Executive Summary
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!
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Welcome, everyone! Welcome to Office Hours with Michael Kitces!
For the topic today, I want to talk about reverse churning.
Churning And Reverse Churning [Time - 0:16]
Almost anybody in the advisory business is familiar with churning. Churning occurs when a broker encourages an unusually high volume of transactions for a client, each of which generates a commission, which can cumulatively rack up a lot of commissions and income for the broker. The key to what makes it "churning" is excessive trading, where there's not actually a good reason to do the trades in the first place, and it was just done to generate brokerage commissions.
Unfortunately, we still see from time to time, complaints come through on FINRA that get announced regarding some broker that did a terrible amount of churning and chewed up the client's investment account, racking up transaction costs in the broker's favor.
Historically, churning has occurred in lots of different contexts. FINRA focuses on it regarding brokerage accounts, where the broker churns stocks , but churning investments of any sort is still a problem. It could be A-share mutual funds, it could be annuities, it could be churning insurance products. Anything that generates an upfront commission creates some conflicted incentive to create churning activity for a commission-based broker.
But the interesting shift that we've had over the past couple of years is regulators starting to ask questions about what they're calling reverse churning. If churning is generating too many transactions in the account just to generate commissions, reverse churning occurs when the advisor puts the investor into an advisory or fee-based wrap account, charges a management fee, but then doesn't actually do anything to earn the ongoing fee.
In other words, from the regulator's perspective, the concern with reverse churning is an advisor charging an ongoing management fee as though there will be ongoing management, but then the advisor just sits on the account and doesn't actually do anything, and therefore is not earning the fee.
The Rise Of Reverse Churning In Fee-Based Wrap Accounts [Time - 2:15]
Historically, churning has been a problem, because most registered reps with broker-dealers were compensated for transactions, which created the incentive to do an unnecessary volume of them. If the broker traded less frequently, there were simply fewer trading commissions. It wasn't "reverse churning", because there was no management fee.
In the past 15 years, though, we've seen the rise of fee-based accounts. It started with an exemption that the SEC gave broker-dealers back in the late 1990s (and finalized in 2005), allowing them to offer fee-based wrap accounts and receive an ongoing fee, without registering as investment advisers. It was used heavily by large wirehouses - and thus was also known as the "Merrill Lynch" exemption. Eventually, the FPA challenged it in court, got it struck down, which forced those charging ongoing fees to actually register as investment advisors, spawning the explosion of hybrid and dually registered advisors.
The good news is that wrap accounts and advisory accounts really do seem to be cutting down on churning. This was actually the primary justification that the SEC gave all the way back when the exemption was first proposed - they were trying to cut down the incentives for churning. Because with a fee-based wrap account, the broker gets the same compensation no matter how many trades occur, so there's no longer an incentive to rapidly trade and churn the account.
But 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. 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. And thus "reverse churning" is born.
So we're seeing SEC ask questions about reverse churning, along with FINRA beginning to focus on it, and I think it's about to become an even bigger deal because the DoL fiduciary rule also raises questions about reverse churning. In the preamble for DoL's fiduciary rule, they specifically noted that advisors charging ongoing management fees better be able to document and substantiate that they're doing something to earn their ongoing fee, and that they didn't just put someone into an advisory account (within an IRA), collect a management fee... and then not actually do any management.
DoL is actually putting so much scrutiny on reverse churning that even the recommendation for a client to switch from a brokerage account to an advisory account - from paying per-transaction commissions to paying AUM fees - that switch itself will be subjected to scrutiny as a fiduciary recommendation for a retirement investor. Such that you not only have to validate what you invest them in within the advisory account, you actually have to validate the switch to the advisory account, too.
The Problem with Reverse Churning For Real Financial Advisors [Time - 5:12]
So here's the problem that crops up with reverse churning, for real advisors.
I should say first that I'm supportive of the concept of enforcing against reverse churning. I'm not a fan of brokers that go out there and gather lots of investments, charge advisory fees, and do nothing for their clients on an ongoing basis.
But here's the problem. As many of us experienced advisors have learned, sometimes the best thing the advisor can do is help the client to do nothing.
