On July 27 I offered some comments on "discretion," from a "GIPS" perspective. This resulted in a few responses, so I thought I'd comment further.
Firms have discretion on how they define discretion ... within reason, of course. But, their rules need to be clear and testable. That is, two parties looking at the firm's rules should draw the same conclusions.
Let's take restricted securities. If a new client includes securities in their portfolio that you can't sell is the account non-discretionary for GIPS (r) purposes? Not necessarily. This question was addressed a long time ago (1992), in a handy "Answers to Common Questions" brochure that AIMR published for the AIMR-PPS(R).
Most accounting systems allow you to flag the account as "restricted" or "non managed," so that it will be excluded from performance. [A key point: the return on such assets are NOT to be included in your performance. On occasion we've found firms that incorrectly included it. Technically, any income (interest or dividends) from these assets should also not be included with the account's performance.]
You CAN, if you so choose, to make a blanket statement that the presence of ANY restricted security, no matter how small, would cause the account to be non-discretionary. I happen to think that this wouldn't be a good idea as it could possibly exclude a lot of accounts and, in many cases, these securities don't impede the manager's ability to invest. The last point is really the important one: does the presence of these restricted assets cause the manager to alter their strategy in such a way that the result really doesn't bear much resemblance to what would have happened had there not been any restricted assets present [talk about a run on sentence!].
As firms broaden their inclusion rules (and as a result, narrow their rules for non-discretion), we can anticipate an increase in dispersion. This is the trade off the manager faces. There are pros and cons, as well as benefits and disadvantages, [I guess I'm being redundant] to each approach. The good news: the manager decides. The bad news: many firms get it wrong. Yes, managers have discretion over discretion, but it's easy to make mistakes. Thus, having a trusted and knowledgeable advisor, consultant, verifier handy is always a good idea.