Building a Soft Dollar Dashboard for Fund Directors
Written by C. Meyrick Payne & Jay Keeshan   

Monitoring soft dollars is a critical component of mutual fund governance. Soft dollars represent an aspect of fund operations where there is potential for extensive conflict of interest between the manager and the fund shareholders. Fund directors have to mediate that conflict within the provisions of the securities laws which specifically permit the use of soft dollars. Soft dollars essentially represent an “off balance sheet” asset and should be treated with as much care as a similar asset class in a commercial company.

Monitoring soft dollars and the process by which they are created and expended can be difficult. What can be of great help to fund directors is a simple dashboard with dials to indicate, detect, and hopefully correct problems. This bulletin summarizes the basic design of a dashboard which contains critical measurements for monitoring soft dollars. A companion bulletin contains a similar dashboard for the monitoring of best execution. Naturally the dashboard will differ for each complex but the principles should generally follow those discussed in the paragraphs below.


1. Soft Dollar Broker Ratio

Typically the trading desk can select one of three classes of broker to effect an equity trade- an execution only broker (usually known as an Electronic Crossing Network or ECN), a full service proprietary broker (usually the classic wire house) or a third party broker, which facilitates the acquisition and expenditure of soft dollars. Proprietary brokers typically charge a higher commission than ECNs, and third party brokers (who usually provide the most expensive research in exchange for soft dollars) charge even more.  So the first dial on the dashboard is the percent of each type of broker used in a quarter along with the average cents per share charged as commission.

2. Soft Dollar Research Budget Percentage

Soft dollars are budgeted just like any other asset class or expense item. One of the best ways for fund directors to understand the dynamics of soft dollars is to follow the budget process. The second dial provides the percentage of research dollars represented by soft dollar purchases.  In addition to the dial would be the list of items included in the soft dollar budget.  

3. Soft Dollar Unexpended Budget Percentage

Through the years we have observed that fund managers are loathe to leave soft dollar budget research items unpaid for. As the year rolls on, there is inevitably pressure to place trades with the third party and proprietary brokers who facilitate the unexpended soft dollar budgets.

4. Three Largest Soft Dollar Research Items

Fund directors should track in detail the three largest items of soft dollar research. These are often research tools which are deeply imbedded in the investment management process such as risk management tools and research aggregators. The reason to track these carefully is that some of them are indeed “mixed use” tools and as such the costs need to be allocated between soft dollars and direct expenses of the management company.

5. Soft Dollar Broker Efficiency

Since using proprietary or third party brokers to make a trade is typically more expensive in commissions, it is very important to monitor how efficient those brokers are when compared to their competitors. Broker effectiveness is typically measured by a science (some call it an art) known as Trade Cost Analysis, or TCA, which is discussed in our companion bulletin about monitoring best execution. The TCA vendors maintain various benchmarks (Plexus has used PAEG/L, ITG has used ACE, and others may use a measure called VWAP) and measure trading efficiency against these benchmarks. As a result fund directors can see which brokers (who facilitate soft dollar transactions) are most effective. This is particularly important because the commission paid is not typically the largest component of total trade cost; market impact or the cost of delay might well be greater. As a result, simply using commissions paid as a basis for measuring the effectiveness of soft dollar brokers can be misleading.    

6. Soft Dollar Redemption Percentage Markup

Whenever soft dollars are expended the facilitating broker charges a mark up, usually expressed as a percentage of the hard dollar cost. So research from Bloomberg, for example, might be priced at $100,000 in hard dollars (i.e. for cash) but marked up at 125% for soft dollars. The logic is that the third party broker should earn a commission for facilitating the transaction, but fund directors should take great care not to be overpaying; as the soft dollars are earned (i.e. paying 4 cents a share for a trade) and when they are redeemed (by paying the mark up).

7. Directed Brokerage Percentage

Over the past few years, some fund directors have cut back on the use of soft dollars, especially when used to acquire third party research. Third party research is typically the most expensive in terms of commissions paid and often the third party research carries the greatest redemption markup. As a result these fund directors have chosen to buy third party research in exchange for hard dollars (i.e. cash). An alternative to buying research with trading credits is to directly reduce the expenses of the fund which creates the credit. This is often called “directed brokerage” and is sensible alternative for fund directors who want to use the full service brokerage system but avoid the complications of buying soft dollar research. Thus a sensible dashboard dial is the percent of “directed brokerage” in relation to all brokerage expended.

The concepts discussed in this bulletin will be extrapolated and refined in the series of regional workshops which MPI will conduct with the Mutual Fund Directors Forum during 2009.