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!
