The horror stories pop up from time to time: An investment adviser makes an unauthorized trade in a client's account and the result is a loss, or high transaction fees, or new holdings in illiquid or inappropriate assets.
At first blush, the proper way to guard against these infractions is to make sure the adviser seeks explicit approval before making transactions.
But in some situations investors might want to take the opposite approach – that is, grant the investment adviser the authority to use discretion to make trades without prior approval.
Most investment advisers are not allowed to make trades without prior approval. Canada's brokerage industry watchdog, the Investment Industry Regulatory Organization of Canada (IIROC), says the buying and selling of a security by an adviser without the proper consent of the client is considered unauthorized or discretionary trading and is a violation of its rules.
The rules do have some exceptions. In limited circumstances an adviser may exercise discretion in a client's account temporarily if authorized in writing by the client. For example, a client might be travelling or otherwise be difficult to reach.
Discretionary trading is allowed, for the most part, in what IIROC calls "managed accounts." The key distinction here, however, is that only registered portfolio managers may operate these accounts. Securities regulators have set requirements to acquire that authority. Advisers can take one of two main paths to meet the requirements – one through the Chartered Investment Manager designation and the other through the Chartered Financial Analyst program. A prospective portfolio manager must also have extensive industry experience.
While few investment advisers are also registered portfolio managers, the number is increasing, industry experts say.
"In the past 15 years or so there's been a rise in the number of financial advisers licensed as portfolio managers," says Dan Richards, chief executive officer of Client Insights and a leading consultant on the financial advisory industry in Canada.
He sees the increasing number of registered portfolio managers as part of a trend that began in the 1980s with the rise of mutual funds and then hedge funds as more money managers looked for ways to use their expertise to manage assets.
When discretionary trading makes sense
The main reason to give authority to a registered portfolio manager to make discretionary trades is to take advantage of the proficiency and expertise of the adviser.
"It can come down to logistics," says Mr. Richards. "Always getting prior approval can be a hassle both for the client and the adviser."
He notes the decision will depend on the nature of the portfolio, of the adviser and of the client. "It's not about the size of the portfolio," says Mr. Richards. "It's more about the approach and philosophy of the adviser and the client."
Granting discretionary trading authority may make sense, particularly for high-net-worth individuals, says Neil Gross, a securities lawyer and the executive director of FAIR Canada, an independent organization that provides a voice for Canadian investors on national policy issues. This kind of arrangement may be considered when the client doesn't understand much about investing, or would rather not be involved in individual investing decisions.
Mr. Gross notes that most registered portfolio managers deal only with high-net-worth individuals or portfolios, simply as a reflection of their added expertise and experience in the industry.
How to protect yourself
Investors can take a number of steps. The first is finding an investment adviser who is properly certified and whom they can trust. That trust can be established through a successful relationship over a period of time with a more standard relationship. If the relationship is new, references should be carefully checked.
In the next step, according to Mr. Gross, the adviser should assess the client's risk tolerance and investment goals, then craft a written investment plan, including guidelines for discretionary trading.
Mr. Richards notes that even if discretionary trading is agreed to, it doesn't mean the adviser can operate with complete autonomy. "They still need to operate within the client's objectives," he says.
Usually that means completing an Investment Policy Statement, with explicit detail about what kind of investments will be made. As well, clients should carefully review all of their account statements to make sure all transactions are appropriate, and meet regularly (usually quarterly) either in person or over the phone to review transactions that occurred or may be planned.
When there's a problem
If advisers are making transactions that clients aren't comfortable with, the first step should be a conversation with both parties. They can reset the terms of acceptable transactions or decide to end the discretionary trading arrangement.
Investors should watch for investments that are outside the guidelines of their investment plan, Mr. Richards says, such as large weightings in one sector, region or individual security. Options trading, and private investments, including securities not listed on a major stock exchange, can also be warning signs.
If a conversation doesn't end in a solution, the investor can escalate the issue to a branch manager, or move to a different adviser.