That's the whole point of advisors helping clients to close the behavior gap. The client calls and says "Hey, the market's crashing. What should we do?" The answer from the advisor: "Nothing! Sit tight. Don't trade. Don't day trade in a bear market. Don't go to cash. Just hang tight, hold onto your investments, give them a chance to recover."
The problem now is regulators are raising the question: "Was that a good recommendation, or is that reverse churning because you told the client to do nothing?" And unfortunately, there's really no clear delineator for where reverse churning begins, and merely prudent passive investing ends.
Ironically, there's almost something implicit in a label like "reverse churning" - it suggests that the natural role of advisors is to always be doing something to validate our fee. Even as the whole rise of passive strategic investing is suggesting maybe the best something-to-do is nothing.
This makes it uncomfortably challenging for good advisors, trying to reconcile being a good advisor that espouses passive strategic investing, and not getting whacked with the reverse churning claim a couple of years down the road.
Because, again, it's not clear what has to be done to not be reverse churning. We know that active managers charge more than passive managers, so perhaps as long as your management fee is low enough, it won't be reverse churning. But what's an "okay fee" for doing passive strategic portfolio design?
Or maybe some number of trades is still okay, even if it's just very low. Maybe you just have to regularly communicate with the client to validate that you're doing something. Your "do-something" is a proactive phone call telling them to do nothing, and if you can show that you're regularly communicating with the client to tell them to do nothing, maybe that's okay?
But it's not clear. And I think this is a real challenge, that's going to get even messier in the next couple of years, because of the huge shift towards fee-based accounts and advisory accounts that the DoL fiduciary rule is driving. The rule may be a good shift - because I'd still argue that churning has done worse things to clients than reverse churning. But it's really concerning that there is rising scrutiny of reverse churning, and very fuzzy about how good advisors validate when we're not reverse churning and are just helping clients stay the course and manage their behavior gap.
Reverse Churning And Financial Planning AUM Fees? [Time - 8:28]
Reverse churning risk gets even messier if you're not just an investment advisor, and instead are a holistic financial planner. I'm talking about all of us that bundle together financial planning services with investment management services, where maybe a significant portion of our AUM fee is for the non-investment portion of our services...
Now, I know there's a whole discussion out there about whether AUM fees are the wrong pricing for financial planning, and some question whether clients are being overcharged for financial planning with the AUM model. But work with me for a moment - let's just assume that the fee is fair for now, and that we're charging a client a reasonable fee for the financial planning and the investment management.
So here's the question: if the advisor endorses a passive investment strategy, plus provides ongoing financial planning, all for a single AUM fee... how does an investment regulator, like the SEC or DoL, properly vet whether someone is doing good, real financial planning to validate this AUM fee, and not constitute reverse churning?
Because, unfortunately, these are regulators that don't have any real purview over financial planning, particularly the non-investment portion of financial planning. I'm not sure they have the right tools to evaluate and vet whether the advisor is earning the non-investment portion of the AUM fee. We don't exactly have a lot of standards around the expected process for, or determining competency of, financial planning and financial planners.
Which means financial planners charging AUM fees for financial planning advice plus passive portfolios may be on a collision course with the DoL fiduciary rule. And the DoL is going to be scrutinizing reverse churning. It's inevitable, as the rule is not only a huge nudge for advisors to move towards levelized compensation - which basically means AUM fees and fee-based wrap accounts of various types - but because the switch from brokerage account to advisory account will itself be a fiduciary transaction.
In fact, I suspect that we'll see is, in the roughly eight months between now and when the rules take effect next April, there's going to be a huge push by broker-dealers to swap people into fee-based advisory accounts. Because if you do it before next April, you just have to justify it under the existing FINRA rules. If you do it after next April, you have to justify it as a fiduciary change. But still, once we're there under the fiduciary rule, there's still scrutiny on those fee-based advisory accounts to determine whether the advisor is now reverse churning, or actually earning the ongoing fee in that new advisory account.
