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Excessive trading can be difficult to spot — that is, until you look back and see how much money it took out of your accounts.
The Financial Industry Regulatory Authority, or Finra, recently barred an adviser and fined his firm for his excessive trading of 14 clients’ portfolios, including two retired women. In one scenario, the adviser, referred to as “CJ,” made 267 trades over three years for a retired woman with a net worth of less than $500,000, causing her to pay more than $61,000 in commissions. CJ placed 533 trades in a three-year period for another client, a retired woman with a net worth of less than $1 million, which led her to pay more than $171,000 in commissions.
In total, the adviser caused all 14 clients to pay more than $650,000 in commissions between 2012 and 2017. Their realized losses totaled more than $300,000, according to Finra, which is a self-regulator in the industry for brokerage firms and their registered representatives.
See: Ask these questions to avoid hiring a bad (or unethical) financial adviser
Finra fined CJ’s firm, Summit Brokerage in Boca Raton, Fla., $325,000, and ordered it to pay restitution to the affected clients, according to the firm’s Letter of Acceptance, Waiver and Consent. The self-regulator also barred CJ from working for any Finra member firm. Cetera Advisor Networks, a broker-dealer that Summit reports to, declined to comment because it is a legal matter.
Excessive trading, also known as quantitative suitability, depends on numerous factors, including a client’s portfolio targets, risk tolerance and assets, as well as various calculations, including turnover rate, which measures how much a mutual fund or other portfolio holding has changed over a specific period of time, and cost-to-equity ratio, which represents the percentage of the client’s portfolio returns needed to clear the cost of commissions and fees, according to Finra.
Although there is no set standard for excessive trading, there are average figures to help determine whether there is a case. Previous scenarios have found advisers are excessively trading if the portfolio’s cost-to-equity ratio is as low as 8.7%, and ratios above 12% “generally are viewed as very strong evidence of excessive trading,” the self-regulator noted on its site.
In CJ’s case, the retired woman with a net worth of less than $500,000 had a cost-to-equity ratio of 27% — meaning her investments would have had to appreciate 27% just to break even with her commissions and fees. The retired female client with a net worth of less than $1 million had a cost-to-equity ratio of 32%.
There are a few ways to spot excessive trading, including finding trades your broker made without your knowledge or authorization (in the case of a financial adviser, that could be trades that went against your investment goals). Clients should also pay close attention to fees that seem exaggeratedly high for all or part of your portfolio, according to the Securities and Exchange Commission.
Clients should always be aware of their adviser’s approach to trading, which can vary from professional to professional, said Evelyn Zohlen, national president of the Financial Planning Association. Some advisers prefer long-ranging buy and hold strategies, while others might be a bit more active in trading. Before choosing an adviser, or even months or years after working with one, clients should ask what their advisers consider a reasonable amount of trading to be — and advisers should be able to give an estimate without hesitation, she said. “They should be able to describe their investment approach.” The SEC also suggests asking the adviser or broker the rationale behind his or her investment strategy and the cost-to-equity ratio.
Registered representatives, who are advisers allowed to make investment trades, are held to Finra’s suitability standard, which dictates an adviser act in a way that meets a client’s needs. This is different than the Securities and Exchange Commission’s fiduciary rule for investment advisers registered with the SEC, which requires they act in their clients’ best interests first.
Also see: 4 critical questions to ask during a market downturn — and how financial advisers answer them
The suitability rule allows advisers to potentially choose an investment product that matches a client’s goal but comes with a higher commission, while the fiduciary rule would not. The Department of Labor was set to move forward with its own fiduciary rule for any advisers managing retirement accounts, legislation known as the “Conflict of Interest” rule created during the Obama administration, but the Trump administration dismantled it.
The SEC recently adopted another version of the fiduciary rule, called “Regulation BI” (short for Best Interest), which requires broker-dealers to disclose conflicts of interest. All firms must comply by June 30, 2020. There are numerous titles and roles an adviser may go by, which can confuse and misguide investors and potential clients.
Clients can usually see portfolio trades in a digital or mailed statement from the firm holding their assets, or they can ask their adviser where to find this information. The amount of trading actually done versus an adviser’s baseline estimate will vary — a client shouldn’t worry if her adviser said to expect 20 trades per quarter and she placed 25 instead. There are also times when trading will be more emphasized, perhaps during market volatility as advisers switch investment strategies or after a client receives a large sum of money that needs to be invested.
“The trick is to be aware, and ask about it,” Zohlen said. “Take ownership. There is action required on the part of the client.”
