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. What is the difference between "hard money" and "soft money"?

    Hard money and soft money are terms that are often used to describe coin money and paper money, respectively. However, these ... Read Answer >>
  2. Why is a mutual fund's expense ratio important to investors?

    Understand the nature of mutual fund expense ratios, and learn why it is critically important for investors to be aware of ... Read Answer >>
  3. Why do mutual fund companies charge management fees?

    Learn why mutual funds charge their investors management fees, which include the cost of hiring investment advisors and various ... Read Answer >>
Related Articles
  1. Trading

    The Difference Between Hard Money And Soft Money

    At their most basic level, hard money and soft money are terms that describe coins and paper money. But in the U.S., they also refer to political contributions.
  2. Trading

    Soft Commodities Could Bounce Higher This Week

    Despite major downtrends on the charts of soft commodities, active traders are taking a closer look because nearby support suggests prices could be readying for a bounce higher.
  3. Investing

    Forget Stocks, Buy Soft Commodities

    So far in 2014, investing in commodities has proven to be the best place to put your money to work.
  4. Financial Advisor

    A Mutual Funds Guide for Young Investors

    Learn how mutual funds work, why they are so popular and how younger investors can get started by putting mutual funds in their IRAs or 401(k)s.
  5. Investing

    4 Mistakes to Avoid When Choosing Mutual Funds to Invest in

    Mutual funds are a great way to build wealth but not all of them are the same. Investors have to be mindful of fees, turnover, redundancy and performance.
  6. Investing

    Trading Mutual Funds For Beginners

    Learn about the basics of trading and investing in mutual funds. Understand how the fees charged by mutual funds can impact the performance of an investment.
  7. Investing

    Looking to Buy Mutual Funds Online? Here Is How

    Learn how to buy mutual funds online; discover which websites offer mutual fund trading services, how to choose a fund and typical fees.
  8. Investing

    Consider These Fees When Evaluating Mutual Funds

    The best way to evaluate a mutual fund is by digging a bit deeper into the fees charged.
  9. Financial Advisor

    Hard and Soft Due Diligence: What's the Difference?

    Learn about the differences between "hard" and "soft" due diligence in a mergers and acquisitions deal (M&A) and why soft diligence is increasingly important.
  10. Investing

    Are Mutual Funds A Relic?

    We list some options other than mutual funds for your retirement plan.
RELATED TERMS
  1. Hard Dollars

    Cash fees or payments made by an investor or customer to a brokerage ...
  2. Soft Stop Order

    A mental price or percentage set by traders where they will place ...
  3. Soft Metrics

    A slang term for intangible indicators used to value a startup ...
  4. Soft Sell

    Advertising and sales practices denoted by subtle language and ...
  5. Soft Market

    A market that has more potential sellers than buyers. A soft ...
  6. Soft Loan

    A loan with no interest or a below-market rate of interest, or ...
Hot Definitions
  1. Book Value

    1. The value at which an asset is carried on a balance sheet. To calculate, take the cost of an asset minus the accumulated ...
  2. Dividend Yield

    A financial ratio that shows how much a company pays out in dividends each year relative to its share price.
  3. Fixed-Income Security

    An investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. ...
  4. Free Cash Flow - FCF

    A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents ...
  5. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to ...
  6. Two And Twenty

    A type of compensation structure that hedge fund managers typically employ in which part of compensation is performance based. ...
Trading Center