Are Soft Dollars Hard on Fund Investors?
It's time to shed light on these dubious arrangements.
Imagine you're setting up a new mutual fund shop, and you're trying to figure out how to pay for research. You can hire a staff of managers and analysts, and see those costs flow through to your expense ratio. One problem with this, however, is that you might not clear expense-ratio screens that planners and investors run when they search for attractive funds to buy.
A second option is to hire a bare-bones staff and pay for research with soft dollars. In such an arrangement, you would deliberately overpay for trade execution in exchange for research from a third party. The fees you pay for trade execution and anything bundled along with it are excluded from the expense ratio. Presto, you still get the stock research you need but without paying any hard cash for it. In effect, you've artificially lowered your expense ratio, but in reality, returns won't be any better assuming that you paid the same amount for research in both cases.
All sorts of everyday costs can be hidden with soft dollars, too. Fund companies receive Bloomberg terminals, news services, consulting services, recruiting services, business school tuition, and even computers in exchange for overpaying. (Some even get subscriptions to Morningstar products, although not directly from us since we don't run a trading desk.)
If the money managers got these supplies more cheaply than they could on their own, everyone would be a winner, but that's not often the case. In fact, the exact costs are tough to determine because these soft-dollar arrangements are sometimes made orally so that there's no paper trail.
Financial planner Harold Evensky summed up the issue quite nicely in an interview on our site in 1998: "It's not like if [fund companies] spend an extra dollar in trading they get a dollar in soft dollars. They may get 50 cents. If they want to charge my client 50 cents more, fine. Let the client save 50 cents on the trading costs. I don't even understand the argument behind soft dollars. The arguments I hear in the SEC are about what they're using it for: 'They shouldn't use it for a trip; they should use it for research.' Well, why on earth does it make a difference? They shouldn't be using it for anything. They should be reducing my clients' fees."
There's one thing soft dollars buy that fund companies couldn't get otherwise: Access to initial public offerings. The more soft dollars paid, the more access fund companies get. Obviously, it's tough for outsiders to figure whether this access boosts returns by more than the price that's paid in commissions.
Trading Costs and Disclosure
So how much do soft dollars affect trading costs? Harold Bradley of American Century funds figures that about four fifths of the fees fund companies pay on trades are for soft dollars. American Century won't pay soft dollars. In Congressional testimony last month, Bradley said American Century pays about 0.85 cents per share for trade execution alone while the industry norm is 5.2 cents per share. He figures the difference must be soft dollars.
Bradley suggests that fund companies should disclose the costs they pay just for execution and their overall costs so that you can subtract the former from the latter to come up with soft-dollar costs. Not only will this shed more light on the subject, but it will also increase price competition, according to Bradley. In addition, he suggests allocating IPOs through Dutch auctions (in which the asking price is lowered until a bid is received) so that the investment banker can't play favorites.
On the flip side, Paul Haaga Jr., president of the fund industry's Investment Company Institute, argued that there's already adequate disclosure in a fund's prospectus and statement of additional information. Further, he argues that including commissions in an expense ratio would be confusing because it wouldn't capture the fact that commissions are sometimes included in bid/ask spreads rather than direct fees. He's got a point, although I don't see why the industry couldn't break out soft dollars and commissions separately as Bradley suggests.
Vanguard founder Jack Bogle has argued for some time that funds should have to disclose their total trading costs. In addition to soft dollars, Bogle would require an estimate of the impact that trades have on a fund. Say a fund starts buying a stock at $20, but the impact of its buying drives the stock's average price to $22--that extra $2 is a trading cost on top of the commission paid. While that sounds simple, you can't put a precise figure on trading impact. However, Bogle argues that a good-faith estimate will do the job and points out that plenty of firms provide trading-cost estimates to money management firms.
John Montgomery of Bridgeway funds argued at the same hearing that rather than requiring greater disclosure, Congress should ban soft dollars because they're not in fundholders' interests. "As a fellow Texan said, 'If you see a snake, just kill it--don't appoint a committee on snakes.' This is one snake we just need to kill."
If Evensky is right, and no one ever gets more than a dollar's worth of goods for a dollar paid in commissions, then we should stop the practice altogether. However, I'd suggest we simply require disclosure along the lines of Bogle's or Bradley's proposals. Once that information is out in the open, let the defenders of soft dollars make their case for preserving the practice.