A previous article by Jack Waymire, What are my Costs when Financial Advisors Buy & Sell Securities? discussed how advisory fees impacted activity in a managed account. He also touched on certain accounts that he characterized as churning.
In a purely legal sense, churning is excessive buying and selling for the purpose of generating commissions for the stock broker. Churning was outlawed in the 1930’s by the original Securities Exchange Acts as a form of fraud. A usual yardstick was the turnover rate – in other words the number of times on an annual basis the equity was bought and sold.
Another yardstick in possible churning is called the cost/equity ratio. The ratio is generally converted into a percentage that the customer is paying the broker for managing the account. The percentage tells us exactly what the customer has to earn before there is any profit. A high ratio might mean that the broker is making more than the customer on the account.
Trading on margin is a form of churning. Margin is a form of borrowing using the securities in the account as collateral. The current economic climate is ripe for abuse of margin accounts. The stock market is booming. Interest rates are low. The more securities that the advisor or stock broker is managing, the more he can charge against the account.
Also there is a little secret of which most are unaware. Interest margin is a profit center in and of itself. Margin interest can be as high as some credit card debt (although not as high as pay day loans). The brokerage house, however, is fully protected by the securities on margin which can and will be liquidated if the securities fall below a fixed amount of equity in the brokerage account.
Also, irrespective of the nature of the securities purchased, as soon as an account is put into margin, it becomes a speculative and highly risky account. It does not matter what your original investment objectives were. You are now speculating. It is automatically unsuitable. The margins rules were drafted so that the brokerage house is fully protected while the customer assumes all the risk.
During my career I have seen many cases where an account was liquidated because the securities fell below margin requirements. The typical investor, however, is totally unaware of the risks of margin. Economics that drive markets certainly change but the rules of proper investing do not. The vast majority of people have no business being on margin.