And, again, it's not bad for consumers to ask good, hard questions about what does an advisor do to earn their ongoing fee... but it's a really awkward challenge when you combine that with the growth of passive investing in ETFs, and the view from a lot of advisors that the right thing to do for many clients is to do nothing. Be passive, be strategic, keep your costs low, regularly rebalance, maybe do some tax loss harvesting. We're going to add some other value outside the portfolio in the financial planning realm. But this is not compatible with the existing landscape of reverse churning regulations.
Reconciling Reverse Churning And Bona Fide Passive Investing? [Time - 11:49]
So if you are an advisor that has a passive strategic investment approach, I'm going to warn you now: start documenting what you do for clients on an ongoing basis. You're going to want this documentation at some point down the road.
I'm not saying you're doing anything wrong. But the point is that you're going to need to be able to validate that you're doing something, or at least that you affirmed the appropriate "doing something" is to do nothing. Which means showing that you're still regularly meeting with clients, communicating with clients, and doing something to validate the relevance of your ongoing fee. You're going to want these notes in the client file, or in your CRM, to validate what you're doing as an advisor. Or you risk a reverse churning allegation, that you're just putting clients into a passive portfolio and then never doing anything to substantiate your ongoing fee.
So unfortunately, the enforcement of reverse churning really is a bit of a double-edged sword. Real reverse churning where investors are charged when the advisor does nothing for them is bad. But a lot of prudent passive investing involves the proactive decision to do nothing. And it's not always entirely clear how to separate the two. Especially when the advisor is also earning their AUM fee from non-investment-related activity.
But the bottom line is that you can expect this to be an ongoing regulatory issue. More than ever in the next couple of years, as the DoL drives more advisors towards advisory accounts and fee-based wrap accounts, which invites both the DoL - and the SEC and FINRA - to ask questions.
So I hope this has been some helpful food for thought around the rise of reverse churning. Thanks for joining Office Hours with Michael Kitces, 1:00pm East Coast Time on Tuesdays. Have a great day, everyone. Take care!
So what do you think? Is reverse churning a legitimate concern? How should regulators distinguish between advisors who really do nothing to earn their management fee, and advisors who earn their management fee by proactively convincing clients to do nothing!? Please share your thoughts in the comments below!
While we’re at it, we might ask why fund companies can justify charging asset-based fees on their passive index funds. All of the costs associated with Vanguard running its S&P 500 ETF (VOO), for example, are fixed and per capita. There’s no question of aligning the incentives of the manager with the clients via an asset based fee, since the “manager” is just a licensing agreement with S&P, which is the only one exercising any real discretion. So if the regulators are going to go after advisers who charge asset-based fees without provisioning services to match them, then they should go after Vanguard, State Street, etc. as well.
Asset-based fees have a rationale when they’re for discretionary investment management; not so much for mere asset allocation _or_ the mere licensing of index data.
By correcting these “wrongs”, Uncle Sam is actually dictating how we give advice and how someone should invest. Only the disclosure of fees/commissions/whatever should be enforced. It’s up to the client to decide if they’re getting value for the buck, not Uncle Sam! Even Warren Buffett promotes the benefits on “sitting on your hands”, when tempted to do something. Maybe he shouldn’t collect a paycheck, for the years he does nothing…
Hi Michael,
I think the information you provide on this blog is incredibly helpful.
From my point of view, the discussion of reverse churning seems to always start with the assumption that financial advisers “do nothing” once an account is invested — just continue to take the fee based on assets under management. However, in my experience working for and with registered investment advisers, their fiduciary obligations and Rule 206(4)-7 under the Advisers Act (the “Compliance Program Rule”), require them to have policies and procedures in place to document the process for monitoring client accounts. This includes providing documentation that the reviews take place. Additionally, the Form ADV Part 2A, the disclosure document investment advisers are required to provide to all clients, requires advisers to disclose whether they periodically review client accounts or financial plans, the frequency and nature of the review, and who is conducting the review. But the review is a two-way street — the client has to provide input periodically. Many investment advisers go over a client’s portfolio with that client at least once a year, and request disclosure of any changes to the client’s financial situation. Obviously if the client has no changes to report, then it may be appropriate to continue with the current strategy.
