Soft dollars are a means of paying brokerage firms for their services through commission revenue, as opposed to through hard-dollar direct payments.
The investing public tends to have a negative perception of soft-dollar arrangements. Many investors believe that buy-side firms should pay expenses out of their own profits. As a result, the use of hard-dollar compensation is becoming more common.
Soft dollars are commission payments to a brokerage firm that are used, in part, to pay for other services such as research.
Soft-dollar transactions are frequently criticized for lacking transparency and hiding abuses.
Soft dollars are sometimes defended as providing access to a greater variety of research.
How a Soft-Dollar Transaction Works
Suppose that an institutional investor pays a brokerage firm six cents per share in commissions. However, it might only cost three cents per share to perform the trade. The other three cents are soft dollars used to pay for additional services provided by the brokerage. In exchange for paying these higher fees, the institutional investor might receive access to research.
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Under the right conditions, none of the above presents a problem for the Securities and Exchange Commission (SEC). The regulator is willing to permit soft-dollar transactions, provided that the investor gets good execution, and the commissions are reasonable.
Criticism of Soft Dollars
Mutual fund investors pay the costs of research and other bundled services provided in the soft-dollar transaction. Yet these costs are not disclosed by the fund. They are simply part of the costs of trades, and they impact the long-term performance of the fund.
Technically, the mutual fund would disclose the hard cost of research in its management fee. However, that charge is not paid from the management fee when it is paid for with soft dollars. The fund managers argue that institutional investors ultimately bear all of the costs. However, using soft dollars to pay for research doesn't allow investors 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 gets. That opens the door for conflicts and abuses. 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. That is especially true as financial reform and issues of transparency become more important in the industry.
Benefits of Soft Dollars
Soft dollars can provide some benefits to investors. One of the main arguments is that they offer access to a greater variety of research.
For instance, investment advisors can use all the research material obtained through soft dollars to benefit all of their clients. According to defenders of soft dollars, eliminating this practice could hinder research efforts by investment advisors and lower returns for their clients.
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Example of Soft Dollars
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, which would be a soft-dollar payment. If the fund simply wanted to buy the research, it might have to pay the brokerage firm $7,000 in hard dollars (cash) instead.
Real-World Example of Soft Dollars
In 2013, the SEC levied sanctions against New York brokerage firm Instinet, LLC. Instinet did not flag payments of more than $400,000 in soft dollars to San Diego-based advisor J.S. Oliver Capital Management. However, there were clear signs that the money was used for dubious purposes and not properly disclosed to clients.
The SEC found that associates at J.S. Oliver Capital had misused the soft-dollar payments. Ultimately, the SEC ruled that Instinet overlooked the misuse of the soft dollars and settled with the company for about $800,000.