Improper Portfolio Management Activity
Seth C. Anderson and Lynn Comer Jones
SEPTEMBER 2005 - Investment accounts can be abused in four
primary ways: 1) ineptitude in management; 2) misappropriation
of account assets; 3) use of unsuitable investment vehicles;
and 4) churning of the account.
in management is difficult to determine. Misappropriation
of assets, although easy to quantify, is beyond the scope
of this article. The authors will endeavor to provide an
efficient overview of suitability and churning. According
to S.C. Anderson and D.A. Winslow [“Definining Suitability,”
Kentucky Law Journal, 81, no. 1 (1992)], suitability
violations involve the use of investment vehicles inappropriate
to meet an investor’s objectives. Churning, according
to Winslow and Anderson [“Model for Determining the
Excessive Trading Element in Churning Claims,” North
Carolina Law Review, 6 (January 1990)], involves the
excessive trading of investment vehicles. When either or
both of these activities occur, the investor’s best
interests have not been served, and there has been a violation
of the fiduciary duties owed to the investor by the financial
Investment Professionals’ Duties
According to a 2004 report from the Zero Alpha
Group, 26% of investors understand that the primary role
of stockbrokers is merely to buy and sell investment products;
the majority of investors (53%) incorrectly believe that
investment advice is a key service offered by stockbrokers.
The requirement that a financial advisor recommend
proper investment actions has several sources, primarily
in the rules of the self-regulatory organizations (SRO).
For example, the New York Stock Exchange (NYSE) requires
that each member “know [the] customer” with
respect to recommendations, sales, or offers; this directive
contains an implicit duty of the financial advisor that
recommendations reasonably relate to the needs revealed
by the customer’s particular situation. Also, National
Association of Security Dealers (NASD) Rule 2300, “Transactions
with Customers,” includes Conduct Rule 2310, “Recommendations
to Customers (Suitability),” which requires a financial
advisor to have reasonable grounds for believing that an
investment is suitable and make reasonable efforts to obtain
information concerning the customer’s financial status
and investment objectives, and other reasonable information
before recommending a particular investment. In the 2001
NASD Securities Manual, the rule states:
(a) In recommending to a customer the purchase,
sale or exchange of any security, a member shall have
reasonable grounds for believing that the recommendation
is suitable for such customer upon the basis of the facts,
if any, disclosed by such customer as to his other security
holdings and as to his financial situation and needs.
(b) Prior to the execution of a transaction recommended
to a non-institutional customer, other than transactions
with customers where investments are limited to money
market mutual funds, a member shall make reasonable efforts
to obtain information concerning:
(1) the customer’s financial status;
(2) the customer’s tax status;
(3) the customer’s investment objectives; and
(4) such other information used or considered to be
reasonable by such member or registered representative
in making recommendations to the customer.
Rule 2300 also addresses the important issues
of excessive trading and trading in mutual fund shares.
The NASD Online Manual (nasd.complinet.com/nasd/display/index.html)
specifically prohibits trading in mutual fund shares because
“these securities are not proper trading vehicles.”
Although the manual gives no specific numerical guidelines
for determining the overtrading of stocks, the commonly
argued guidelines below have been used in court cases and
If a financial advisor violates any of the
aforementioned rules, the SRO may institute a disciplinary
action, although these have been infrequent. If the financial
advisor’s actions violate Rule 10b-5 [the general
securities antifraud rule promulgated under section 10(b)
of the Securities Exchange Act of 1934] or common-law fiduciary
duties, the investor has a potential private right of action
that might result in an award of damages against the financial
advisor. It is worth noting that, according to J.S. Cohen
and M.B. Lee (“Arbitration Showdown: The Battles Over
Account Decisions Gone Wrong Are Heating Up,” Financial
Planning, July 2003), the number of filed suitability
arbitration claims increased 22% from 2002 to 2003.
Elements of a Violation
According to Anderson and Winslow (1992),
for an advisor to violate the fiduciary duty owed to a customer
insofar as suitability or churning are concerned, specific
elements must be present: 1) explicit or implicit control
over the account by the advisor; 2) excessive trading; and
3) scienter, meaning reckless disregard for the investor’s
welfare. These elements are often readily determinable but
also usually involve legal issues beyond this article.
