A discretionary account is an investment account in which an investor gives an authorized broker or manager the power to place trades without asking for permission for each trade. The investor documents this authority by signing a discretionary agreement or disclosure. Within that agreement the investor can set limits or rules the manager must follow.
Key terms
– Managed account: another name often used for a discretionary account, especially when a professional manages the portfolio.
– Assets under management (AUM): the dollar value of assets the manager oversees; management fees are frequently charged as a percentage of AUM.
– Robo-adviser: an automated manager that runs algorithms to manage portfolios with minimal human intervention; robo services usually have low minimums and comparatively low fees.
– Fiduciary: a legal/ethical duty requiring the manager to act in the client’s best interests.
– Alpha: returns above what would be expected given the portfolio’s risk and a chosen benchmark.
How discretionary accounts typically work (short)
– The client signs an agreement that lets an approved broker or manager trade without prior trade-by-trade approval.
– The client can impose constraints (for example, limit investments to certain sectors, require a target stock/bond ratio, or exclude specific companies).
– Managers may execute block trades across multiple discretionary accounts to obtain consistent execution and pricing.
– Fees are usually a percent of AUM and can be higher than for self-directed accounts; robo-advisers offer a lower-cost discretionary alternative.
Advantages and disadvantages — practical checklist
Advantages
– Convenience: manager handles day‑to‑day trading and rebalancing.
– Faster execution: manager can act quickly on market opportunities without contacting each client.
– Professional oversight: investors gain access to portfolio management and risk monitoring.
Disadvantages / risks
– Fees: discretionary management commonly costs more than self-directed investing; typical traditional fees often range around 1%–2% of AUM; robo-advisers may charge ~0.25% or sometimes no fee.
– Performance uncertainty: actively managed portfolios may underperform benchmarks; studies have shown many managed portfolios do not outperform the market.
– Less control: handing trading discretion to a manager reduces a client’s direct control unless constraints are clearly specified.
– Conflicts of interest: always ask how the manager is compensated and whether any incentives affect trading choices.
Step-by-step setup checklist
1. Confirm the manager/broker is registered (check FINRA/SEC registration).
2. Request and review the discretionary agreement and disclosure; insist any limits you want be written into the agreement.
3. Ask about minimums (some managed accounts require large minimums; robo-advisers typically require very little).
4. Understand the fee schedule: AUM fee, billing frequency, and any additional costs (trading, custody, mutual fund fees).
5. Specify investment objectives, risk tolerance, time horizon, and any prohibited holdings (e.g., tobacco).
6. Ask for benchmark(s) and performance reporting cadence; request historical gross and net returns, if available.
7. Confirm who has trading authority, who supervises them, and the fiduciary standard that governs their conduct.
8. Document how you can change or terminate the arrangement and what notice is required.
Worked numeric example — fee impact on compounded growth
Assumptions:
– Starting portfolio: $250,000.
– Pre-fee (gross) annual return: 6.00% (assumed for illustration).
– Time horizon: 10 years.
– Fee scenarios: 1.50%