Discretionary vs. Discretionary vs. Directed Investment Directed Investment

RiskRisk

By: By: Melody BohlmannMelody Bohlmann

IM&T Investment Risk ManagerIM&T Investment Risk Manager

Wells Fargo Wealth Management GroupWells Fargo Wealth Management Group

Key RisksKey Risks

►Operational RiskOperational Risk►Market RiskMarket Risk►Business RiskBusiness Risk

Operational RisksOperational Risks

► You have them whether you have discretion You have them whether you have discretion or allow for directionor allow for direction

Example: IM/Asst. input trade incorrectly – Example: IM/Asst. input trade incorrectly –

wrong asset – incorrect ticker, wrong asset – incorrect ticker,

wrong amount - shares, units, dollarswrong amount - shares, units, dollars

►What is different is disputes – internal vs. What is different is disputes – internal vs. external external

Operational RisksOperational RisksWays to mitigate internal vs. external risk:Ways to mitigate internal vs. external risk:

► Require direction via:Require direction via: Recorded phone linesRecorded phone lines

► Issues:Issues:expenseexpenseresearchresearch

Written direction onlyWritten direction only► FaxFax► EmailEmail► After the fact confirmationAfter the fact confirmation► Issues:Issues:

TimingTimingFollow-up monitoringFollow-up monitoring

Can be addressed with appropriate language in Can be addressed with appropriate language in governing instrument and disclosuresgoverning instrument and disclosures

Operational Risks continuedOperational Risks continued

You also have the following operational risks:You also have the following operational risks:► Asset set upAsset set up►Dividend/Income processingDividend/Income processing► Pricing/valuationPricing/valuation

The difference is that when you are The difference is that when you are purchasing discretionary assets you purchasing discretionary assets you generally have a controlled process for generally have a controlled process for ensuring that they happen correctlyensuring that they happen correctly

Operational Risks continuedOperational Risks continued

Soft dollars – Section 28(e) safe harbor Soft dollars – Section 28(e) safe harbor - only commissions from discretionary - only commissions from discretionary trades can be used for research or trades can be used for research or services services

Market RiskMarket Risk

► Market movements - timing difference between Market movements - timing difference between time of direction and execution time of direction and execution

Errors – do you make client whole, how do you make client Errors – do you make client whole, how do you make client wholewhole►Gains vs. lossesGains vs. losses►Tax effectsTax effects►Performance differentialsPerformance differentials

► Long-term difference between value of asset Long-term difference between value of asset directed and what could have beendirected and what could have been

Do you have an obligation to monitor the asset?Do you have an obligation to monitor the asset? How are they monitoredHow are they monitored

Issues To Address When Issues To Address When Deciding on an Individual Deciding on an Individual

Account LevelAccount Level►AuthorityAuthority►PurposePurpose►Type of AccountType of Account► Investment ObjectiveInvestment Objective►Asset allocationAsset allocation►DiversificationDiversification►Risk MitigationRisk Mitigation

Business RiskBusiness Risk► Firm decision vs. individual client and individual asset Firm decision vs. individual client and individual asset

decisiondecision

What does the competition doWhat does the competition do Will a decision not to allow for direction cause the business line to Will a decision not to allow for direction cause the business line to

lose business to the competitionlose business to the competition What does it cost firm to allow direction and put in proper controls What does it cost firm to allow direction and put in proper controls

and monitoringand monitoring

Reputation, Operational, Investment risks:Reputation, Operational, Investment risks:

if we do, if we do, if we do but don’t do it properly or monitor properly, or if we do but don’t do it properly or monitor properly, or if we don’t if we don’t – – same questions should be asked on individual account same questions should be asked on individual account and individual asset level and individual asset level

AuthorityAuthority

What does the governing document What does the governing document say?say? SoleSole SharedShared Allow for directionAllow for direction

PurposePurpose

Purpose of the AccountPurpose of the Account

Purpose of the proposed investmentPurpose of the proposed investment

Type of AccountType of Account

►AgencyAgency►RevocableRevocable► IrrevocableIrrevocable

Uniform Prudent Investor Act Uniform Prudent Investor Act §2 §2 (b)(b)

““A Trustee’s investment and A Trustee’s investment and management decisions respecting management decisions respecting individual assets must be evaluated individual assets must be evaluated not in isolation but in the context of not in isolation but in the context of the trust portfolio as a whole and as the trust portfolio as a whole and as part of an overall investment strategy part of an overall investment strategy having risk and return objectives having risk and return objectives reasonably suited to the trust.”reasonably suited to the trust.”

§§184 & 185 Restatement of Trusts, 184 & 185 Restatement of Trusts, Second & Second & §9 Uniform Prudent Investor §9 Uniform Prudent Investor

ActAct

► Scope of duty under trust or agency agreementsScope of duty under trust or agency agreements Expectations of the parties reflected in the Expectations of the parties reflected in the

compensation paid for the duties undertakencompensation paid for the duties undertaken

Reasonable expectation of the bene/principal based on Reasonable expectation of the bene/principal based on the representations and conduct of the institutionthe representations and conduct of the institution

General duty of directed trustee to reject directions or General duty of directed trustee to reject directions or seek instruction where the direction facially constitutes seek instruction where the direction facially constitutes a breach of trust - which violate either the terms of the a breach of trust - which violate either the terms of the agreement or general fiduciary principlesagreement or general fiduciary principles

Investment Objective & Asset Investment Objective & Asset AllocationAllocation

►How does the investment proposed fit How does the investment proposed fit with the investment objective of the with the investment objective of the accountaccount

►Does it take into account income, Does it take into account income, principal and/or remainder bene’sprincipal and/or remainder bene’s

► Is the asset a type that is one of your Is the asset a type that is one of your firm’s asset allocation typesfirm’s asset allocation types

►Will a re-allocation be needed if the Will a re-allocation be needed if the asset is acceptedasset is accepted

Asset Set Asset Set Up/Pricing/ValuationUp/Pricing/Valuation

►Do you have the appropriate types of Do you have the appropriate types of asset codes to ensure that the asset is asset codes to ensure that the asset is set up properly and can be monitoredset up properly and can be monitored

►Will the pricing feeds automatically Will the pricing feeds automatically price the asset or will manual pricing be price the asset or will manual pricing be necessary, if manual necessary what necessary, if manual necessary what will the pricing be based on and how will the pricing be based on and how often updated?often updated?

►Will the valuation meet regulatory/legal Will the valuation meet regulatory/legal requirementsrequirements

DiversificationDiversification

►Generally requiredGenerally required►What is your policyWhat is your policy►Will the acceptance of the asset cause Will the acceptance of the asset cause

a concentrated position, concentrated a concentrated position, concentrated asset type, sector, industryasset type, sector, industry