The Meaning of “Discretionary” in Composite Construction

Overview

I remember the first time I encountered the term “discretionary” in composite construction—it was my second week working at a boutique investment firm, and I got that panicked sense of “Uh, are we all speaking the same language?” Our CIO casually asked if a new client portfolio was discretionary or non-discretionary because that would determine which composite it would go into. Honestly, at that moment, I had no idea what he was talking about. And if that rings a bell, trust me, you’re not alone!

In the context of GIPS (Global Investment Performance Standards), discretionary basically means the portfolio manager has a sufficient level of freedom—or “discretion”—to implement the intended investment strategy fully. If the manager’s hands are tied by client-imposed or regulatory constraints that fundamentally alter the strategy, the portfolio may not accurately represent the manager’s skill or approach. And that is precisely where the distinction has real teeth: GIPS standards demand consistent and appropriate composite assignments, ensuring that performance reporting is fair, comparable, and unbiased.

Understanding what is (and isn’t) discretionary is critical for:
• Accurately grouping client portfolios into composites.
• Complying with GIPS standards regarding presentation and reporting.
• Ensuring that performance numbers reflect actual skill and strategy.

Identifying Discretion

Before we get lost in all the details, let’s talk about what “discretion” even means in day-to-day portfolio management. Discretion refers to a manager’s ability to make investment decisions without being unduly constrained by client guidelines, legal requirements, or other limitations that severely hamper the strategy.

• Client-Imposed Restrictions: Clients might say, “No companies with a market cap under $2 billion,” or “Absolutely no tobacco stocks.” Usually, small restrictions like these might reduce but not eliminate manager discretion.
• Regulatory Constraints: Regulated funds often operate under statutory requirements—such as liquidity limits—that may or may not limit strategic freedom.
• Guidelines vs. Absolute Prohibitions: There’s a difference between a guideline (e.g., maintain some level of diversification across certain sectors) and an outright prohibition (e.g., can’t hold more than 10% in any single security). When these constraints become near-absolute, they can transform the portfolio into something that no longer reflects the manager’s standard strategy.

When Does a Portfolio Become “Non-Discretionary”?

The big question is where to draw the line. If a manager is so restricted that they can’t execute their strategy, then the portfolio is deemed non-discretionary under GIPS. If you’re basically forced to deviate from your normal selection process to accommodate these constraints—even to the point that the portfolio’s risk-return structure no longer mirrors your stated mandate—well, that’s a pretty good sign that the portfolio has lost the discretionary label.

In practice, that might look like a situation where a client invests in your mid-cap growth strategy but decides, “Actually, I don’t want any stocks in technology or healthcare,” which are typically high drivers of growth. If your mid-cap growth invests heavily in those sectors, you’re effectively not able to manage this portfolio as you normally would. This portfolio would likely be non-discretionary.

Composite Construction

Composite construction under GIPS is all about grouping portfolios that share a similar strategy or investment objective. This ensures apples-to-apples comparisons—no mixing a large-cap value portfolio with a short-term bond fund, obviously! According to GIPS, all discretionary portfolios must be included in at least one composite to provide a comprehensive and consistent performance track record.

Composite Assignment

Think of composite assignment as categorizing your wardrobe. The best approach is consistent labeling: put each outfit (portfolio) in the correct “closet section” (composite) so that your performance “outfits” for each strategy are portrayed accurately. The GIPS standards are quite explicit that once a portfolio is deemed discretionary, it has to go into a composite that reflects its primary strategy or mandate.

Failure to include a discretionary portfolio in a relevant composite can create something known as “selection bias,” where a firm might be—intentionally or unintentionally—cherry-picking which portfolios show up in performance. This obviously leads to misleading results, since the performance that gets reported might only be from the “best-dressed outfits,” so to speak.

Avoiding Selection Bias

Selection bias can occur if:
• Firms exclude portfolios that underperform due to “special client constraints” that aren’t truly special or heavily restrictive.
• Portfolio managers stretch the definition of non-discretionary to camouflage less attractive performance.

