How Discretionary Investment Managers Make Financial Decisions

Discretionary investment management is a form of investment management in which buy and sell decisions are made by a portfolio manager or investment counsellor on behalf of the client. The term discretionary refers to the fact that investment decisions are made at the portfolio manager's discretion, based on their judgement, rather than under the direction of the client. Discretionary investment managers are responsible for developing and executing investment strategies that align with the client's financial goals and risk tolerance. They have the authority to make investment decisions on behalf of the client, including buying, selling, and holding various financial assets.

Investment decisions

Investment decisions are a key component of discretionary investment management. This form of investment management involves a professional investment manager, often a portfolio manager, making investment choices on behalf of clients. The term "discretionary" refers to the manager's authority to make these decisions independently, based on their judgement, without requiring explicit direction from the client.

Discretionary investment managers have the discretion to buy, sell, and hold various financial assets within a portfolio. They are responsible for developing and executing investment strategies that align with the client's financial goals, risk tolerance, and investment horizon. This includes conducting thorough market research, selecting appropriate assets, and continuously monitoring the portfolio's performance.

The investment decisions made by discretionary managers are guided by the client's pre-agreed investment strategy and risk profile. While managers have autonomy, they must operate within the boundaries set by the client's preferences and constraints. This is often outlined in a Investment Policy Statement (IPS) or an investment mandate, which can include specific investment directives, such as ethical or exclusionary guidelines.

The investment products and strategies employed by discretionary investment managers can vary. They may invest in a range of securities, including stocks, bonds, ETFs, and financial derivatives. Managers typically group clients based on their financial goals and risk tolerance, creating investment portfolios that align with these common objectives. This approach allows for efficient execution of investment strategies and enables clients to benefit from economies of scale.

Discretionary investment managers are expected to have extensive investment industry experience and advanced educational credentials. They are held accountable for the performance of the investments they manage and must demonstrate competence, integrity, and trustworthiness. The investment decisions they make are intended to outperform benchmarks and provide alpha, or superior returns, for their clients.

Investment strategies

Discretionary investment managers employ various investment strategies tailored to their clients' needs, financial goals, and risk tolerance. Here are some common strategies used:

• Asset Allocation: This is a fundamental strategy used to balance risk and return in an investment portfolio. Discretionary investment managers distribute investments across various asset classes, such as equities, fixed income, real estate, and commodities, based on the client's risk tolerance, investment goals, and market conditions. They use models to determine and adjust the optimal asset mix as market dynamics and client objectives change.
• Risk Management: Discretionary investment managers implement techniques to mitigate risk while pursuing desired investment outcomes. They diversify investments across different asset classes and geographic regions, use derivatives for hedging, and set stop-loss limits to protect against market downturns. They also monitor market volatility and liquidity risks to make informed decisions aligned with the client's risk profile.
• Investment Approach Selection: Discretionary investment managers carefully select the right investment approach by evaluating various investment philosophies and methodologies. Their selection is influenced by market trends, economic forecasts, and their expertise. The chosen approach must align with the client's investment goals, timescale, and risk tolerance.
• Portfolio Monitoring and Rebalancing: Regular portfolio monitoring and rebalancing are crucial in discretionary investment management. Managers review portfolios to ensure they align with the client's objectives and risk profile, monitoring market trends, economic indicators, and individual investment performances. Rebalancing is used to adjust the portfolio's asset allocation and respond to significant market movements, helping to capitalise on opportunities and mitigate risks.
• Economies of Scale: Discretionary investment managers can pool their clients' capital to achieve economies of scale. This allows clients to benefit from lower trading fees and the ability to participate in block trades.
• Ethical and ESG Considerations: Some clients may have specific ethical or environmental, social, and governance (ESG) preferences. Discretionary investment managers incorporate these considerations into their investment strategies, steering clear of industries or companies that do not align with the client's values.

Investment types

Discretionary investment managers are professionals who manage investment portfolios on behalf of clients. They have the authority to make investment decisions, such as buying and selling assets, without needing prior approval from the client. This means that clients must place a high level of trust in their discretionary investment manager.

