If you have ever traded stocks, you must be familiar with any transaction fees for executing trades. Placing trades directly with a brokerage firm incurs a different type of fee.
If you place your trades with a brokerage firm, the broker will not only charge you for executing the trade, but also levy a commission for his services.
These fees are called soft dollar arrangements, and can have a meaningful impact on your long-term returns.
This article will discuss soft dollar arranegments in detail and discuss a few strategies for how you can avoid them.
What are Soft Dollars?
Soft dollars are the amount money managers, including mutual fund managers, pay to a brokerage firm out of their clients’ accounts to cover the cost of research the firm provides. Soft dollars also cover the transaction fees associated with executing trades.
This means that an investment management firm uses client generated commissions instead of the firm’s capital to purchase research services from the broker. They allow fund managers to gain services at the investors expense.
Are Soft Dollars Legal?
Soft dollar arrangements are legal if the services purchased by the investment management firm using the clients’ commissions are to support investment decision-making.
If the research purchased is consistent with SEC requirements, using soft dollars is not a violation and can prove to offer valuable information to the investor.
What type of research do brokerages provide?
In exchange of soft dollars, a brokerage may provide a variety of services such as free research, hardware, software, or even non-research related services.
Research services from brokers include fundamental, technical, economic analysis of individual companies, daily market updates, industry analysis, peer comparison, potential for future growth, and other factors.
All the above are in the interest of investors and help them maximize the benefits of their investment.
Example of Soft Dollars
Let us say you invest your money with an investment management company ABC.
ABC invests your money along with all its other clients’ money through a brokerage firm XYZ and pays six cents per share in commissions.
However, the actual cost of executing trades is only three cents and ABC pays an additional three cents to XYZ in exchange of research services provided by the brokerage firm.
Therefore, ABC investment management company spends the commissions received by its investors by executing trades with XYZ in exchange of the research services provided by XYZ, and this would be a soft dollar payment.
Difference between Soft Dollars and Hard Dollars
Unlike soft dollars where mutual funds do not pay directly for services but pay in-kind by giving business to the brokerage, hard dollars are cash fees or payments to a brokerage firm in exchange of its services.
Hard dollar amounts are usually known to the customer before dealing with the broker and include transaction charges, account maintenance charges and any research provided by the broker.
Using our previous example of soft dollars, if ABC wishes to directly buy the research from XYZ brokerage, it could pay cash in exchange for the research and this would be a hard dollar payment.
Soft dollars are paid through commission revenue by executing trades whereas hard dollars are actual payments in cash.
Companies have a difficult time calculating the total cost of soft dollar arrangements as opposed to hard dollars due to the complex nature of treatment with soft dollars.
Advantages of Soft Dollars
The biggest benefit of using soft dollars is the access to research and information that can help fund managers with better decision making.
This wide variety of research obtained from a brokerage can assist funds to meet their clients’ needs and benefit from their investments, thus generating high return on investment.
While it can be difficult to put a value to the research or services purchased using soft dollars, but, if used wisely, it can prove to be beneficial to the individual investor.
Disadvantages of Soft Dollars and Why Investors should Pay Attention
When investing in mutual funds, investors often pay the costs associated with transactions, account management fees and research as part of bundled or packaged services.
These costs include any soft dollar arrangements which are not disclosed by the fund, but merely treated as part of the cost of trade. While this may not seem like a problem in the short-term, it does impact the long-term performance of the fund.
If you pay $5 for a pack of gum, you are aware of the product you purchased using hard dollars. However, soft dollars are difficult to quantify. Not only are soft dollars difficult to compute, but they vary between different investment funds and pose a variety of problems.
Let us say you invest your money with two mutual funds X and Y with similar charges. The fund manager at X may receive research from a brokerage firm which can be far more beneficial from the research received by the fund manager at Y.
Although both funds charge the same, the value of their soft dollar arrangements may differ greatly, thereby impacting your overall investments in the long-term.
Funds do not include soft dollar expenses as part of their expense ratios and financial advisors are not required to quantify the amount. This lack of transparency has led to a lot of criticism towards soft dollars, resulting in a movement to eliminate them.
High Costs Low Returns
Soft dollars can result in higher commissions and execution costs, thereby impacting investor returns. These added costs often lead to lower fund returns.
Conflict of Interest
The amount of soft dollars paid is at the discretion of the investment manager leading to a conflict of interest.
To generate a greater number of soft dollars, an investment manager may be overpaying for research, or trades, or to pay for services benefiting a different fund. Thus, investors can remain in the dark while receiving no benefit on their investment.
Real-World Example of Soft Dollar Arrangement
In 2013, a New York brokerage firm Instinet, LLC. received over $400,000 in soft dollar arrangements from San Diego based investment firm J.S. Oliver Capital Management.
Upon investigation, the SEC found that associates at J.S. Oliver Capital had misused the soft dollar funds with clear signs that the money was not used for research services, keeping their client unaware of its malpractices.
Eventually, the SEC ruled that Instinet had overlooked the misuse of soft dollars and settled with the company for about $800,000.