How to know if your investment portfolio is a victim of churning
What is churning?
Churning refers to a frequent turnover of clients’ investments by traders with the aim of getting more commissions. As the trades executed are not in the client’s best interest, it is considered an investment fraud and is illegal.
Why do traders churn?
Traders typically earn their commission in one of two ways, through annual management fees or transaction charges. For transaction charges, when traders execute a transaction, they can immediately take a cut of the transacted amount. This means that every trade made translates into immediate income for the traders.
As such, should a trader choose to cash in on quick returns at your expense, he can carry out an excessive number of trades to maximise commissions.
Why is churning bad?
Churning eats into your investment returns, leaving you with an unoptimised portfolio that does not prioritise your interests at all. The expenses incurred are significant, and does not add value to your portfolio performance.
Needless to say, churning harms customers.
A few years ago, a US broker churned the account of a 93-year-old Holocaust survivor, causing the customer to lose over $700,000 while the broker made almost that exact amount in commissions.
Types of churning
Many people have the misconception that churning is limited to having an excessive volume of trades. However, churning takes place in many forms. Your wealth manager can also do this by switching the types of financial products allocated as well. For example, he/she can switch your mutual funds to unit trusts, and then to annuities.
Do note that this does not mean that traders who charge for every transaction are automatically churning. We are talking about a small population of bad apples.
While there are more than one type of churning, the end result is always the same. Your portfolio will be left in a less than ideal state, and your money would not have been used efficiently.
How can you detect churning?
Unfortunately, it can be difficult to detect churning, especially if the customers are not really paying attention to their account statements.
Even with safeguards in place by trading platforms, the broker can circumvent them by going below the benchmark so that you will not receive any alerts. For example, he can have a trade volume just slightly under the threshold such that he will not be detected, or selectively churn using customers who are least knowledgeable or who are too busy to check their accounts.
Thankfully, there are two key indicators to watch out for.
Turnover rate
This refers to the number of times that your securities are being replaced by new securities.
Generally, FINRA and other regulators view turnover rates of 6 or more as suggestive of excessive trading.
Cost-equity ratio
This refers to the amount your account would need to appreciate to break even. If your cost equity ratio is 20%, it means that your account will need to appreciate by 20% for you to cover your costs.
FINRA and other regulators believe that cost equity ratios of 20% or more is suggestive of excessive trading.
Do note that these are indicative figures, and may not apply to every investor. Each investor has a different risk appetite and profile. If you adopt a high risk and active trading strategy with a speculative investment objective, you may have a higher turnover rate and cost-equity ratio as compared to a more conservative investor.
Generally speaking, if you notice trades being made that do not increase the value of your investment accounts, it is a cause of concern.
The traders could be intentionally switching to different products that are not in your best interest for personal financial gain. This can be supported by the overall trend of the market, as if it is trending upwards and the value of your account remains the same or lower, something could be amiss.
Another indicator could be you receiving multiple updates or confirmations informing you of switches to other mutual funds or annuities. If you are receiving these many times a week or a month, it could be a sign of account churning.
Lastly, if your broker, brokerage firm, or financial planner is unable to provide sound reasons for the transactions made, it is a sign of churning. If you are a value investor, but they are doing seemingly random in-and-out sales, it is a cause of concern.
If they are unable to justify their move, something is very wrong.
Seek a second opinion
If you feel suspicious, it means that your wealth manager has either not explained his actions to you well enough, or may have made some questionable moves to make you feel that way.
As investors, it is your job to routinely check your account statements and review your account balances and have an idea of the trading volume that typically goes on in your account. Make sure that you are comfortable with the trading volume that is present, and be ready to seek clarifications should there be any deviation from the norm.
If you have doubts about whether your current wealth manager has your best interests, it can be useful to seek a second opinion.
Having a second opinion can inject a new sense of insights and objectivity into how you view your investment portfolio. This second pair of eyes may be able to see certain blind spots that you may have missed.
Here at Life First Advisory, we charge an annual fee to ensure that our interests are well aligned. Think of it as a retainer fee for our professional wealth management services.
Speak to us for a non-obligatory consultation today.
If you would like to kickstart your wealth management journey, reach out to us too. Afterall, it is never too soon to start financial planning.