Discretionary investment managers can manage investments in any type of security, including stocks, bonds, ETFs, and financial derivatives. They can also set up different investment vehicles, such as mutual funds, with tailored strategies to fit the risk preferences of different groups of investors.

Stocks

Stocks, also known as equities, represent ownership in a company. When you buy a company's stock, you become a shareholder and have a claim on a portion of that company's assets and profits. Stocks are typically considered a higher-risk, higher-reward investment, as their value can fluctuate significantly based on market conditions and the company's performance.

Bonds

Bonds are a type of fixed-income security, representing a loan made by an investor to a borrower, such as a corporation or government. Bonds are often used to raise capital for large projects or to finance ongoing operations. In exchange for the loan, the borrower agrees to pay the investor a fixed rate of interest over a set period, making bonds a relatively lower-risk investment compared to stocks.

ETFs (Exchange-Traded Funds)

ETFs are baskets of securities, such as stocks, bonds, or commodities, that trade on an exchange like a single stock. They are designed to track a particular market index or sector, and their value fluctuates throughout the day as they are bought and sold. ETFs offer investors a level of diversification, as they hold multiple underlying assets, and they are known for having lower fees compared to other investment funds.

Financial Derivatives

Financial derivatives are contracts whose value is derived from an underlying asset, such as a stock, bond, commodity, or currency. Common types of derivatives include options, futures, forwards, and swaps. Derivatives can be used for various purposes, including hedging against potential losses, speculating on future price movements, or gaining exposure to an asset without owning it directly. They are considered complex financial instruments and may carry a higher level of risk.

Investment management fees

Discretionary investment management is a form of investment management where a portfolio manager makes investment decisions on behalf of clients. The term "discretionary" refers to the fact that investment decisions are made by the manager, rather than the client. This means that clients must have a high level of trust in the manager's capabilities and integrity.

Discretionary investment management is typically utilised by high-net-worth individuals and institutional investors, such as pension funds, due to higher minimum investment requirements, often starting at $250,000. The investment manager's strategy is tailored to the client's risk profile and financial goals, and they may invest in a variety of securities, including stocks, bonds, ETFs, and financial derivatives.

• Assets under management (AUM) fees: This is the most common fee structure, where investment management companies charge an annual rate of 0.1%-4% of the value of the managed asset portfolio.
• Transaction fees: In addition to an AUM fee, a fee may be charged for each transaction executed.
• Performance fees: This is a fee charged as a percentage of the profits generated for the client, typically ranging from 10%-30% of the profits. Clients do not pay this fee when the fund loses money.

The fees associated with discretionary investment management can be a hindrance to new investors with smaller amounts to invest. It is important for clients to conduct thorough due diligence on potential investment managers and understand the fee structure before entrusting them with their capital.

Benefits and drawbacks

Discretionary investment management is a form of investment management where a portfolio manager or investment team makes buying and selling decisions on behalf of a client at their discretion. The term "discretionary" refers to the investment decisions being made by the manager based on their judgement and not under the direction of the client. This type of investment management offers several benefits and drawbacks.

Benefits

One of the main advantages of discretionary investment management is that it frees clients from the burden of making day-to-day investment decisions, allowing them to focus on other matters. Delegating the investing process to a competent manager can result in better investment opportunities and more efficient execution of investment strategies. The manager's interest is also aligned with that of the client, as they typically charge a percentage of the assets under administration, incentivising them to grow the portfolio.

Discretionary investment management provides clients with access to professional insights and expertise in financial markets, potentially leading to better investment performance. It also allows for economies of scale, as clients can pool their capital together, reducing trading fees and accessing block trades.

Drawbacks

One of the significant drawbacks of discretionary investment management is the cost. This type of service typically comes with higher fees, including assets under management (AUM) fees, transaction fees, and performance fees. The minimum account balance required for discretionary investment management can also be a hindrance, especially for new investors with smaller amounts to invest.

Another key consideration is the level of trust and confidence required in the investment manager. Clients must conduct adequate due diligence before entrusting their savings to a portfolio manager, as there is a risk of underperformance or the manager acting contrary to the client's goals.

Additionally, discretionary investment management may not be suitable for clients who need to carefully manage their capital gains tax position, as the regular rebalances done without prior client approval could lead to unwanted tax liabilities.

Frequently asked questions