Risk Aversion and Investor Objectives
The concept of risk aversion is fundamental
to modern finance theory. It holds that a rational investor
will assume incremental risks only if incremental returns
can be expected. The risk-return paradigm can be used to
show that particular types of investments are suitable for
certain investor objectives.
1 (adapted from Anderson and Winslow, 1992) presents
the relative positions of a variety of investment vehicles
within a risk-return space. Government securities are the
least risky investment. Savings accounts are considered
less risky than corporate bonds, which in turn are less
risky than preferred stock. Futures and options can be viewed
as the riskiest financial assets.
Ultimately, an investment vehicle’s
risk-return characteristics determine its suitability for
an investor with a given objective. Fortunately, data are
available that show the historical risk-return relationship
for the broad classes of financial instruments comprising
the vast majority of investment vehicles. Exhibit 2 [from
R.G. Ibbotson and R.A. Sinquefield, Stocks, Bonds, Bills,
and Inflation: Historical Returns (1926–2004),
Dow Jones-Irwin, 2004] shows the arithmetic mean return
for five groups of investment vehicles for the period 1926
The standard deviation of each series is listed
for comparison of the relative riskiness of each group.
Common stocks have exhibited greater riskiness than bonds,
as measured by the standard deviation of returns. Small
company stocks have returned more than common stocks in
the aggregate, and their standard deviation of returns has
2 also shows that the relative positions of the investment
vehicles are approximate. Mutual funds may be stock- or
bond-oriented, and may be specialized or general. A fund’s
objectives will determine where it lies in risk-return space
relative to other funds. The particular use of a financial
vehicle may also determine where a fund lies. For example,
put options may be used for pure speculation, or they may
be used more conservatively for protection against price
Although the relative positions of different
vehicles are approximate, certain vehicles are more appropriate
for specific classes of investors. Exhibit
3 presents a stereotypical view of where particular
classes of investors lie in risk-return space.
High-risk investing as a rule should be reserved
for sophisticated investors that are willing and able to
lose money in anticipation of gaining large returns. At
the other end of the spectrum lie investors such as retirees,
whose primary objective is often preservation of capital
rather than large returns.
Determining where a particular investor lies
in the risk-return space of Exhibit 3 is ultimately a function
of three interrelated attributes: investment horizon, financial
resiliency, and relative risk aversion.
Investment horizon. An
investor with a long investment horizon can take greater
risks because there is more time to recover from potential
losses. For example, in recent years technology issues have
been detrimental to young professionals’ portfolios,
but disastrous to the portfolios of retirees.
Financial resiliency. The
retiree with a $2 million portfolio can obviously better
withstand a $200,000 loss than can one with a $700,000 portfolio.
For young investors, however, the impact of their time horizon
may override the obvious effect of losses relative to portfolio
worth. If two young professionals, Jones and Smith, with
similar retirement goals have initial portfolios of $5,000
and $50,000, respectively, then Jones may justifiably invest
in securities that are more risky than Smith because Jones
seeks higher returns.
Relative risk aversion.
Even if two investors are identical in time horizon and
in portfolio worth, they may differ widely in risk tolerance.
Some individuals have a much lower tolerance for risk-taking
than others, and this should be taken into consideration
when considering the suitability of particular investments.
Broker Tax-Reporting Requirements
Brokers are required to provide an information
return, Form 1099-B, Proceeds From Broker and Barter Exchange
Transactions, to their investors by January 31 [IRC section
6045(b); Treasury Regulations section 1.6045-1(k)(2)]. Brokers
must report each sale transaction on a separate Form 1099-B
[Treasury Regulations section 1.6045-1(c)(2)], except for
regulated futures and foreign currency transactions, which
may be reported in the aggregate [Treasury Regulations section
Recognizing Suspect Broker Transactions
Matching an investor’s sale transactions
between the 1099-B and the brokerage account statement facilitates
the identification of suspect transactions, which may involve
any of the following: mutual fund sales; unusual trading
activity; large commissions; low-priced stocks; options
activity; and investor suitability issues such as age, wealth,
and risk tolerance.
Mutual fund sales.
