Churning is a deceptive and illegal practice in the financial industry where brokers or advisors execute excessive transactions in a client’s brokerage account with the primary intent to generate commissions or fees, rather than to benefit the client’s investment strategy or financial goals.
How Churning Works
Brokers working on a commission basis might be incentivized to trade frequently, regardless of market conditions or client suitability. Every trade, whether buying or selling stocks, mutual funds, or other securities, generates a commission fee for the broker. This means the more trades churned through the account, the more commissions earned—often at the client’s expense.
For example, if a client’s portfolio of $10,000 is traded hundreds of times a year without a clear investment rationale, these costs accumulate and can severely reduce the portfolio’s net performance.
Regulatory Background
Regulatory bodies including the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have established strict rules to detect and prevent churning. According to FINRA, churning violates duty of care and good faith obligations to clients and can lead to disciplinary actions or legal recourse by victims.
Who Is Most at Risk?
Churning can happen to any investor but is particularly common among accounts managed under commission-based compensation models rather than fee-only advisory arrangements. Investors who are less familiar with how or why trades are made are especially vulnerable.
Recognizing Churning
Signs of possible churning include:
- An unusually high volume of trades relative to the size of the account
- Trades that do not align with the stated investment objectives
- High commission fees consuming a substantial portion of returns
- Rapid switching among funds or securities without clear strategic reasons
Consequences of Churning
Churning can result in considerable financial harm:
- Eroded portfolio returns due to excessive fees
- Increased tax liabilities from frequent asset sales
- Loss of trust in financial advisors
How to Protect Yourself
- Understand Your Fee Structure: Know whether your advisor is paid commissions or a flat fee. Fee-only advisors have less incentive to churn.
- Monitor Trading Activity: Review brokerage statements regularly for excessive or unnecessary trades.
- Ask Questions: Always inquire about the reasoning behind trades.
- Check Credentials: Verify your broker’s background and complaints via FINRA’s BrokerCheck tool.
- Consider Fee-Only Advisors: These advisors are compensated based on assets under management, reducing motive for excessive trading.
Legal Remedies
Churning is illegal under securities laws, and investors may file complaints with regulators like FINRA or the SEC. Victims can pursue arbitration or lawsuits to recover losses caused by unscrupulous brokers.
Active Trading vs. Churning
Active trading involves making trades with a strategic intent to improve portfolio performance and is legal. Churning is excessive trading without legitimate investment purpose designed to generate commissions. Understanding this distinction helps investors evaluate their account activity properly.
| Aspect | Churning | Legitimate Active Trading |
|---|---|---|
| Purpose | Generate commissions for broker | Improve investment returns |
| Trading Frequency | Excessive and unnecessary | Based on market conditions or strategy |
| Benefit to Client | Often negative or minimal | Linked to portfolio growth |
| Fees | High total commissions | Aligned with investment strategy or plan |
| Legal Status | Illegal | Legal and common |
Additional Resources
For more on understanding broker commissions and investment fees, see our Broker Compensation Limits and Expense Ratio pages. To learn about active management strategies, visit our Actively Managed Fund entry.
References
- FINRA Investor Alert: Churning
- SEC Investor Bulletin: Understanding Churning
- Investopedia: Churning Definition
By staying informed and vigilant, investors can protect their portfolios from churning and make sure their investments are working toward their financial goals.