Definition
Discretionary investment management is an arrangement in which a professional manager is authorized to make buying and selling decisions for a client’s account without getting prior approval for each transaction. The client delegates day-to-day investment authority to the manager within a set of agreed objectives and constraints.
Key terms (defined)
– HNWI: high-net-worth individual, generally someone with substantial investable assets.
– ETF: exchange-traded fund, a pooled investment vehicle that trades on exchanges like a stock.
– Derivative: a contract whose value is based on an underlying asset (e.g., options, futures).
– AUM (assets under management): the total market value of assets a manager oversees.
– Churning: excessive trading in a client account primarily to generate commissions.
– Custody: who holds client assets (broker, custodian bank) separate from the advisor.
How discretionary management works (step-by-step)
1. Agreement and mandate: the client signs a discretionary authorization (often via an investment management agreement and an investment policy statement) that specifies goals, risk tolerance, permitted instruments, and constraints (e.g., no tobacco stocks).
2. Manager selection and credentials: the client hires an experienced manager or firm; many managers hold professional credentials such as CFA (Chartered Financial Analyst), CAIA (Chartered Alternative Investment Analyst), CMT (Chartered Market Technician), or FRM (Financial Risk Manager).
3. Pooling and implementation: managers often group clients into model portfolios based on similar objectives and risk profiles. Cash provided by each client remains in separate accounts, but trades are implemented across the group (block trades) and pro rata allocations are applied.
4. Execution and administration: the manager places orders, monitors positions, and rebalances as needed. Custodians hold the assets; the manager reports performance and fees regularly.
5. Fees and alignment: managers typically charge a fee based on a percentage of AUM (for example, 1% per year). Some may also charge performance fees. The AUM fee structure ties the manager’s compensation to portfolio size and, indirectly, to performance.
Benefits
– Time savings: clients do not need to make frequent trading decisions.
– Professional oversight: access to skilled managers and institutional-grade processes.
– Economies of scale: block trades and consolidated execution can reduce transaction costs and obtain better prices.
– Alignment through AUM fees: managers paid on AUM have less incentive to churn for commissions compared with transaction-based models.
– Rapid decision-making: managers can act quickly across multiple accounts to seize opportunities or limit losses.
Risks and downsides
– Higher entry requirements: discretionary mandates commonly require substantial minimums (often starting around $250,000), limiting access for smaller investors.
– Fees: AUM and possible performance fees can be large relative to returns, especially for smaller portfolios.
– Manager risk: the client must rely on the manager’s skill and integrity; poor judgment or misconduct can hurt returns.
– Reduced control: clients give up pre-approval of trades; if the mandate is not precise, investments might drift away from personal preferences.
– Concentration or strategy risk: a model portfolio may not be personalized beyond the client’s broad risk grouping.
Worked numeric example