Understanding Discretionary Accounts- An In Depth Guide

What is a Discretionary Account?

A discretionary account is a specialized investment account that empowers a broker or financial advisor to make trading decisions on behalf of the client, without needing prior consent for each transaction. Clients must consent to this arrangement by signing a discretionary disclosure agreement with their broker, establishing the framework under which the broker will operate.

Often referred to as managed accounts, discretionary accounts appeal to investors who prefer the convenience of having their assets professionally managed. Many brokerage firms require a minimum investment to qualify for this service, which can range from $250,000 to even higher thresholds depending on the sophistication of services and account features. Clients can expect to pay annually between 1% to 2% of their assets under management (AUM) in fees.

Key Takeaways

Discretionary accounts give brokers or advisors full control over investment decisions.
Clients have the ability to customize their accounts to meet specific investment preferences or restrictions.
The increasing popularity of robo-advisers has introduced a new, automated method of managing discretionary accounts, often with lower fees and account minimums.

Benefits of Discretionary Accounts

1. Convenience and Time-Saving

One of the principal advantages of a discretionary account is the convenience it provides. Clients can save significant time by allowing brokers to execute trades without needing constant approval. This feature is especially beneficial for individuals with limited time or expertise in managing investments.

2. Expert Management

Investors who are less knowledgeable about the stock market may benefit from the expertise of professional advisors. Investment professionals have access to resources, research, and tools that are usually available only to institutional investors.

3. Quick Execution of Trades

Brokers managing discretionary accounts can act swiftly on buying and selling opportunities. This swift action helps in obtaining better pricing and reduces the risk of price fluctuations that can occur when seeking client approval for each trade.

4. Customizable Guidelines

Clients may set specific parameters regarding investment preferences. For instance, some might limit investments to blue-chip stocks or exclude companies associated with ESG (Environmental, Social, and Governance) issues. This customization can provide peace of mind, ensuring that investments align with personal values or financial goals.

5. Reduced Market Impact

Discretionary accounts allow brokers to execute large block trades without needing to consult each client individually. This feature minimizes potential market impact and epilogue pricing discrepancies among clients.

Disadvantages of Discretionary Accounts

1. Higher Fees

One of the drawbacks of discretionary accounts is the higher cost. Due to the personalized service and advisory expertise offered, clients typically pay more in fees compared to non-discretionary accounts.

2. Performance Risk

A significant study by Asset Risk Consultant (ARC) illustrated that about 50% of portfolios managed through discretionary accounts underperformed the market. This statistic raises concerns over whether clients are achieving the returns they expect and suggests that not all advisors deliver consistently positive outcomes.

3. Loss of Control

Some clients may feel uneasy relinquishing control over their investment decisions. Although clients can set parameters, they are ultimately entrusting their financial well-being to someone else.

The Evolution of Discretionary Accounts through Robo-Advisers

With the rise of technology in finance, robo-advisers have emerged as a popular alternative for discretionary account management. Unlike traditional brokerage services, robo-advisers use algorithms to manage investment strategies, often employing modern portfolio theory for passive investment management.

Advantages of Robo-Advisers

Low Fees: Robo-advisers typically charge significantly lower management fees, often around 0.25% per annum, and in some cases, they can offer no fees at all.
Low Minimum Investments: Many robo-advisers have very low account minimums (as low as $5 or $1), making investment more accessible to a wider audience.

Limitations of Robo-Advisers

Limited Customization: While clients can set certain guidelines, the degrees of customization in a robo-advised account may not match that of traditional discretionary accounts managed by human advisors.
Less Personalization: The algorithm-driven approach may lack the personal touch of experienced human advisors, which can be pivotal for certain client preferences or complex financial situations.

Steps to Set Up a Discretionary Account

Research Brokers: Begin by finding a reputable brokerage that offers discretionary account services. Look for brokers with solid reputations and an established history of client success.
Understand Requirements: Be aware of any account minimums that are required for opening a discretionary account. For example, brokerage firms like Fidelity offer a tiered structure: some require as low as $25,000, while others may necessitate upwards of $350,000.
Review Terms and Fees: Make sure to familiarize yourself with the associated fees and services included in the account. Higher minimums often correlate with lower fees and additional services.
Sign the Necessary Documentation: Complete the required paperwork, including a discretionary disclosure agreement, that specifies the power and limitations granted to the broker.
Set Investment Parameters: Clearly communicate your investment goals, risk tolerance, and any restrictions or guidelines you wish to establish for your account.

Conclusion

Discretionary accounts offer an efficient and convenient way for investors to manage their portfolios, leveraging professional expertise while allowing for some customization. However, potential clients must weigh the associated fees, performance risks, and the loss of some control when granting trading authority to their chosen brokers. With advancements such as robo-advisers gaining traction, investors have more options than ever to align their financial management strategies with their personal investment philosophies.