The Discretionary Mandate Drift
A discretionary portfolio manager at a registered advisory firm manages a retired client's account under a mandate that specifies a 40-60% equity range and a maximum 20% allocation to a single sector. Over eight months the manager has built a 34% position in technology stocks, arguing that earnings momentum justifies the overweight. The client has not been informed; the internal compliance system flags breaches only at quarter-end, and the last check showed 33% tech with no action taken. The client calls to ask why the account fell 9% in a month while a peer's account fell only 3%. The manager wants to rebalance quietly before the next compliance cycle and avoid mentioning the breach.
1. Identify the compliance and ethical issues raised by the manager's proposed course of action.
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Three distinct problems, layered:
Mandate breach. The 20% single-sector cap is a contractual constraint, not a guideline. Holding 34% is a breach regardless of performance rationale. Momentum is not a documented exception unless the IPS or investment policy allows tactical deviations in writing.
Control failure. A quarter-end-only monitoring system is inadequate for a hard limit. The firm should have pre-trade and daily post-trade checks. The manager's knowledge of the breach triggers an obligation to escalate, not to self-remediate silently.
Ethical failure in the proposed fix. Rebalancing quietly to hide the breach is concealment. The client asked a direct question about relative underperformance; the honest answer connects the loss to the concentrated position. Under professional standards, the manager must disclose the breach, correct it, and report it internally. Silent correction destroys the audit trail and prevents the firm from assessing systemic control weaknesses.
The correct path: disclose to the client, notify compliance, rebalance to mandate, and recommend tightening monitoring frequency.
2. How should the manager respond to the client's question about relative performance?
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Directly and without spin. The peer's account was presumably within its sector limits; the client's account carried an out-of-mandate 34% tech weight, which amplified the drawdown. The manager should:
- Explain the concentration and that it exceeded the agreed 20% cap.
- Acknowledge that the client was not informed and that this was the firm's failure, not the client's.
- State the remediation: rebalance to mandate, review the IPS with the client, and confirm ongoing monitoring.
What the manager must not do is attribute the loss to "market conditions" while omitting the concentration. A half-true explanation that survives scrutiny only because the client lacks the data is still misleading.