Although many of us invest in the markets, we often don’t know how they manage our accounts due to a lack of time or deep interest. As a result, we typically hire a financial advisor to assist. Trust is placed with the financial advisor to while is responsible for diversification and a balanced portfolio. To be proactive, you should understand the strategies that are being used by your financial advisor. However, there are situations where the financial advisor will “set it and forget it” and still charge you a fee based on the number of assets they are managing in your portfolio. When this happens, the financial advisor’s lack of activity and management of your portfolio is called reverse churning.
What is Reverse Churning?
According to the Wall Street Journal, reverse churning boils down to your financial advisor doing little, to nothing, with your account. The investor makes very few adjustments or transactions on behalf of the client. The client, however, still pays an annual fee directly to the firm. The SEC no longer accepts this type of practice within investment firms. Notably, there have been recent enforcement cases where the SEC levies charges against financial advisor and the firms that condone this practice. You typically will not see reverse churning in smaller investment accounts. Instead, firms concentrate on higher-fee accounts with larger assets under management to ensure they profit from the client. At the end of the year, the advisor has not done anything to grow the client’s assets but still collects a substantial fee. Unlike churning, reverse churning is a passive practice. The first appearance of reverse churning appeared around 2005. During this year, the SEC launched a widespread campaign to examine financial advisor and their practices closely. During the sweep, actions such as churning, double-dipping on accounts, and reverse churning were all found.
Many of the legal issues surrounding reverse churning directly connect to the trend of getting more clients to switch from commission-based accounts to fee-based accounts. Fee-based accounts have a higher expense due to the charges related to any services performed by the firm. Fee-based accounts grew in popularity due to regulations surrounding retirement accounts. According to Investment News, many firms chose fee-based accounts as a direct response to the compliance demands set forth by the Fiduciary Ruling from the U.S. Department of Labor. In essence, the Department of Labor requires that financial advisors to retirees must always act in the client’s best interest. Under the ruling, no conflict of interest is allowed, and the firm must fully disclose all fees. The Fiduciary Ruling was not popular with financial advisors and has gone through a significant amount of debates over the years. Reverse churning cases increased following the Fiduciary Ruling. However, no client should have a fee-based account if it’s not in his or her best interests. The gray area is whether firms are moving clients to fee-based accounts for reverse churning purposes or if the setup is genuinely beneficial.
Registered Investment Advisors have lost millions and millions of dollars due to reverse churning. In one recent legal battle with the SEC, the commission charged a group of Registered Investment Advisor firms with levying unnecessary fees to more than 1,000 clients. The SEC brought charges against the firms for not monitoring the accounts and participating in the act of reverse churning. The firms paid approximately $10 million to settle the reverse churning charges. Another lawsuit has launched against the investment firm Edward Jones. As part of this lawsuit, the plaintiffs claim that the firm charged unnecessary fees on fee-based account clients.
Most fee-based accounts are subject to reverse churning. Fee-based accounts average a management fee of approximately 1 percent, based largely on total assets under management. The management fee, however, may change based on what services the investment firm includes and the size of the portfolio. If you trade often, then fee-based accounts are usually recommended over commission-based accounts. For those who rarely trade, of use a “buy and hold” strategy, a commission-based is usually the best bet.
The choice is always up to the consumer whether or not to choose a fee-based account. Investment firms may recommend a particular account type, but regulations prevent them from pushing a specific type of account on the client. Clients should always keep a close eye on portfolios to confirm that they are not the victim of reverse churning strategies, or other improper investment schemes.