What Is a Discretionary Account and How Does It Work?

Managing investments requires time, expertise, and attention to market changes. For those who prefer a hands-off approach, discretionary accounts allow financial advisors or portfolio managers to trade on behalf of clients without needing prior approval for each transaction.

This arrangement benefits investors who lack the time or knowledge to manage their portfolios but requires trust in the advisor’s ability to act in the client’s best interest. Understanding how these accounts function and the level of control they provide is essential before deciding if this approach aligns with your financial goals.

Key Features of a Discretionary Account

A discretionary account operates under a formal agreement granting an investment professional the authority to manage assets on behalf of the client. This arrangement is governed by a discretionary investment management agreement (DIMA), which specifies the advisor’s decision-making power, investment objectives, and any restrictions imposed by the client. These agreements must comply with regulations set by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) to ensure transparency and investor protection.

One defining characteristic of these accounts is the ability to execute trades without obtaining client approval for each transaction. This allows for quicker responses to market fluctuations, which can be particularly useful during periods of volatility. For example, if an advisor sees an opportunity in short-term bonds due to rising interest rates, they can act immediately rather than waiting for client confirmation, which could result in missed gains or increased risk exposure.

Risk management is essential, as advisors must align investment decisions with the client’s risk tolerance and financial goals. This is typically determined through a suitability assessment evaluating factors such as income, investment experience, and time horizon. A retiree focused on capital preservation would likely have a portfolio weighted toward lower-risk assets like Treasury securities, while a younger investor with a longer time frame might have a higher allocation to equities.

Full Discretion vs. Limited Discretion

The level of authority granted to an investment professional in a discretionary account varies, with two primary structures: full discretion and limited discretion.

Full discretion gives the advisor complete authority to manage the portfolio without requiring client input on individual trades. This allows for swift execution of investment strategies, particularly in fast-moving markets where delays could impact returns. For example, if an advisor overseeing a fully discretionary account determines that shifting investments from one industry to another is necessary due to changing economic conditions, they can make the adjustments immediately. This structure is common among institutional investors and high-net-worth individuals who place a high degree of trust in their advisor’s expertise.

Limited discretion imposes specific restrictions on the advisor’s decision-making capabilities. While they can execute trades, they may need to operate within predefined parameters, such as adhering to asset allocation limits or seeking client approval for transactions exceeding a certain dollar amount. A client may, for example, allow an advisor to rebalance their portfolio quarterly but require consent before purchasing speculative investments like emerging market equities or high-yield corporate bonds. This structure provides a balance between professional management and client oversight.

Role of the Investment Firm

Investment firms oversee discretionary accounts, ensuring portfolio management aligns with regulatory requirements and client expectations. These firms employ teams of analysts, traders, and compliance officers who work with advisors to construct investment strategies, execute trades, and monitor risk exposure. Their infrastructure provides advisors with proprietary research, advanced trading platforms, and asset allocation models that enhance decision-making efficiency.

Beyond trade execution, investment firms must comply with SEC and FINRA regulations. Internal controls are in place to prevent conflicts of interest, such as front-running or excessive trading, which could harm clients. Compliance departments conduct routine audits and trade surveillance to ensure advisors adhere to fiduciary obligations under the Investment Advisers Act of 1940.

Technology plays a growing role in managing discretionary accounts. Many firms use algorithmic trading systems and artificial intelligence-driven analytics to identify market trends and optimize portfolio performance. These tools allow advisors to adjust asset allocations dynamically in response to economic shifts or geopolitical events. Additionally, client portals provide real-time account performance data, transaction histories, and risk assessments, offering greater visibility into portfolio management.

Common Fees and Commissions

The cost structure of discretionary accounts varies based on the investment firm, portfolio complexity, and level of service. Most firms charge a management fee based on assets under management (AUM), typically ranging from 0.25% to 2% annually. This fee compensates the advisor for portfolio oversight, asset allocation adjustments, and ongoing financial planning. For example, an investor with a $500,000 portfolio paying a 1% management fee would incur $5,000 in annual charges, deducted periodically from the account.

Some firms also impose performance-based fees, particularly for high-net-worth clients or hedge fund-style discretionary management. These fees, often structured as a percentage of profits exceeding a predetermined benchmark, incentivize advisors to pursue strong returns. A common model is the “2 and 20” structure, where clients pay a 2% management fee plus 20% of gains above a hurdle rate, such as the S&P 500’s annual return. While this aligns advisor compensation with client success, it can lead to higher costs in strong market years.

In addition to management and performance fees, trading commissions may apply when securities are bought or sold. While many brokerage firms have eliminated commissions on stocks and ETFs, other assets—such as options, mutual funds, and foreign securities—may still carry transaction costs. Mutual funds, for instance, often have front-end or back-end load fees ranging from 3% to 5.75%, which can erode returns over time.

Monitoring Trades and Account Activity

Even though discretionary accounts allow advisors to make investment decisions independently, clients still have access to account performance and transaction details. Most investment firms provide online dashboards where investors can review holdings, recent trades, and portfolio performance in real-time. These platforms often include analytical tools that break down asset allocation, historical returns, and risk exposure. Some firms also offer periodic performance reports detailing gains, losses, and benchmark comparisons.

Regulatory requirements ensure firms maintain transparency in reporting. Under SEC Rule 206(4)-2, investment advisors must provide clients with account statements at least quarterly, disclosing all transactions and current asset values. Clients can also request trade confirmations, which detail the price, quantity, and execution time of each transaction. If discrepancies arise, investors have the right to dispute trades or seek clarification from their advisor. Regularly reviewing these reports helps detect unauthorized activity or deviations from the agreed-upon strategy.

How to Modify or Close the Agreement

Clients who wish to adjust or terminate their discretionary account agreement have several options depending on their financial goals or concerns about portfolio management. Modifications can include changing investment objectives, adjusting risk tolerance parameters, or imposing new restrictions on asset classes or trading strategies. These changes typically require a formal amendment to the discretionary investment management agreement, documented and approved by both the client and the investment firm. Some firms may limit how frequently modifications can be made, as frequent adjustments can disrupt portfolio strategy.

Closing a discretionary account involves liquidating holdings or transferring assets to another account type, such as a self-directed brokerage account or a different advisory service. The process may take several days, depending on the liquidity of the investments. If the portfolio contains illiquid assets, such as private equity or real estate funds, liquidation may be subject to lock-up periods or redemption restrictions. Clients should also consider potential tax implications, as selling appreciated assets could trigger capital gains taxes. Before terminating the agreement, it is advisable to review any exit fees or penalties outlined in the original contract, as some firms charge account closure fees or require a notice period before finalizing the termination.