No manager wants to get caught misrepresenting performance. The surest way to avoid selection bias is to adopt a standardized procedure for labeling portfolios as discretionary or non-discretionary and to consistently update this classification if client circumstances change.

Practical Examples

Here are a few examples from my own (sometimes bumpy) experiences:

1. A High-Net-Worth Client with Modest Constraints: Suppose the client invests in large-cap equities but demands no more than 20% of the portfolio be in technology stocks. If your strategy typically invests across all sectors (with technology at 25–30%), you might still be able to run your usual approach with a minor tweak. That likely remains discretionary.

2. The “No Sin Stocks” Portfolio: A foundation instructs you to avoid alcohol, tobacco, and gambling. If that’s still consistent with your broad ESG-oriented equity approach, then you probably remain discretionary. But if your strategy historically invests significantly in, let’s say, the gambling industry, and you can’t do that anymore, you need to consider whether the entire strategy is fundamentally altered.

3. Regulatory Requirements for a Pension Fund: Pension funds might require you to hold a certain threshold of duration to meet liabilities. If the manager typically invests flexibly across durations, but now is forced to maintain a specific duration band, it might well be a partial constraint. Enough constraints stacked together can tip the portfolio into non-discretionary territory.

Common Pitfalls

• Mislabeling: Accidentally labeling a portfolio as discretionary when constraints severely hamper the manager’s approach.
• Complacency: Failing to re-evaluate whether changes in client instructions or regulatory shifts have made the portfolio non-discretionary.
• Inconsistent Policies: Having “gray areas” in your guidelines that lead different teams to label similar constraints differently—this is a GIPS compliance nightmare.

Best Practices for Composite Construction

• Standardize Your Definition: Document explicit criteria for what is discretionary vs. non-discretionary.
• Review Constraints Periodically: Clients often add or remove restrictions over time, so your compliance officer (and/or portfolio manager) should confirm the portfolio’s status regularly.
• Keep Evidence: If you classify a portfolio as non-discretionary, maintain documentation that clearly explains your rationale.
• Communicate and Educate: Some clients may not realize how a seemingly harmless restriction might undermine your entire strategy. Having a conversation early on can mitigate issues.

Below is a high-level depiction of how a manager might evaluate discretionary status:

    flowchart LR
	    A["Receive Portfolio <br/>with Client Restrictions"] --> B{"Assess <br/>Materiality of Constraints?"}
	    B -- "Material Constraints" --> C["Label as <br/>Non-Discretionary"]
	    B -- "Minimal Constraints" --> D["Label as <br/>Discretionary"]
	    D --> E["Assign to <br/>Appropriate Composite"]
	    C --> F["Exclude from <br/>Composite or Create <br/>Its Own Category"]

Exam Tips

• Always clarify whether constraints are material. In the context of a CFA Level III question, expect to see scenario-based prompts asking you to decide if a portfolio remains discretionary under GIPS.
• Familiarize yourself with the definitions from the official GIPS standards, especially around how to treat partially discretionary portfolios.
• In constructed-response questions (essay format), you might be asked to interpret an investment policy statement and determine whether constraints cross the threshold to non-discretionary. Support your conclusion with clear references to GIPS.
• Watch out for “selection bias” in all item-set or essay scenarios. The exam might present you with a borderline constraint situation and test whether you can spot attempts to artificially boost reported performance.

References for Further Study

• CFA Institute’s “GIPS Standards: Questions and Answers,” particularly sections addressing the classification of discretionary vs. non-discretionary portfolios.
• Feibel, B. J. (Performance Attribution and GIPS). This book offers additional insights and practical examples of how constraints can affect a manager’s discretion and, ultimately, composite construction.
• CFA Institute GIPS Handbook for detailed, official guidance on composite construction and the nuances of discretionary classification.

Test Your Knowledge: Discretionary vs. Non-Discretionary Compliance