
How Does a Discretionary Managed Account Work?
An investor will authorize a portfolio manager to transact on their behalf. It includes a written contract, and investors may define portfolio parameters. A minimum deposit applies, and the investor must pay an annual performance fee if the portfolio managers reach specified performance metrics.
The discretionary authority definition states that the portfolio manager must act in the best interest of their clients. Regrettably, a conflict often exists, as discretionary accounts operate in a grey area despite legal frameworks. Most investors never know when a portfolio manager has failed to act in their best interest as long as the portfolio performance meets or exceeds agreed metrics.
Who Should Consider a Discretionary Account?
A discretionary account is for investors who have the capital to deploy but lack the resources, like time and knowledge, to manage investment portfolios actively. They will pay performance fees, but the last decade brought several low-cost alternatives and disruptors to traditional discretionary accounts, giving investors more choices to achieve objectives with greater flexibility.
Discretionary Investment Account Setup
A discretionary investment account setup is straightforward. Investors open a brokerage account that offers discretionary account services, must meet the minimum deposit requirement, grants the portfolio manager discretionary authority, and optionally sets portfolio parameters.
What is discretionary authority?
Discretionary authority is the permission an investor grants the portfolio manager via a written contract to transact on their behalf in the funded investment account based on given parameters and in their best interest.
The Importance of Discretionary Accounts
Discretionary accounts remain essential in the financial ecosystem, as most investors with capital lack the resources to manage portfolios, especially time knowledge.
Therefore, a discretionary account offers a solution to invest across markets for a fee. Many discretionary account providers simplified their cost structure, marketing them as wrap accounts, where a percentage-based annual fee on assets under management (AUM) applies rather than traditional performance fees.
For example, a wrapped account could carry a 1.5% fee, meaning an investor with a $100,000 portfolio would pay an annual fee of $1,500.
The Pros and Cons of a Discretionary Account
Investors considering a discretionary account must weigh the pros and cons of discretionary investing before handing over capital and control of their portfolio.
The pros of a discretionary account are:
- Knowledgeable and skilled portfolio managers (in many cases, but investors should not assume them and conduct proper due diligence)
- Customized portfolio parameters based on individual preferences
- Execution efficiencies, especially at market-leading brokers and investment managers, lowering trading costs via block orders for numerous portfolios under management
- Convenience as investors hand all responsibilities to a third party
The cons of a discretionary account are:
- Fees to the broker for discretionary account services and investors often get what they pay for, meaning low fees equal low performance.
- Underperformance, as confirmed by numerous studies that suggest 50%+ of discretionary accounts trail markets, while only 20% beat markets
- Fiduciary risks, where the portfolio manager fails to act in the best interest of their clients
- Traditional discretionary accounts have high minimum deposits, making them inaccessible to most retail traders.
Discretionary Account Conclusion
Discretionary accounts offer investors managed account services, but many brokers require high minimum deposits and 50%+ underperform markets. The past decade disrupted the industry with robo-advisories, MAM/PAMM accounts, and copy trading services, which lower trading costs and provide investors with low capital entry requirements and portfolio diversification. Passive portfolios began displacing many discretionary account providers amid low-cost outperformance.
FAQs
When should you use a discretionary account?
A discretionary account suits investors and traders with capital to deploy but neither time nor knowledge to manage a portfolio.
Should you put your tax refund in a discretionary account?
It depends on individual preferences. Some place it in a discretionary account. Others prefer it in a retirement account, while Many decide to spend a tax refund on nondiscretionary items.
Who can benefit from setting up a discretionary account?
Brokers and other investment firms benefit from discretionary accounts as they collect performance fees. Individuals who meet minimum discretionary account criteria but lack the resources or knowledge to manage portfolios also benefit from having a dedicated account manager in a discretionary account.
What is the difference between IRA and discretionary accounts?
An IRA is a self-managed retirement account, while a discretionary account is a third-party managed account, usually for non-retirement purposes.
What is a discretionary and nondiscretionary account?
In a nondiscretionary account, the account owner must approve any investment or trading transactions that may be made. In a discretionary account, the account owner has agreed on a mandate which allows the account manager to make such decisions alone or in line with an agreed policy or algorithm.
What does discretionary mean in finance?
Discretionary means that the portfolio manager makes investment decisions and does not require the account owner's approval. However, the account owner must agree to the terms of the discretionary account.
Who approves discretionary accounts?
The usual practice is for the account owner or beneficiary to sign a written agreement governing the terms of the discretion used on the account.
What does discretionary mean in finance?
Discretionary means that the portfolio manager makes investment decisions – he or she has discretion.
What is an example of a discretionary account?
A typical discretionary account could be where the portfolio manager may invest in any stocks traded on a certain stock market or stocks of a certain type.