What are Soft Dollars
Soft dollars are a means of paying brokerage firms for their services through commission revenue, as opposed to through normal direct payments (hard-dollar fees). The investing public tends to have a negative perception of soft-dollar arrangements, because they believe that buy-side firms should pay expenses out of their profits, rather than from investors' pockets. As such, the use of hard-dollar compensation is becoming more common.
BREAKING DOWN Soft Dollars
For example, a mutual fund may offer to pay for research from a brokerage firm by executing trades at the brokerage. Assume that a large-cap value fund wants to buy some research from XYZ Brokerage Firm. The fund may agree to spend at least $10,000 in commissions for brokerage services in return for the research; this would represent a soft-dollar payment. Alternatively, if the fund simply wanted to buy the research and not agree to any kind of soft-dollar fee, it might have to pay the brokerage firm $7,000 in hard dollars (cash) for the service.
How a Soft-Dollar Transaction Works
The commission for a trade that an institutional investor may have paid the brokerage firm is 6 cents per share, but it actually only cost 3 cents per share. The other 3 cents are used for soft-dollar rebates. Under this arrangement, the institutional investor is obligated to direct future trades to the brokerage firm. None of this presents a problem for the Securities and Exchange Commission (SEC) as long as the investor receives best execution and the commission is not unreasonably disparate from what is charged by other firms.
The Inherent Problems With Soft Dollars
The costs of research and other bundled services provided in the soft-dollar transaction are essentially borne by the mutual fund investor, yet they are not disclosed by the fund. They are simply built into the cost of trades, which impacts the long-term performance of the fund.
Technically, the mutual fund would disclose the hard cost of research in its management fee. However, when it is paid for with soft dollars, it is not paid from its management fee. The fund managers argue that the institutional investors ultimately bear all of the costs. However, using soft dollars to pay for research doesn't allow the mutual fund investor to conduct an accurate cost analysis when selecting the fund.
Soft dollar values are not determinable, nor are they equal. What one investment manager receives in the form of services may differ from what another manager receives. This opens the door for conflicts and abuses, and the mutual fund investors never know what portion of their transaction costs are applied to the soft services or their actual investment.
Although soft-dollar transactions are still widely used, there is a growing movement to eliminate them, especially as financial reform and issues of transparency dominate the industry.
Abuses of Soft Dollars
The haziness of soft dollars has made the practice subject to misuse by investment professionals and examination by the SEC. In one case in 2013, the SEC levied sanctions against New York brokerage firm Instinet LLC for not flagging payments of more than $400,000 in soft dollars to San Diego-based adviser J.S. Oliver Capital Management despite clear signs they were used for dubious purposes and not properly disclosed to clients. The SEC found that associates at J.S. Oliver Capital had used the soft dollars payments toward divorce expenses, rent payments and costs related to a personal timeshare. Ultimately, the SEC ruled that Instinet overlooked the misuse of the soft dollars and settled with the company for $800,000.