Considerations for Discretionary vs. Non-Discretionary Investment Management

What is Discretion?

Discretionary investment management is a form of investment management in which buy and sell decisions are made by a portfolio manager or investment counselor for the client's account, without the responsibility to obtain client authorization for each transaction. An Investment Adviser must not exercise discretionary power over securities transactions without obtaining the proper discretionary authority from the client.

There are quite a few items to consider for investment advisory firms when determining whether or not advisers will have discretionary authority over securities to be purchased and sold in client accounts. Most notably, is the additional Net Capital Requirements that most States place on firms who have discretion. In some states, the net capital requirement may be met through the purchase of a surety bond. However, some states require that the net capital requirement be met based on assets listed on the firm's balance sheet. This can be particularly challenging for firms that are just starting out. This will be discussed in greater detail later.

Portfolio Management Strategies

Active portfolio management strategies often require  making decisions that must be acted upon based on current market conditions. In volatile markets, the adviser may need to place trades or execute reallocations in the client's portfolio quickly. If the adviser has discretionary authority over the account, then such adjustments can be made without the client's permission and acknowledgement of the changes. In a non-discretionary account, the adviser may find themselves attempting to contact the client repeatedly to gain their permission to execute transactions in the account, as the market moves against them. If for any reason the client cannot be reached on that trading day, then the window of opportunity closes, and the performance of the portfolio may suffer.

While discussing portfolio strategies, it is important to consider portfolio turnover, or the frequency at which securities are purchased and sold in a portfolio. Passive Investment management strategies, which are characterized by low portfolio turnover, are generally more compatible with non-discretionary accounts. The same would be true of a “buy-and-hold” strategy. The fewer the trades, the less client meetings or phone calls necessary to gain authorization to execute transactions.

Documenting Client Authorizations

With Discretion, the firm does not have to show client approval or authorization for each transaction in the account. This is seen as one of the major advantages to having discretionary authority. However, if the relationship or account is Non-discretionary, then the Adviser has to gain client permission prior to executing the transaction. The process of documenting client authorizations is a two-part process.

  1. Maintaining a Trade Blotter - This is a record of trades including order details such as account number, time, order price, order type, buy or sell etc. Trade Blotters can be difficult to maintain manually, so check with your Custodian or Broker Dealer to determine what reports can be run from their end. Along with this item, firms should make sure they fully understand how all Third Party Managers and Custodians operate regarding trading activity.

  1. Client Notes and Records - Firms are advised to document every time client contact is made (via physical meeting, phone, email or mail). When a client communicates permission to submit an order or perform an asset allocation verbally, firms are wise to use detailed notes, and enter the order promptly. Such notes can be maintained in CRM, Excel or any other document maintenance system designed by the firm.

It is important to note per the above, that trade blotters that are downloaded from the Custodian may, or may not have orders marked as discretionary or non-discretionary. Whether or not such information will be notated on the blotter, depends on the system capabilities of the Custodian, and how their trading system is built. Some Custodians will allow  firms to mark an order as discretionary or non-discretionary at the point of order entry.

Net Capital and Surety Bond Requirements

In most cases, there will be stricter regulatory requirements for firms that have discretionary authority over client accounts. This comes mostly in the form of net capital requirements. Rather during the initial registration process, or upon adding discretionary authority for an existing firm, net capital requirements are an important consideration. In most cases for State Registered firms, the regulatory agency will evaluate the financials of the firm, to make sure that there are sufficient assets on the balance sheet to meet these requirements. The Minimum Net Capital requirement will usually range from $2,000, to $25,000, depending on the State Requirements. Additionally, some State Regulators will allow the purchase of a Surety Bond, in place of the minimum net capital requirements, while others do not. If the regulatory agency does not allow for a surety bond in place of the Minimum Net Capital Requirement, this is can be especially challenging for firms that are just starting out, because there will need to be sufficient assets on the balance sheet, usually in the form of cash. Therefore, it is important to review individual State Minimum Net Capital and Surety Bond requirements, when contemplating taking on discretionary authority.

Advisory Contracts - Making the Connection

Another important aspect of taking on discretionary authority, is making sure that the advisory contract that the client signs outlines that authorization. In a vast majority of advisory contracts, there will be a statement towards the beginning of the agreement which outlines rather or not the adviser will have discretionary authority. The details of this section of the agreement, need to be consistent with the description of discretionary authority in Form ADV Part 2A. As a result, it is imperative that the Adviser or CCO of the firm review both documents simultaneously, when adding or removing discretionary authority.

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