Mutual funds are long-term investment vehicles and may be
either front-end, level, or rear-end load funds on which
investors pay commissions, respectively, when purchased,
over time, or upon sale. Transactions more frequent than
annually are usually suspect.
Unusual trading activity. Annualized
trading activity (gross purchases plus sales, divided by
two) relative to average account balances should not be
greater than one. The ultimate impact of a turnover greater
than one is commission expense, which amounts to approximately
4% annually of an average account balance (see Winslow and
Anderson, 1990). This 4% must be considered in light of
the fact that, historically, stock returns have been in
the 10% to 12% range. Because bond returns have been in
the 6% to 8% range, annual expenses for bond portfolios
should not exceed 2%.
Low-priced stocks. Active
trading in low-priced stocks (under $10 per share) is frequently
encountered in churning claims. Trading in these securities
often allows for excessive commission charges, which are
sometimes hidden in net trades of unlisted securities. In
recent years many brokerage firms have begun discouraging
broker solicitations of stocks under $5 per share; thus,
trading activity in such issues is suspect.
trading is highly speculative and usually generates large
commissions. A form of nonspeculative option trading is
the writing of covered calls in order to generate income.
Option speculation should be used only by speculators able
to lose capital in the pursuit of risky profits.
Other potential problem areas are specific
to particular investors rather than the broader issues discussed
above. For example, elderly investors seeking high income
may be sold restricted or otherwise unsuitable issues that
pay large, risky returns but have potential liquidity problems
if the investor needs to cash out. Advisors should be especially
wary of voluminous trading activity when investors are at
or near retirement age because, as noted, trading usually
decreases investment returns. Another possible misuse of
investment tactics involves margin trading, by which borrowed
funds lever an account into an unnecessarily risky position.
With margin positions, the combined impact of commissions
and margin interest expense frequently outweigh expected
A brokerage account statement should disclose
the sale quantity, sale price, and net proceeds of each
sale as seen in the following example. John C. Smith is
a 76-year-old, risk-averse retiree who relies partially
on dividend income for basic living expenses. Smith’s
brokerage account statement (Exhibit
4) lists multiple sales transactions for 2004. The issue
of overtrading initially seems probable because of the large
number of sales relative to the year-end number of holdings.
In addition, the sales represent approximately 190% of the
total portfolio year-end value, for an approximate turnover
ratio of 1.9. Assuming that comparable quantities of purchases
were made, then the annual expense ratio is approximately
8%; $11,600 in commissions relative to an ending portfolio
value of $152,679.50. The sale transactions may also be
suspect from a suitability perspective because many of the
stocks sold were higher dividend–paying stocks (ALD,
CLP, EPD, ERF, RF, and SNH) than those retained in the portfolio.
Under the circumstances, the holding of non–dividend
paying stocks (CSCO and MSO) is suspect.
Investor’s Options When Problems
The investor ultimately has three options
when problems of suitability or churning are suspected.
The investor can go directly to the brokerage operation,
pursue mediation, or pursue arbitration. At the brokerage
operation, the broker is the first point of contact, followed
by the office manager, then the home-office compliance area.
When dealing with the brokerage operation, investors should
provide written communications that clearly define the concerns
and provide specific items to which the brokerage operation
can respond. If the brokerage operation does not respond
satisfactorily, the NASD has a standard process for arbitration
and mediation. The NASD regulates these dispute forums under
rule 10000, Code of Arbitration Procedure, adopted in the
1970s. NASD Resolution, Inc., offers dispute services to
public customers and NASD members.
Mediation is voluntary, less expensive than
arbitration or litigation (filing fees of $50, $150, or
$300, based on the amount in controversy), nonbinding (the
mediator does not decide the case), and since 1995 has an
80% settlement rate. The NASD prefers that parties undergo
mediation before filing an arbitration claim. Arbitration
is more formal and similar to a court trial. The parties
present their cases and stipulate the restitution or damages
they are seeking. The arbitrators weigh the evidence and
make a determination with a set award that is binding. Investors
can file mediation and arbitration claims at the NASD website,
Seth C. Anderson, PhD, CFA, is a professor
of finance, and Lynn Comer Jones, PhD, CPA,
is an assistant professor of accounting, both at the Coggin
College of Business, University of North Florida, Jacksonville,