One of the best things about being a freelance financial writer and blogger is that I often learn new things in the course of my writing. A reader recently left a comment on a post here on the blog and mentioned reverse churning. Until that time, I had never heard this term, but after a bit of research its’s one more thing that clients of stock brokers and registered reps need to be aware of.
What is churning?
Investopedia defines churning as “Excessive trading by a broker in a client’s account largely to generate commissions. Churning is an illegal and unethical practice that violates SEC rules and securities laws.”
Churning conjures images such as the boiler room in the movie Glengarry Glen Ross (actually they sold real estate) or the iconic 2002 ad by Charles Schwab (SCHW) in which a brokerage house manager is depicted as telling the brokers, “Let’s put some lipstick on this pig” in reference to a sub-par stock he wants them to pitch to clients.
What is reverse churning?
A 2014 piece by Daisy Maxey in The Wall Street Journal describes reverse churning as follows:
“The Securities and Exchange Commission says the practice of so-called “reverse churning”–putting investors in accounts that pay a fixed fee but generate little or no activity to justify that fee–is on its radar. Regulators will be watching for signs of double-dipping by advisers who generate significant commissions within a client’s brokerage account, then move that client into an advisory account and collect additional fees.”
Evidently this occurs in brokerage accounts that at one point generated significant commissions for the broker from the purchase and sale of individual stocks or other commission generating transactions. If the activity in the account tails off the broker makes little or nothing from this client.
As a way to generate continual fees from this type of client the broker may suggest moving to a fee-based advisory account, often called a wrap account.
Under this arrangement there is an ongoing fee based upon the assets in the account plus often trailing commissions in the form of 12b-1 fees from the mutual funds usually offered in this type of account. These generally include proprietary mutual funds offered by the brokerage firm or at the very least costly actively managed funds in share classes geared to offering broker compensation.
Fee-based is not fee-only
Fee-based is often confused with fee-only. I suspect the brokerage industry likes it this way.
Fee-only compensation, which I wholeheartedly support, means that the financial advisor earns no compensation from the sale of financial products including trailing fees and commissions. Their fees come from their clients. These can be hourly, a flat-fee or as a percentage of the assets under management.
Fee-based compensation, also called fee and commission by some, is a mix of the two forms of advisor compensation. A common form of the fee-based model entails the client paying the advisor to do a financial plan and then if the client chooses to have the financial advisor implement their recommendations this will often be via the sale of commission-based products.
The version with fee-based advisory accounts associated with reverse churning by brokers and registered reps arose out of a 2007 rule that prohibits the charging of fees in brokerage accounts. Many broker-dealers have a registered investment advisor (RIA) arm which runs these accounts.
The fiduciary rule
The new fiduciary rules makes fee-based accounts more desirable for brokers and other fee-based advisors. These types of accounts will become even more prevalent with the disclosures required for retirement accounts under these new rules.
There has been a movement towards fee-based accounts in the brokerage world for several years now, likely in anticipation of the eventual issuance of these rules. This movement should accelerate in IRAs. In some cases, this will be a good thing as clients will fully know what they are paying in terms of fees.
In other cases, clients will find themselves paying 100 basis points or more in wrap fees for accounts where they were formerly trading infrequently on a commissioned basis. Whether the fee-based account will be a better deal will vary.
If all they are getting is an expensive managed account filled with bad to mediocre mutual funds that charge high fees on top of the wrap fee, this is not a good deal. If the advisor does little more than collect a fee, this sounds like the definition of reverse churning based on my understanding of the term. Much will depend upon the level and types of advice clients receive for the fees they will now be paying.
If you are working with a stock broker or registered rep and they propose moving to a fee-based or wrap account, you should take a hard look at what you are being offered. What is the wrap fee? What types of investments are used in the account? Are they expensive actively managed mutual funds that throw off 12b-1 fees in addition to wrap fees? What is the track record of the manager of the account that the advisor is proposing? What types of advice and service will you receive for the fees you will paying?
The Bottom Line
I can’t recall hearing about a case of churning in recent years. Reverse churning is a new term to me, but from the perspective of a broker or registered rep fee-based advisory accounts make a ton of sense. They provide ongoing fee income and frankly require little attention from them. If your broker proposes a wrap account to you make sure you understand how this arrangement benefits you the client. Clients of brokers and fee-based advisors are likely to see more of these types of accounts proposed to them as the implementation of the new fiduciary rules nears.
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