Churning
In the financial sector, churning is understood to mean the frequent switching of a portfolio by an asset manager or broker. In this way, the broker earns the highest possible commission at the expense of the investor. Churning occurs primarily in futures transactions, but increasingly also in the securities sector.
Churning explained
The term was coined in reference to butter production, where milk is churned and the cream skimmed off until there is no more milk. In the same way, the asset manager shifts the capital and skims off the accruing fees.
Churning is considered as an illegal fraud practice. It is hard to spot. Churning is made through frequent shares, securities or any other assets purchases and sells. Overtrading is not productive for clients profit as it leads to constantly high commissions showing decreasing amounts of revenue.
The practice of Churning arises because of the inherent conflict of interest. Brokeres make it seems that they are right people who know how to easily multiply assets of the clients and provide them with necessary investment strategy.
The bulk of a broker's income comes from commissions charged for executing buy and sell orders in the securities markets. There is a conflict of interest here: the broker makes little or no money if the client does not buy and sell securities.
Brokers who force their clients to perform transactions that serve solely for his benefit. That is, they force their clients to trade only in order to generate a commission for the broker with little or no profit for the client.
Churning Forms
Prepaid mutual funds, or referred to as A-shares, can be classified as long-term investments. Sell and buy of an A-share fund in less that 5 years must be justified by the broker with reasonable justification. If the transaction has not produced a noticeable increase in the investor's portfolio, it may be a case of churning.
One of the most widespread types of churning is stock and bond broker overtrade. Nevertheless, churning can occur with other types of securities as well, for example, brokers can also use mutual funds in addition to listed above and annuities.
How to detect Churning
An investor can detect a failure on the part of a broker when the frequency of trades becomes counterproductive to their investment objectives, resulting in increased commissions with no visible results over time.
Another sign is when an investor pays more in commissions than they earn from their investment. Courts take into account how many times investment capital is reinvested over the course of a year. With churning, all of an investor's assets are usually traded once a month or even more often.
Opening a revolving account (an account that is managed at a fixed rate instead of charging a per-transaction fee) is a way for investors to protect themselves from churning.
