Is My Investment Advisor Worth It? How to Spot Account Neglect

Want to know if you’re getting your money’s worth from your investment adviser? Look out for reverse churning.

“Reverse churning” is when your investment adviser collects a management fee for your investment portfolio without performing any management duties, like executing trades. This is a type of financial misconduct — charging investors management fees without doing any work goes against SEC rules. As fiduciaries, investment advisers are required to act in their investors’ best interests.

The SEC has recently highlighted reverse churning as an area where existing rules may not offer sufficient investor protections. You may be more familiar with “churning,” which is one of the most common investor complaints. Churning occurs when an advisor executes an excessive number of trades to generate more commissions for themselves, to the financial detriment of their investor. FINRA has a formula that determines if a broker has engaged in churning, but it can be less clear if an investment advisor has engaged in reverse churning.

What Type of Investor Portfolios Are Vulnerable to Reverse Churning?

Investors can choose from securities accounts that charge either per transaction or a percentage of the assets under management (AUM). Reverse churning involves portfolios with AUM fee structures. Most accounts charge around 1% per year. That may not sound like much, but 1% of $1,000,000 is $10,000 — quite a lot to be paid for not performing any work.

Investors might hear the term “under management” and assume they don’t need to do anything to ensure their account generates healthy return. After all, the investor is paying the investment adviser for their expertise. Unfortunately, some investment advisers might take advantage of a distracted or cognitively impaired investor.

What is the Difference Between Passive Investment and Reverse Churning?

To make matters more confusing, some financial advisers utilize a legitimate passive investment strategy. This involves buying shares and holding them over a long period of time, allowing the portfolio to slowly accumulate a healthy return. From the outside, it may look like the adviser isn’t doing anything. Advisers might also refer to this as a “buy-and-hold” strategy.

While this is a legitimate strategy, investors should consider lower-cost options. There are passive investment vehicles that charge lower fees and do not come with the risk of reverse churning. Most broad market exchange-traded funds (ETFs) charge around .4% to .74% in fees and can expose the investor’s portfolio to a sizable swath of the market. Index funds also expose investors to a variety of stocks, and charge even less — investors can expect to pay 0.2% to 0.5% in fees.

Reverse Churning Cases: Raymond James Fined $3,000,000 By the SEC

The SEC fined Raymond James after they found that the firm failed to properly review 7,708 advisory accounts that had no securities trading activity for at least 12 months. The inactive accounts, meanwhile, had paid $4.9 million in advisory fees to advisers who had not fulfilled their fiduciary duties.

Raymond James’ brochures stated that they would “regularly monitor” their advisory accounts to ensure suitability. Their own policies required a suitability review of managed accounts to ensure that the firm could justify its fees. Raymond James also had policies in place that required reviews for accounts that remained inactive for 12 months.

Once the SEC started their investigation, Raymond James’ advisers conducted suitability reviews. Only then did they discover that 1,703 of the inactive accounts were unsuitable for fee-based advisory arrangements. As a result, Raymond James converted them to brokerage accounts. They also closed 2,112 inactive accounts.

The SEC fined Raymond James $3,000,000 following their allegations. You can read a copy of the order here.

What Can I Do to Avoid Reverse Churning?

Investors should do their homework and regularly review their accounts. You can ask your investment adviser how often they plan to execute trades, and then monitor your account to make sure they follow through. Most importantly, investment advisers should also be able to explain their investment strategy. If they incur losses by ignoring their fiduciary duty, it’s time to contact a securities attorney and pursue a reverse churning lawsuit.