What is Churning and How Can Investors
Protect Themselves from Such Investment Fraud
It is quite unlikely that a common person will have required knowledge and expertise to recognize financial scams and frauds. As such, it is necessary that you take advice of an experienced financial adviser to understand different tactics fraudsters use and accordingly take required steps to protect your investments. We will look at the topic of financial scams and frauds in greater depth in the following sections and explore fruad schemes such as churning which you need to be aware of to make judicious investment decisions.
Churning – A Financial Fraud Investors Need to be Aware of
One of the illegal as well as unethical practices you need to be aware of is churning. In churning inordinate amount of trading is carried out by brokers on your investment account. The main aim of such trading is to make better commissions.
Questions related to churning
Question #1: How to recognize churning?
A common sign which will help you recognize churning is extraordinary increase in transactions. But you will notice that there isn't any associated increase in portfolio's value. Thus, any frequent buying or selling of your securities that is not going to help you achieve investment objectives will be considered churning.
Question #2: What makes it a negative trading activity?
By consulting a financial adviser you will be able to clearly understand the main reasons churning is considered to be a fraudulent activity. However, the primary reason is that it can lead to significant losses. In addition to it, any profitable trading will not be beneficial for you since it will increase your tax liability.
Question #3: What can be done to avoid risk of churning?
Basic thing you will have to do is not give discretionary authority to your broker. The reason is that churning can not be performed if broker does not have such authority on your account.
You should consult your financial adviser to understand how you can prevent your broker from gaining such authority over the account. Another step you can take is create a account which is fee based rather than a commission based account. This way you will be able to ensure that broker receives only annual fee and force him or her to conduct trading that is most profitable for you.
Question #4: What type of trading activity is involved in churning?
Churning consists of unreasonable amount of trading in mutual funds as well as annuities. Let us go through the details here.
- Mutual Funds: Here broker sells mutual funds which are part of your long term investment within a short period of time (such as in five years) and replaces them with other mutual funds which are also of long term duration.
- Annuities: If annuities are surrendered too early then it constitutes churning activity. The reason is that annuities carry a surrender charge if they are surrendered too early (such as within seven to ten years) and you will hardly be gaining anything from such annuities which are surrendered way too early.
As we can see there are many things investors need to be wary of and by taking help of an experienced financial adviser they can be sure that their investments are moving in the right path.