Why Reverse Churning Is About To Become A Big Advisor Problem

In the past, the practice of broker churning has been a major concern for regulatory agencies. Churning is when a broker encourages trading in a client’s account for the purpose of running up commission fees.

However, a regulatory crackdown on churning in recent years coupled with a new SEC exemption in 2005 that permitted fee-based compensation for brokers has now created a brand new regulatory headache: reverse churning.

Reverse churning occurs when an advisor places a client’s money into a fee-based advisory account to rake in management fees and then performs little or no actual management from that point forward.

“Now that we’ve had fee-based accounts for a number of years, regulators are starting to get concerned that there’s a subset of advisors out there who are gathering assets into fee-based wrap accounts, and then not actually doing anything… never calling the client, never engaging any trades, never doing something to validate the ongoing management fee they’re earning,” financial planner Michael Kitces recently said on his podcast.

“They’re just gathering up lots of assets and moving on to the next client and taking an ever-growing volume of management fees without doing any management.”

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Unfortunately for regulators, the line between true reverse churning and prudent passive investment strategies can be very blurry. However, Kitces believes the reverse churning problem may be getting big enough for regulators to make it a priority in the near future.

In the meantime, Kitces urges financial advisors, particularly those that utilize passive investing strategies, to document everything they are doing to maximize their clients’ returns.

Earlier this year, American International Group Inc AIG paid a $9.5 million settlement related to charges of reverse churning.

Disclosure: The author holds no position in the stocks mentioned.