What is a Discretionary Account?
A discretionary account is an investment account that allows an authorized broker to buy and sell securities without the client’s consent for each trade. The client must sign a discretionary disclosure with the broker as documentation of the client’s consent.
A discretionary account is sometimes referred to as a managed account; many brokerage houses require client minimums (such as $250,000) to be eligible for this service, and usually pay between 1 percent and 2 percent a year of assets under management (AUM) in fees.
A discretionary account is one in which clients hand over control of their trading account to brokers or advisors, who select and execute trades for them.
Clients can customize such accounts by specifying restrictions or preferences for investing style or themes. In recent times, robo-advisers have also become popular instruments for discretionary accounts.
Advantages of Discretionary Accounts
1. Professional investing
Investors without much prior knowledge about investing or the financial markets can get professional investing insights that are customized to their risk-return profile and their personal desires and beliefs.
Unlike other retail investing alternatives that offer generalized mutual funds or exchange-traded funds (ETFs), discretionary accounts are more personalized.
If a client trusts their broker enough to open a discretionary account, they will have peace of mind knowing that the broker will execute trades that will benefit the client.
3. Execution efficiency
The broker will be able to execute trades more efficiently. They will be able to get lower trading costs and can implement trading ideas more effectively when they do not have to get the client’s consent before each trade.
For example, if a broker discovers a trade that is beneficial to all clients, they can execute a large block trade in which the clients will get a favorable deal on the trading costs in aggregate. It is an example of economies of scale in operations for large brokerages.
Disadvantages of Discretionary Accounts
In general, a discretionary account will charge higher fees than a non-discretionary account since it requires the services of a manager to constantly manage the portfolio, monitor risk, and execute trades.
2. Fiduciary risks
Discretionary account managers are held to an ethical standard that they will act in their client’s best interest. However, there may be a substantial conflict of interest at times, and there is a risk that the manager may not be acting in the client’s best interest all the time.
Like most active investing strategies, it is well documented that after fees, discretionary accounts end up underperforming passive investing strategies. They underperform in the broad market index. It is difficult for such strategies to consistently generate alpha, especially when they are charging relatively high fees.