Christine O. Asasa says investors on stock markets should know the brokers they are dealing with.

While on the move to stock markets, we should very much appreciate the work of brokers and other intermediaries.

It is important to take a more precautionary, preventative approach rather rely completely on exposing problems after they occur. We should thus take time to understand our intermediaries, more especially brokers, their weak spot and take precautions before disappointments. Well, any industry has its bad apples. And the brokerage industry is no exception. But not all investment professionals are devious, but it certainly helps to be armed with information that helps you understand the investment profession, and ask the right questions when seeking its services.

For the most part, the Rwanda Capital Markets Advisory Council (CMAC) is there to oversee and do a fairly good job, regulating and policing the brokerage community. Even so, the best way to avoid deceitful brokers is to do your assignments. And even then, the most thorough background check of the firm, broker or planner doesn’t always prevent investors from falling prey to fraudulence.

It should be understood that, in any business environment, whether heavily regularised or not, we still meet dishonest managers, directors, taking into consideration the conflicts of interests of different stakeholders.

To help you be as informed as possible, this article will explain some of the more unscrupulous and dishonest practices, brokers have used to boost their commissions and push poor-quality investments onto unsuspecting investors.

This is the act of excessively trading a client’s account. Some brokers with discretionary authority over an account use this unethical practice to increase their commissions. Churning is done to benefit the broker rather than the investor, as the only purpose of the trade is to increase commissions, not a client’s wealth. In fact even one trade can be considered churning if it has no legitimate purpose. A warning sign of churning may be an unusual increase in transactions without any gains in the portfolio value.

If you’re truly worried that your account might be churned, you might want to consider a wrap account. This is an account by which a broker manages a portfolio in exchange for a flat fee. The advantage of a wrap is that it protects you from overtrading. Because the broker gets a flat annual fee, he or she only trades when it is advantageous to your portfolio. Even if you’ve allowed your broker to trade for you, it is always prudent to keep up to date on what is going on in the portfolio; in spite of everything, it is your money.

This occurs when brokers try to convince a customer that purchasing a particular investment such as stock or mutual funds will be profitable because of an upcoming dividend. But, in reality, the broker is trying to generate commissions through selling a client on a quick and easy gain.

Say, for example, in mutual funds: an advisor will tell a client to buy a fund because dividends are being paid out by companies in the fund. Just like the stock price, the mutual fund’s net asset value is discounted by the value of the dividend, resulting in a gain only for the broker - in the form of commissions. In fact, the investor is better off waiting until after the dividend offer: the stock is at a lower price and the investor avoids relatively higher taxes on the income from the dividend.

Many brokerages and mutual fund companies have a sales charge on certain investments. It isn’t that these sales charges are illegal, but sometimes the sales charges cause investors to pay more than they should. For example, let’s say that a mutual fund company charges 5 per cent for investments under Frw250,000 but only 4 per cent for investments of Frw250,000 and upwards. A cut-off point sale would occur if you invest at Frw250,000 because at this amount your investment is in a lower sales-charge bracket.

Unscrupulous advisors, however, to preserve their sales, may recommended that you invest Frw240,750 into the fund even though you would save Frw2 500, or 1 per cent, in sales charge by investing Frw250,000. Advisors may keep you from reaping the benefits of breakpoints also by splitting your money up among different investment companies, even though each company offers similar services. This leads to more commissions for the advisor and less cost savings to you as you are unable to take advantage of the lower commission rates when you reach the higher breakpoint.

Unsuitable transactions

To sum up the nature of all these practices, I would like to emphasise the meaning of "unsuitable transactions", a general term for investments made in a manner that is not consistent with the client’s circumstances and/or investment objectives. You should know that your broker is duty-bound to know your financial needs and constraints and to make investment recommendations accordingly.

Now, here are other transactions that may be characterised as unsuitable:

• High-risk investments if you have a low-risk tolerance.

• Placing a high concentration of your money into one stock or security.

Conclusion

It is important for all investors, regardless of their financial background, to maintain focus on the dealings going on in their accounts. This does not mean that you need to review it every day but by no means only once a year. If this is done along with a thorough examination of broker’s investment proposals, you should avoid most types of broker fraud.