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Commentary

It's Time for Better Soft-Dollar Disclosure

New regulations in the European Union present an opportunity for the SEC to revisit and clarify soft-dollar regulations in the U.S.

Investors have intensely focused on expense ratios over the past decade, overwhelmingly choosing to invest in mutual funds with the leanest costs. Despite the fact that investors care so intensely about expenses, there are still opaque ways that funds can spend money on research--without it showing up on an expense ratio or anywhere else. The costs to investors are still very real.

In fact, since at least 2003, Morningstar researchers have been calling for funds to disclose what they spend in these so-called "soft dollar" arrangements. (To give credit where it is due, the SEC has cracked down on some more-egregious practices in the intervening years.) Now, a new European regulation may also have the salubrious side effect of shedding some sunlight on these practices in the United States.

How do soft dollars work? To paraphrase Russ Kinnel, it's the practice of funds overpaying for trade execution, in exchange for which a broker provides research and other benefits. The cost of trade executions reduces a fund's returns, but it doesn't show up in a fund's expense ratio, because the SEC regards trading commissions as an investment cost, not a cost incurred by management. As we recently told the SEC, given a new mismatch between U.S. and EU regulations, now is a great time to reform the soft-dollar system with new disclosures.

Current Disclosures Reveal Little 
U.S. soft-dollar disclosures are opaque, and the magnitude of any harms to investors from these arrangements can be difficult to discern. The only disclosures on the commissions that mutual funds pay to execute trades are in absolute dollars on the Statement of Additional Information, and these disclosures do not disaggregate between the cost of execution and the cost of research that broker/dealers may provide to mutual funds as part of their fees for executing a trade.

As an ordinary investor, you cannot glean much information on a fund's brokerage costs relying on disclosures of commissions in absolute dollar terms. Such arcane disclosures tell you next to nothing about the extent to which trading costs reduce your returns. At best, one could calculate a fund's brokerage costs using the dollar value of commissions divided by the average assets under management for the period, the method Morningstar uses. However, this calculation would not accurately reflect the actual reduction in returns owing to commissions because the timing of the commissions throughout the year is unknown. Moreover, without going through the whole exercise for comparable funds, there is no way to understand if the trading costs for a fund in question are unusually high.

The upshot is that we do not really know the extent to which soft dollars reduce returns for investors because these costs are not disaggregated from the costs of commissions. However, given the high degree to which investors respond to management fees, which are clearly disclosed, we can assume that this is information they might like to have and on which they would act.

Further, undisclosed soft-dollar payments present a conflict of interest. For example, firms have an incentive to engage in more trading than they otherwise would, as they attempt to hit specific trade volume to receive research payments.

European Regulations Could Spur the SEC to Add Additional Transparency
This brings us to the Markets in Financial Instruments Directive, also known as MiFID II, which European regulators finalized last year.

The regulation requires mutual funds to either pay directly for the research they receive from soft-dollar arrangements or pass the costs on to their customers explicitly through a fairly complicated mechanism. (So far, most funds are just eating the costs.) The flip side of this is that brokers must now separate out the costs for research from the costs for trade execution.

This is a problem in the U.S. because brokers are not supposed to provide advice unless it is incidental to their business, and they are currently prohibited from breaking out these costs. European funds executing with U.S. broker/dealers and American funds with European clients are caught between two conflicting regulatory schemes.

In the short term, the SEC threw up its hands and took a temporary step with the "no-action" letters that helped ensure broker/dealers and asset managers could comply with MiFID II for 30 months. This approach is fine for now but could potentially lead to some unintended outcomes in the long term. For example, the no-action letters may encourage asset managers to use commissions from non-EU clients to pay for research, perhaps worsening any existing conflicts that soft-dollar commissions create. 

The good news is that MiFID II presents an opportunity for the SEC to revisit and clarify soft-dollar regulations in the context of modern arrangements.

To address the differences between U.S. and EU regulations and improve things for American investors at the same time, we recommended that 1) the SEC create a "safe harbor" to allow U.S. brokers to disaggregate research costs from execution costs, and 2) require U.S.-based mutual funds to disclose soft-dollar payments for research in the Statement of Additional Information as a percentage cost.

These two steps would harmonize the U.S. system with MiFID II and allow asset managers with clients in the European Union to more easily comply with the European directive when they must. (We don't think the SEC should adopt some of the more controversial and complicated parts of MiFID II, such as the mechanism for passing on costs of soft-dollar research, which might not translate well in the U.S.)

Furthermore, these steps should support a long-overdue increase in transparency in the U.S. fund market. We would expect such disclosures to help advisors, ordinary mutual fund investors, and asset managers better assess the value of this research, and it might lead to some of these costs declining as they become easier to scrutinize.