A:

The term soft dollars refers to the payments made by mutual funds (and other money managers) to their service providers. The difference between soft dollars and hard dollars is that instead of paying the service providers with cash (i.e. hard dollars), the mutual fund will pay in-kind (i.e. with soft dollars) by passing on business to the brokerage.

Let's take a look at an example: Wittenberg LLP provides MegaMutual Fund with computer equipment and software for transmitting investment information. Under an agreement or understanding between the two firms, MegaMutual will pay for these services by directing trades through to Feral Hitch, a large brokerage firm. Feral Hitch will charge an added fee onto the trades from MegaMutual. The money from these fees will then be sent to Wittenberg, which, in turn, gets its compensation for its services to MegaMutual. The added fee usually amounts to tenths of a cent, but because MegaMutual trades billions of shares a day, the amount adds up to real money - the fee it would've had to pay in hard dollars.

Soft dollars are a way for mutual funds to get services without having to pay for them directly. A hard dollar payment would require a check to be issued and recorded on MegaMutual's books, and the corresponding expense to be passed onto investors via the fund's annual fee. Under soft dollars, the expenses are hidden in the trading costs. While the practice is not illegal and the end result is the same (the investors pay), it does not help investors analyze the costs of using one mutual fund versus another.

Soft dollars became more of an issue as Wall Street activity came under greater scrutiny in the wake of the dotcom bust. However, soft dollars have been around a very long time and there are rules that govern their use. According to Harold Bradley (senior vice president of American Century Investments), fund companies do an estimated $10 billion annually in soft dollar business. And the Association for Investment Management and Research has established standards for the use of soft dollars to clarify and limit potential abuses. For more information, here is a link to their site: http://www.aimr.org/featuring/modules/softdollar/readings.html..

RELATED FAQS
  1. Is there a situation in which wash trading is legal?

    Wash trading, the intentional practice of manipulating a stock's activity level to deceive other investors, is not a legal ... Read Full Answer >>
  2. What action is the SEC likely to take on 12b-1 fees?

    The Securities and Exchange Commission (SEC) may take action to impose greater regulation on how 12b-1 fees are used, or ... Read Full Answer >>
  3. What is considered a reasonable 12b-1 fee?

    A reasonable 12b-1 fee is generally considered to be 0.25% of the assets of the mutual fund. The maximum amount allowed for ... Read Full Answer >>
  4. What are some of the most common mutual funds that give exposure to the retail sector?

    There are a number of mutual funds that give exposure to the retail sector. Three of the most popular funds are the Fidelity ... Read Full Answer >>
  5. What is the 12b-1 fee meant to cover?

    A 12b-1 fee in a mutual fund is meant to cover the fees of companies and individuals through which investors of a fund buy ... Read Full Answer >>
  6. What are the most popular mutual funds that give exposure to the utilities sector?

    Some of the most popular mutual funds that provide exposure to the utilities sector include American Century Utilities, Prudential ... Read Full Answer >>
Related Articles
  1. Investing

    Five Things to Consider Now for Your 401(k)

    If you can’t stand still, when it comes to checking your 401 (k) balance, focus on these 5 steps to help channel your worries in a more productive manner.
  2. Professionals

    Index or Target Dates in 401(k)s: Which is Better?

    A common question is whether or not plan participants should choose index or target date funds in a 401(k). The answer depends on different scenarios.
  3. Investing

    6 Reasons Why Every Investor Should Consider ETFs

    Once you understand the benefits of ETFs, you’ll see how they could be an exciting and smart way to help meet your financial goals. Here some key facts.
  4. Term

    What's an Investment Advisor?

    An investment or financial advisor makes investment recommendations and analyzes securities.
  5. Investing News

    Understanding How Mutual Funds Pay Dividends

    The process by which mutual fund dividends are calculated, distributed and reported is fairly straightforward in most cases. Here's a look.
  6. Investing Basics

    Explaining the High-Water Mark

    A high-water mark ensures fund managers are not paid performance fees when they perform poorly.
  7. Investing Basics

    Explaining Front-End Load

    A front-end load is a commission or sales charge paid by the investor at the initial purchase of an investment.
  8. Mutual Funds & ETFs

    What's The Difference Between Bond & Equity ETFs?

    Learn how different stock ETFs and bond ETFs are, though they actually have quite a few things in common.
  9. Mutual Funds & ETFs

    What's an Equity Fund?

    An equity fund is a mutual fund that mainly invests in stocks.
  10. Mutual Funds & ETFs

    What You Need To Know About Bond ETF Yields

    When it comes to fixed income investing, yield is an important component of a bond investment’s total return to accurately assess if it's the right move.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Series 6

    A securities license entitling the holder to register as a limited ...
  3. Exchange-Traded Mutual Funds (ETMF)

    Investopedia explains the definition of exchange-traded mutual ...
  4. Dividend

    A distribution of a portion of a company's earnings, decided ...
  5. Sharpe Ratio

    A ratio developed by Nobel laureate William F. Sharpe to measure ...
  6. Historic Pricing

    A method for calculating the value of an asset using the last ...

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!