Even if the strategy remains appropriate, it has been my experience that most investment advisers are reviewing and monitoring performance of account investments periodically. Clients demand it, especially in times of market volatility. The DOL’s Fiduciary Rule simply re-emphasizes an obligation that registered investment advisers already have — to continuously manage their clients’ assets.
There may be more of uptick in looking at these processes from SEC examiners, but up to this point, there haven’t a lot of fines, sanctions or other serious penalties imposed on advisers for “failure to manage.”
This may be more of an issue on the broker dealer side of the business.
Jaqueline M. Hummel, Managing Director
Hardin Compliance Consulting
Jaqueline,
The focus on reverse churning definitely originated on the broker-dealer side of the business, precisely because they don’t have as much of a framework around obligations for ongoing monitoring of client accounts.
But ultimately, I don’t think that means that RIAs are immune. If only because what the SEC calls “reverse churning” for an RIA could simply BE a violation of Rule 206(4)-7 for failure to have (and properly implement) a process for monitoring client accounts. Different rule framework for consequences, but similar concept?
– Michael
I agree with you that RIAs are not immune from reverse churning. My point is that RIAs are already required to perform ongoing monitoring because of their existing fiduciary duty and IA Rule 206(4)-7. SEC staff routinely requests documentation with respect to the review of client accounts and process for monitoring investments. Therefore, there should be some distinction (by the media and regulators) between a buy-and-hold strategy, which may be appropriate for investors with long-term investment goals and a “set it and forget it” strategy, which would not meet fiduciary standards. Investors should not jump to the conclusion that if an adviser isn’t trading an account that he/she isn’t doing his/her job. The decision to hold a security for the long term is also an investment decision. Thanks!
Jaqueline Hummel
I agree with most of the comments below. However I always have trouble with the idea that “passive investing” means doing nothing. Most advisors recommending etfs and index funds still have to research the funds, determine the clients risk tolerance, monitor and rebalance the portfolio, and provide other services. That can be a lot of work.
The other issue is with inactive clients that choose to be disengaged from the process. They don’t meet with their advisor, don’t respond to emails or phone calls, etc. Even if you have discretionary authority over your clients accounts its hard to operate in a vacuum for years at a time. Where does the client responsibility come in?
Lastly, I wonder how long an account has to sit before reverse churning becomes an issue. How many trades constitutes reasonable activity? What about the size of the trades? Annual rebalancing might make for a happy compliance officer but does it always add meaningful value to the client?
I feel that these regulations often create more questions than they answer. If clients file a formal complaint the advisor better be able to justify his actions (or inactions). If the client doesn’t have any complaints I don’t see why the regulators should intervene.
The irony here is that an advisor can charge a fee to move money around in actively manged, over priced, underperforming mutual funds, do a poor job of managing client assets and offer no financial planning services, and that’s OK. Or you can sell a variable annuity with a BICE agreement and do the same thing. That’s OK too. But if you put together a portfolio of low cost index funds that you “buy and hold” and pair that with a comprehensive financial plan for no additional cost other than the AUM fee, that’s a problem.
Mike,
Your last paragraph summarizes the issue perfectly. :/
– Michael
I can appreciate your main points albeit not in a positive way (from the perspective of the client). You make the argument that “Most advisors recommending etfs and index funds still have to research the funds, determine the clients risk tolerance, monitor and rebalance the portfolio, and provide other services” can be a lot of work.
1) There are numerous “Lazy Portfolio’s” available that perform just fine over 3, 5, 10+ year time horizons. What research is required to select the total stock market index, total international stock market index, and total bond index?
2) How hard is it to determine a clients risk tolerance? Usually they’ll have you fill out a survey with leading questions – 5 minutes. It can be as simple as using your age: 40 year old will invest 40% in bonds and 60% in equities. In most cases, if your time horizon is 10+ years (depending on your goals) it doesn’t really matter. There are 60 year olds in 60% equities and 60 year olds in 60% bonds but over time the returns are very similar.
3) Rebalancing? If you can do basic arithmetic you can adjust your allocation once a year in a very emotionless way (same day every year regardless of the market conditions, adjust your allocation back to its original %’s). An added benefit of rebalancing is tax loss harvesting (whether you meant to or not). Rebalancing once a year is not hard work and basic arithmetic is anything but complex.
