A soft commission, or soft dollars, is a transaction-based payment made by an asset manager to a broker-dealer that is not paid in actual dollars. Soft commissions allow investment companies and institutional funds to cover some of their expenses through trading commissions as opposed to normal direct payments via hard-dollar fees, which must be reported. For example, receiving research from a counterparty in exchange for using their brokerage services. Thus, the expense would be classified as a trading commission and at the same time would lower their reported expenses on research in this instance.
The investing public tends to have a negative perception of soft-dollar arrangements. They believe that buy-side firms should pay expenses out of their profits. As such, the use of hard-dollar compensation is becoming more common.
Breaking Down Soft Commissions
The use of soft dollar compensation by registered investment companies with ERISA-covered pensions is covered under Section 28(e) of the Securities Exchange Act of 1934. Hedge funds are not covered, however, as they're generally not registered. If soft commissions are employed outside Section 28(e) regulation, the disclosure must be made to investors.
Many investment funds buy research or services using soft commissions because it allows the fund to avoid reporting expenses to cost-sensitive investors. Soft commissions thereby allow funds to finance their expenses and ultimately lower their expense ratios by agreeing to inferior transaction pricing. This type of reporting has frequently resulted in reporting problems for fund companies for various reasons.
Soft Commission Criticism
The investor essentially bears the costs of research and other bundled services provided in a soft-commission transaction, yet an asset manager does not disclose them. They are built into the cost of trades, which impacts the long-term performance of a fund. Some speculate that soft commissions can bump up the per-share cost of executing and clearing institutional trades by roughly 2-3%, though there is little reliable research on the matter.
The use of soft commissions lacks transparency. They are not comparable, nor are they consistent between different products or firms. What one investment manager receives in the form of services may differ from what another manager receives. As such, an investor will never know what portion of their transaction costs are applied to the soft services or their actual investment.
Soft Commission History
Soft commissions have a long history in the brokerage business. For many years, the New York Stock Exchange published a fixed price commission schedule. Since brokers couldn't compete on price, they sought to win business by providing additional services, such as research. This was known as 'bundling.' In the early 1970s, the government looked into the pricing practice and later concluded that it constituted price fixing.
As of May 1, 1975, a date often referred to as 'May Day' within the brokerage industry, brokerages would have to negotiate commissions on each trade with each client. Approaching the deadline, brokerages attempted to restructure themselves by offering more services and negotiating the price of such services separately. Such restructuring — known as 'unbundling' — gave birth to discount-brokerages. Meanwhile, the industry lobbied congress for the right to keep, including the cost of investment research it offered to institutional clients as part of its commission. The May 1 rule was subsequently amended [in Section 28(e)] to give safe-harbor status to any fiduciary that pays more than their negotiated commission for research or services.
Despite criticism, soft commissions are still widely used in the U.S. They are legal elsewhere (Singapore, Hong Kong, Canada, United Kingdom) but more closely regulated than in the U.S. For example, soft commissions are legal in Australia but must be fully and disclosed.
For more on soft commissions, see the SEC's Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds.