What is Churning?

Definition

Churning refers to the illegal and unethical practice by brokers of excessively trading assets in a client's account to generate commissions. While there is no quantitative measure for churning, frequent buying and selling of stocks or any assets that contribute little to the client's investment goals may be evidence of churning.

Origin

The concept of churning originated from the need for regulation in financial markets, particularly in the mid-20th century, as securities markets expanded and became more complex. Regulatory bodies began focusing on broker transparency and client protection, making churning a significant issue in financial regulation.

Categories and Features

Churning can be categorized into two main types: overt excessive trading, which involves frequent buying and selling of the same asset in a short period, and covert excessive trading, often involving complex financial products. Its features include high trading frequency, misalignment with client investment goals, and significantly increased broker commissions.

Case Studies

Case Study 1: In the early 2000s, a major brokerage firm was fined after its brokers were found to be churning client accounts. Investigations revealed that these brokers increased their commission income through frequent trading, but clients saw no growth in investment returns. Case Study 2: An investment advisory firm was accused of churning in 2010, leading to a decline in client account values. The firm eventually settled with regulators and paid substantial fines.

Common Issues

Investors often find it challenging to identify churning, as it may be disguised as active investment management. A common misconception is that high trading frequency always benefits investment returns, whereas excessive trading can lead to high fees and low returns.