The term soft dollars refers to the payments made by mutual funds, as well as other money managers, to their service providers. The difference between soft 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 to Feral Hitch, a large brokerage firm. Feral Hitch will charge an added fee for 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. With 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. Still, the practice has been around for a very long time, and rules are in place governing its use. According to Harold Bradley (senior vice president of American Century Investments), fund companies do an estimated $10 billion annually in soft-dollar business.