4) Provide other services? Quarterly meeting with the client? Client phone calls? Sending annual gift because they feel guilty charging AUM fee? In that sense, you’re really sending yourself a gift.
The last paragraph of the comment is the most enlightening. “But if you put together a portfolio of low cost index funds that you “buy and hold” and pair that with a comprehensive financial plan for no additional cost other than the AUM fee, that’s a problem.” By your own admission you will encourage your clients to buy and hold a portfolio of low cost index funds and charge an annual AUM fee knowing that they could achieve this more cheaply and simply on their own. Is my assessment too simplistic, absolutely. Is it generally accurate, yes. I know there will always be a large group of lazy people (doctors, lawyers, elderly, etc.) using FA services but I can’t help but think you’ll be losing huge numbers of clients as the “AT&T land line generation” transfers their wealth to the next generation. The future of industry is likely the ala carte alternative that Scott Stolz mentioned above. It will be exciting to watch it unfold.
Fortunately we have an industry where people can choose to work with advisors on a “full service basis” or “a la cart”. They can even hire an advisor on an hourly or retainer basis. And there has never been a better time to “do it yourself” and manage your own investments and do your own financial planning. Yes. The future will be interesting and exciting indeed.
As usual, Michael is correctly seeing where the puck is heading. Seems to me that the long term solution here is for the industry to quit wrapping all of its services into one total fee. Rather than charge 1-1.5% on assets for “investment management and financial planning”, we need a model where we charge 0.4% for investment management, 0.25% to establish and monitor a financial plan, 0.15% to assist with college planning, 0.25% to assist with retirement planning, etc. The problem from my perspective is not that we aren’t worth 1%+ per year, but that we don’t do a good job of articulating what the client is getting and not getting for that 1%+. It would be difficult for someone to accuse us of reverse churning if it’s clear that the client is only paying 0.4% (or something similar) for the actual investment allocation decisions.
Great blog post and great discussion in the comments. Thanks all around.
The element that I see missing from the discussion is that the SEC paired Reverse Churning with what they described as Fee Selection in the 2016 Examination Priorities. See the section titled Fee Selection and Reverse Churning on page 2:
https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2016.pdf
Scott Stolz’s point of unbundling the fees seems to be exactly what the Commission would like to see.
Also, the Commission reminds advisors that we have the responsibility to review the account type selected “thereafter” implies that if an advisor comes to the conclusion that a managed account will not be traded the account type should be changed and the fee type should be changed as well.
This is so tricky. Being able to point to the value you add with your services is so difficult when the intangible benefit from keeping investors safely on the course and not reacting to market events is hard to quantify. It’ll be fascinating to see what the regulatory guidance results in for planners.
MIchael, as usual some great insights here. With 21 years of enforced pensions here in Australia our advisers have many years of experience with ‘on-going’ investment fees and the perennial question of value for on-going advice. The ‘big elephant in the room’ for advisers pitching their approach as ‘holistic’ is pricing advice on value not on amount of product supplied. The approach we are seeing successfully implementing is value pricing. Value pricing is based upon client’s perception of value not beating markets, not cost-cutting competitors, not tax savings provided, but majority of client agreement to value. Being cost competitive, being tax competitve, being investment performance competitive, being competitive in general is the ‘ticket to the game’ of advice. The ‘little elephant in the room’ just underneath the big one is dollar based pricing. Pricing advice in dollars rather than percentages so customers can assess value of advice like they assess most value decisions in their financial lives. Addressing both elephants (and many many others) is trust. Trust between adviser and client. Trust in the adviser’s heads they are worth it. Trust that inevitably the market wil decide which works best. Great writing Michael.
“So if you are an advisor that has a passive strategic investment approach, I’m going to warn you now: start documenting what you do for clients on an ongoing basis. You’re going to want this documentation at some point down the road.”
Accusations of reverse-churning is just one of countless reasons to document what you are doing for clients. I’m always shocked at how poor a job many advisors do at documenting their client relationships, both from a compliance perspective and from the perspective of being a business owner trying to provide value to clients.