Discretionary Account: Understanding the Concept and Its Function

Highlights:

• A discretionary account allows someone else to manage the trading activities on behalf of the account holder.
• The individual or organization managing the account has the authority to make trades without prior approval.
• It offers a flexible approach to investing but requires trust in the account manager’s expertise.

Introduction: A discretionary account is a type of investment account where the account holder grants another individual or organization the authority to make trading decisions on their behalf. Unlike a regular account where the account holder must approve every transaction, a discretionary account provides the manager with the freedom to execute trades at their discretion, without seeking the account holder's approval for each action. This flexibility can be appealing for those who prefer to delegate their investment management to experts or who may not have the time or expertise to actively manage their portfolio.

How a Discretionary Account Works:

1. Granting Authority: In a discretionary account, the account holder gives a third party, typically a financial advisor or a portfolio manager, the authority to manage the account. This includes the ability to buy and sell securities, adjust the portfolio, and make investment decisions based on market conditions and the account holder’s investment objectives.
2. Trading Without Approval: One of the defining features of a discretionary account is that the person managing the account does not need to obtain the account holder’s consent before executing trades. This means that the manager has the ability to act quickly on market opportunities or respond to changing conditions without waiting for approval, allowing for greater flexibility and efficiency in managing the portfolio.
3. Risk and Reward: The discretion given to the manager can lead to significant benefits, such as quicker responses to market opportunities and the potential for higher returns. However, it also involves risks, as the account holder must trust the manager’s judgment and expertise. While the manager is bound by the account holder’s stated investment goals and risk tolerance, the account holder is still responsible for the results of the account.

Advantages of a Discretionary Account:

1. Expert Management: Discretionary accounts are often managed by professional portfolio managers or financial advisors with expertise in managing investments. These professionals bring knowledge of market trends, asset allocation strategies, and risk management, which can lead to better investment outcomes for individuals who lack the time or expertise to manage their own portfolio.
2. Efficiency and Flexibility: Since the account manager does not need to seek approval for every transaction, they can act quickly on opportunities or changes in market conditions. This can be particularly beneficial in fast-moving markets where timing is critical. Additionally, the flexibility to make trades without waiting for approval can help capitalize on opportunities that may not be available if approval processes were required.
3. Time-Saving: For investors who are busy or lack the inclination to monitor their investments regularly, a discretionary account provides a time-saving solution. The account holder can delegate the responsibility of managing the portfolio, knowing that it is in the hands of a professional who is actively monitoring and adjusting the investments as needed.

Risks and Considerations:

1. Lack of Control: One of the main disadvantages of a discretionary account is that the account holder gives up a degree of control over the investment decisions. While the manager is required to act in the account holder’s best interest, the investor may not always agree with the decisions made, especially if the account manager’s actions lead to losses or underperformance.
2. Trust and Confidence: Since the account holder is relying on the expertise and judgment of the account manager, it’s essential to choose someone trustworthy and experienced. Poor decisions or mismanagement by the manager can lead to significant financial losses, and the account holder must feel confident in their advisor's ability to make sound financial choices.
3. Costs and Fees: Discretionary accounts often come with higher fees compared to non-discretionary accounts. These fees can include management fees, transaction fees, and other administrative costs. It’s important for the account holder to fully understand the fee structure and ensure that the value of the management services justifies the costs.

Different Types of Discretionary Accounts:

1. Individual Discretionary Account: This is a discretionary account set up for a single individual. In this setup, the individual authorizes a professional money manager or financial advisor to manage their portfolio according to their investment goals, risk tolerance, and preferences. The manager has full discretion to make investment decisions.
2. Institutional Discretionary Account: Institutional discretionary accounts are similar but are typically used by larger entities, such as pension funds, mutual funds, or foundations. These accounts are managed by professional investment managers who make decisions on behalf of the institution, often with larger sums of money involved and more complex investment strategies.
3. Managed Discretionary Account (MDA): In an MDA, the account is typically managed by a portfolio manager who makes day-to-day investment decisions on behalf of the client. These accounts may be more tailored to the client’s specific goals, and the manager may also provide ongoing reporting and performance analysis.

Legal and Regulatory Aspects:

1. Fiduciary Duty: When managing a discretionary account, the manager is legally bound by fiduciary duty, meaning they must act in the best interest of the account holder. This includes making decisions that align with the investor’s goals, risk tolerance, and financial objectives, and avoiding conflicts of interest.
2. Regulatory Oversight: Discretionary accounts are subject to regulatory oversight by government agencies such as the Securities and Exchange Commission (SEC) and other financial regulatory bodies. These regulations are designed to protect investors by ensuring that account managers act ethically and transparently.

Conclusion: A discretionary account offers a flexible and efficient way for investors to delegate the management of their investments to professionals, without needing to approve each trade. By granting a trusted manager the authority to make decisions on their behalf, investors can benefit from expert guidance and quick decision-making in response to market conditions. However, it is important to weigh the potential risks, such as the loss of control and the costs associated with these accounts, and to choose a trustworthy and competent manager. Ultimately, discretionary accounts can be a valuable tool for those who wish to entrust their investment management to professionals, but they require careful consideration and trust in the appointed manager's abilities.