What Is Reverse Churning and How Can You Spot It?

Investors often encounter terms like “churning.” A less understood but equally impactful practice is “reverse churning,” which relates to how financial advisors charge for their services. This concept describes situations where clients pay ongoing fees for minimal or no active management of their investments. Understanding reverse churning helps investors ensure they receive appropriate value for the fees they pay.

Defining Reverse Churning

Reverse churning occurs in fee-based advisory accounts. An advisor collects ongoing fees, as a percentage of assets under management (AUM), while providing little to no active trading or management services that justify these charges. The Securities and Exchange Commission (SEC) describes reverse churning as a practice where a client is charged a wrap fee, which covers advisory services and trading costs, even if the client trades infrequently.

This practice contrasts with “churning,” which involves excessive buying and selling of securities in commission-based accounts for broker commissions. While churning is characterized by excessive activity, reverse churning is defined by a lack of activity or management in a fee-based account where active management is implied by the fee structure. The SEC and the Financial Industry Regulatory Authority (FINRA) have focused on combating reverse churning, viewing it as a breach of fiduciary duty. Firms are not permitted to reverse churn under the SEC’s Regulation Best Interest (Reg BI).

The fee structures enabling reverse churning include asset-based fees, a flat annual percentage of the total account balance, or wrap accounts, a single fee covering advisory, brokerage, and administrative services. A common fee might range from 1% to 3% of the assets under management annually. This structure can become problematic if an account requires minimal management, such as a “buy and hold” portfolio, yet the client continues to pay a recurring management fee for services not rendered. Firms engaging in reverse churning may be held liable to reimburse improperly charged fees to investors.

Circumstances Leading to Reverse Churning

The shift from commission-based compensation to fee-based models has created an environment where reverse churning can occur. Historically, brokers earned commissions on each trade, incentivizing frequent transactions. With the rise of fee-based advisory accounts, the incentive structure changed to align advisor interests with client growth. Regulators partly encouraged this transition to reduce churning, as a flat fee means the advisor’s compensation does not increase with trading volume.

Despite this intent, the fee-based model can lead to situations where advisors collect fees without providing commensurate services. One common scenario involves accounts designated for a “buy and hold” investment strategy. While this approach is suitable for certain investors, it inherently involves minimal trading activity. If an advisor charges an ongoing management fee for a portfolio requiring little active oversight, the client may be paying for unrendered services.

Accounts with substantial positions in cash, bonds intended to be held to maturity, or long-term holdings like company stock or mutual funds also present circumstances susceptible to reverse churning. These assets do not require frequent management, yet contribute to assets under management on which the advisory fee is calculated. Advisors managing many client accounts might inadvertently or intentionally provide less attention to individual portfolios, leading to unnoticed inactivity and accruing fees. The SEC emphasizes advisors have a continuous fiduciary duty to assess account suitability, even with minimal trading.

Recognizing Indications of Reverse Churning

Identifying potential reverse churning requires an investor to monitor their financial statements and advisor services. A primary indicator is consistent advisory fees on account statements with little to no trading activity. For example, if an investor is paying an annual fee of 1% to 3% of their assets, but the account shows minimal buy or sell transactions over an extended period, warrants closer examination.

Lack of proactive communication or regular portfolio reviews can signal reverse churning. Advisors are expected to provide ongoing monitoring and advice. Absence of these interactions, beyond routine statements, might suggest inadequate service for fees charged. Portfolio performance mirroring a broad market index without evidence of active management strategies (e.g., rebalancing, tactical adjustments, security selection) could also be a warning sign. While passive investing is a valid strategy, the ongoing fee should justify advisory services provided, including financial planning, tax considerations, or estate planning, beyond just investment management.

If an investor feels neglect regarding account management, or if their advisor fails to justify ongoing fees, these are important indicators. The SEC notes that charging a fixed fee for accounts requiring little work is a concern. Investors should review their advisory agreement to understand the scope of services they are to receive for fees paid and compare this with actual activity and communication from their advisor.

Investor Options for Addressing Concerns

If an investor suspects reverse churning, the initial step is to review their advisory agreement and recent account statements. This documentation outlines the agreed-upon services, fee structure, and the frequency of statements. It clarifies contractually obligated services versus what has been delivered. Investors should scrutinize fees charged, ensuring alignment with activity and advice received.

Following this review, direct communication with the financial advisor or the advisory firm’s management is the next step. Investors should clearly articulate their concerns, referencing inactivity or lack of communication, and request clarification on how ongoing fees justify services. This direct dialogue can resolve misunderstandings or prompt the advisor to rectify the situation, potentially by adjusting fees, increasing engagement, or suggesting a more appropriate account type.

Should direct communication prove unsatisfactory, investors have avenues for seeking independent professional advice. Consulting with another financial planner offers an objective assessment of the account’s management and fee structure. Legal counsel specializing in investment fraud or securities law provides guidance on potential claims. These professionals help evaluate whether a breach of fiduciary duty has occurred and explain available recourse.

For formal complaints, investors can approach regulatory bodies. If the advisor is associated with a broker-dealer, complaints are lodged with FINRA. If the advisor is a registered investment advisor, the complaint is filed with the SEC. Both organizations oversee financial professionals and investigate misconduct. In some cases, disputes may proceed to arbitration, often mandated by client agreements, providing a structured process for resolving claims outside of court.