Historically, churning – where a broker encourages excessive trading in a client’s account in order to generate a large volume of trading commissions – has been a significant regulatory concern. In fact, the rise of fee-based brokerage and wrap accounts, and the ongoing shift to advisory accounts, has been driven heavily by regulators encouraging the switch, specifically because brokers who aren’t paid based on the number and frequency of transactions don’t have any incentive to churn accounts. However, it now appears that the efforts to stamp out churning may have been “too successful” – giving rise to an emerging new problem: reverse churning.
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we look at the concept of “reverse churning”, where an advisor charges an ongoing investment management fee, and how it is likely to be a growing regulatory concern in the coming years, as the DoL fiduciary rule spurs a massive shift towards various forms of fee-based brokerage and advisory accounts.
Arguably, the regulatory concern about reverse churning – where advisors charge an ongoing investment fee but fail to provide any substantive ongoing investment services – is appropriate. However, the scrutiny on reverse churning raises troubling concerns when paired with the growing popularity of using index funds, ETFs, and passive investment approaches. How is an advisor supposed to justify an ongoing advisory fee when the right thing for the client to do might really be to do nothing? And what if the bulk of the advisor’s AUM fee is actually for other non-investment (i.e., financial planning) services, paired together with an otherwise passive investment portfolio?
Ultimately, the regulators may be pressured in the coming years to more clearly delineate the difference between true reverse churning, and a prudent passive investment approach. But in the meantime, advisors that charge AUM fees – especially those who espouse a passive investment philosophy – would be well served to clearly and rigorously document exactly what they do for clients on an ongoing basis, to avoid the risk of a reverse churning allegation in the coming years!