"Follow the Money" to Understand Soft Dollars Print E-mail
Written by C. Meyrick Payne   

Much has been written about the legal niceties of soft dollars in the context of mutual fund operations, particularly what is allowed and how it can be legally accomplished. Little has been written about the economics of soft dollars. The industry has long argued that fund shareholders benefit. Once the underlying dollar flows are laid out it becomes clear that, while technology will erode the creation of soft dollars, they are not going away quickly because (1) they are well accepted in the securities industry and (2) they make pretty good sense since the brokerage commission has to be built into the share price. On the other hand, an understanding of both sides of a soft dollar transaction, creation and recapture, highlights the need for independent directors to stay alert to the potential for unfair treatment of the fund investors.

At the most basic level, the fund pays a commission for brokerage services. The cost of brokerage is added to the purchase price of securities acquired or deducted from the sale prices of securities sold. This means that the cost of brokerage shows up in the performance of the fund not as an expense but rather as a reduction from total return.

Until the mid-1970s, brokerage houses were prohibited from discounting their fees by rules from the depression era. To compete for business they bundled investment research into their pricing structure as a way to differentiate themselves from other brokers. Investment management firms came to depend on this "free" research. When the rules changed, investment managers wanted to retain their research sources. Thus was born the concept of soft dollar credits as a form of bundled brokerage rebate.

There were two problems with the bundled concept. First, the investment managers needed research from unrelated sources, and second, they needed the research at a later, or even earlier, time. Consequently, the brokers established clearing houses to "bank" the soft dollar credits. Most of these were established as subsidiaries of the brokerage houses, but others were set up as specialized consultants. The exhibit provides a simple overview of the process.

The actual cost of a share trade is something in the region of 2 cents per share. The price often paid by the funds is more like 6 cents a share, which leaves 4 cents for the broker's profit and for soft dollar rebates. The 6-cent price is permissible if the independent trustees are convinced that the fund receives "best execution". This means that the broker effectively and efficiently executes the trade for a commission which is not unreasonably disparate from that offered by alternative vendors. Not a difficult test to meet, as most brokers are anxious to preserve their margin and negotiate soft dollar rebates, rather than play the cut-price game. A typical amount of soft-dollar credit might be 2 cents per share, leaving 2 cents as profit for the broker.

The catch-leading to concern about brokerage rates for the independent directors-is that a typical fund trade may be for 40,000 shares. At 6 cents per share that equals $2,400. Now every director knows that, however unreasonable the comparison, an electronic trade on E*Trade can be executed for under $20.

In fact, brokerage is rarely negotiated on a per share basis but rather on some aggregate amount that is earned over time and over multiple transactions. By way of example, let us assume that the amount of brokerage paid over time and some number of transactions is $600,000. Following our rough guidelines, the fund might accrue $200,000 in soft dollar credits that reside with a soft dollar clearing house. These credits are not recorded on the books of the investment manager or the fund — but are rather kept as a memo item.

Under the SEC's rules, any fund or funds within the same complex can redeem and make use of the soft dollar credits for research services. Another provision says that the original broker or its affiliated clearing house must provide the research. But there is nothing to prevent them from buying the required research and reselling it. So let's say that the fund or funds needs research from a third party, say Bloomberg or First Call; the investment manager requests the vendor to provide the research to the clearing house, which then resells the same research to the fund or funds. The clearinghouse typically takes a ratio markup of between 1.5 and 2.0. So $100,000 in Bloomberg research may be marked up to $150,000. Transactions such as this use up all the soft dollar credits ­ technically called "soft dollar recapture".

From the point of view of fund shareholders, there are several problems. First, there is little motivation for the fund manager to negotiate a lower fee for the research itself. Second, the research itself ends up costing more than the research house actually charges as result of the clearing house's markup. When these problems are added to the possible over-payment for brokerage in the first place, it is easy to see why independent directors need to be vigilant.

Many industry experts argue that soft dollar credits are inevitable. A broker is always willing to provide an added service to stay competitive or to differentiate their services. If soft dollars are inevitable, then using them for the benefit of the complex is preferable than ignoring them altogether. However, the independent directors need to understand the benefits and potential problems of soft dollars and that their use has been fairly disclosed to shareholders.

Management Practice Inc. is available to assist independent directors in grappling with the ramifications and subtleties of mutual fund brokerage allocation policies. In addition to explaining directors' specific responsibilities in this area, MPI can put on realistic demonstrations of the day-today mechanics and profit motivations that sustain the soft dollar and directed brokerage activities of the mutual fund and brokerage industries. If your board would be interested in delving into the realities and practicalities of mutual fund brokerage practices, please contact us.

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