Commission churning in wealth management

 

Churning! We come across this term in our everyday life. It means to produce something at a frequent rate. Like we shake milk rapidly to produce butter. That’s what it is in finance. Commission churning means unnecessary executing trade in a customer’s investor account by a broker for earning commission frequently.

Now you would wonder why brokers do commission churning? Well that’s simple. Just to earn more commission. Sometimes a broker along with your account, churns accounts of his other clients. It clearly affects the trustworthiness of stockbrokers. The more he does this practice, the more he is filling in his pockets.

The key to identify it is that the trades that are placed are not increasing your account value. If you have given your broker trading authority over your account, then the possibility of churning can only exist if they are trading your account heavily, and your balance either remains the same or decreases in value over time

All this is fine. But exactly how they do commission churning? Have an insight on these points-

- they recommend their investor with a long term buy and hold strategy to convert their account to a managed account that charges a fee based on a percentage of assets under management

- Cancelling or decreasing the contributions from an existing investment policy in order to start a new one with new set up fees.

- not providing customer commission discounts associated with the purchase of investments even though the customer is for the discounts.

- taking partial withdrawal from an existing investment platform in order to buy an off plan property either by manipulating the investor or not even informing him.

You know everything is paid in business out of some fund associated with it. Same way the churned commission is also get paid out of commission paying funds.  There are so many funds related to it.

TER is one of them. It stands for Total Expense Ratio. It means the total cost associated with operating an investment fund. Now you are getting a clear idea about how it actually works. The formula for TER is-

TOTAL EXPENSE RATIO = TOTAL FUND COSTS / TOTAL FUND ASSETS

It is very important for investors as it actually tells them about annual cost they have to pay on a particular investment. Like you are earning 15% from your investment but TER is 10%, then you will be only remaining with 5% in your hand. In the formula, total fund cost includes all cost like managing fee, transaction fee, auditing fee, operating expenses and so on. And total fund assets are the assets related with the cost.

The more total fund cost will be, the more TER so and less profit. Of course if you are buying a book for say 100 rupees, out of which its actual cost is 80 and selling cost is 10 and commission of broker is 10 the you will be remaining with only 0 rupees.

TER also includes commission fee, so if a broker is churning commission then for sure you will be having more TER. The more actively managed the fund, the higher the associated TER.

The next one is OCF. It stands for operating cash flow. It is a measure of cash generated from a company’s normal day to day activities.

 Operating cash flow, provides a clear picture of the current reality of the business operations in its success. It works like a mirror.

For example, a big sale will generate a big revenue, but if the company is not able to collect the cash, then it is not a true economic benefit for the company. Every investment holder needs some cash in his hand to operate. and yes operating cash flow is adjusted after taking care of all expenses related to it. What if the commission fee or transaction fee is that much that OCF is only able to pay that only? That is what churning commission does. It trades excessively, and as a result the transaction fee for every transaction will be more along with commission and eventually you will be remaining with 0 rupee in your hand. Sometimes it incurs liabilities too.

Now the question arises how to identify that your broker is churning your account? here are some clues that can help: -

• If your broker does not respond to you, it may be a green signal that he or she is not looking out for your best interests.
• To make sure you're not being duped by a wrong broker, do your research, make sure there are no complaints, and read through all the major points on documents.
• Try opening a mini account with a small balance first, and make trades for a month before attempting a withdrawal.
• If you see buy and sell trades for securities that don't fit your objectives, your broker may be churning.
• If you are stuck with a bad broker, review all your documents and discuss your course of action before taking more drastic measures.

One of the finest reason that how brokers are successful in churning commission is that the investment holder is not paying attention. He totally relies on his broker. We know that it is the duty of broker to be trustworthy and fair but we never know when filling pockets becomes more important than being a loyal person. The investment holder should have to cross check regularly his broker to avoid these kind of things.

Commission churning is totally illegal in many places. In the U.S., the securities and exchange commission states that-

1.     SEC Rule 15c1-7 classifies a broker’s actions as fraudulent if they use their discretionary power over the investor’s account to engage in transactions that are excessive in view of the financial resources and character of the account in question.

2.     FINRA (Financial Industry Regulatory Authority) Rule 2111 advocates that brokers must always act in the best interest of their clients. It states that a broker must have a reasonable basis to believe that a trade will be beneficial for the customer based on their investment objectives, liquidity needs, tax status, and risk tolerance.

3.      NYSE rule 408 (c) prohibits investment firms from legally allowing their brokers to churn accounts.

Now you would be wondering that commission based advisors has so many disadvantages. Is there an alternative for this? Yes. Fee based advisors is a major alternative for commission based advisors. They charge an annual fee corresponding to the assets they manage. They are not dependent on your account. They will charge their fee even if your investment suffers losses. Whereas commission based advisors get commission only on profit.

Here are some key differences that will enable you to decide who is the best? –

-a fee based advisor gets paid only by there clients whereas a commission based advisor gets paid both by client and institution.

-Fee-based advisors are bound to put the interests of their clients’ interests before their own whereas a commission-based advisor’s first interest would be in earning the highest commission for selling the product which they sell. 

-Fee- based advisors are the advisors who give honest and most appropriate advice to the investors as they do not receive any commission from the fund house or any other fund provider and hence it becomes extremely important for them to ensure the success of their client’s portfolio whereas there are very low legal standards that govern commission based advisors and hence they are free to sell any type of product that or may not suit the investor and so they are not that much trustworthy.

Although we know the somewhere fee based adviser is best because they are trustworthy and there are negative chances of fraud but it is a psychological thing that when it comes to you, you will prefer not paying fee even when you suffer losses. And automatically you would prefer commission based advisor even after knowing its disadvantages.

“If you’re only going to trade five or seven times a year, it’s probably more economical for you to pay a commission as opposed to paying someone one percent of your assets as a management fee,” said Ira, general counsel for the Securities Industry and Financial Markets Association, the lobbying group for the brokerage industry.

At last, to summarize I would say that commission churning in wealth management is totally illegal. How and with what intentions the broker do this we have already known. It has a major effect on an investment holder’s account as it decreases its value and increases its cost by every frequent transaction and high commission to be paid. We know how to identify and how to avoid it by some major points along with its consequences. There are many alternatives related to it in which one major alternative is fee based advisors. It has its own disadvantages and advantages.

“Price is what you pay. Value is what you get.”- Warren Buffet

If you are paying commission, and it is decreasing your value, then clearly it is not so good. At last, the decision will be yours.