What Are Soft Dollars?
Soft dollars are additional payments made by mutual fund managers and other money managers to any brokerage firm from the clients’ accounts to pay for the research offered by the firm. Such payments also cover the transaction charges incurred for executing trades.
Such payments allow mutual fund companies to avail of services without paying directly. The payments are legal only if the money managers utilize their clients’ commissions to purchase services that help make investment decisions. Using this arrangement is legal if the purchased research fulfills the U.S. Securities and Exchange Commission (SEC) requirements.
Table of contents
- Soft dollars meaning refers to the payments made by mutual funds and other investment managers to brokerage firms to partly or fully pay for services such as research.
- The arrangement comes with various disadvantages, for example, lack of transparency and conflict of interest. Moreover, the arrangement can result in higher commissions and execution costs. As a result, investors receive lower returns.
- The SEC allows such an arrangement only if the rational payments and the investors get good execution.
- Hard dollar arrangements involve actual cash payment.
Soft Dollars Explained
Soft dollar meaning refers to an arrangement wherein a mutual fund or any other money manager makes payment to their service provider via commission revenue. The payments cover the research-related expenses and the cost of executing the trades incurred by the latter. In other words, investment management companies utilize client-generated commissions instead of the available capital to pay for the brokerage firm’s research services. As a result, money managers can get services at their client’s expense.
Let us look at a scenario to understand how this payment works.
Suppose an institutional investor, ABC pays DBC, a brokerage firm, four cents for each share in commissions. Nevertheless, it might cost two cents per share only to execute a trade. The remaining two cents account for the additional services provided by DBC. In return for paying the higher fees, ABC might get access to research. This scenario is not an issue for the SEC as the regulator permits this arrangement if the commissions are reasonable and investors get decent execution.
One must note that brokerage firms provide a wide range of services in exchange for payments. Such services include software, free research, and hardware. The research services offered include the following:
- Peer comparison
- Industry analysis
- Fundamental analysis
- Technical analysis
- Daily market-related updates, etc.
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Soft Dollars vs Hard Dollars
As noted above, in the case of soft dollars, mutual funds do not pay for the services offered by brokerage firms directly. However, in the case of hard dollar arrangements, mutual fund companies, and other money managers pay the brokerage firms with cash in exchange for their services. Usually, the clients are already aware of the hard dollar amount payable to the broker. The payments include account maintenance charges, transaction charges, and fees levied for the research provided.
Thus, the main difference between soft and hard dollars is that institutional investors pay the former via commission revenue. In contrast, hard dollar arrangements involve actual cash payment.
Companies find it challenging to compute the overall cost of soft dollars arrangements owing to their complex treatment. On the other hand, calculating the total cost of hard dollar arrangements is straightforward.
Let us look at this soft dollars example to understand the concept better.
Suppose a small cap value fund wants to purchase research services offered by a brokerage firm, NTC. The mutual fund agrees to pay a minimum of $5,000 in commissions to avail of the brokerage services in exchange for the research provided. This is a soft dollar arrangement. That said, if the fund wanted to purchase the research, it could pay $2,000 in cash, i.e., hard dollars, to NTC.
In 2013, the SEC imposed sanctions on Ney York-based Instinet LLC. After an investigation, the former found that the latter approved soft dollar payments worth over $400,000 to J.S. Oliver Capital Management, although there were clear signs that such payments were improper.
The SEC investigation found that J.S. Oliver Capital Management associates misused the payments. As a result, the regulator agency charged the San Diego-based company separately. In the end, Instinet paid over $800,000 to settle the SEC’s charges.
The main soft dollars benefit is that it can provide fund managers with extensive information, helping them make better investment decisions. As a result, mutual funds can generate higher returns and fulfill investors’ financial goals. Although it can be challenging to value any brokerage firm’s research services, the information provided can be extremely beneficial for individual investors if used prudently.
The following are the disadvantages of this arrangement:
#1 – Lack of Transparency
When investing in a mutual fund, investors pay transaction charges and the fees associated with research and account management as a part of packaged or bundled services. Such costs include soft dollar transactions, which a mutual fund does not disclose. Although this might not appear to be an issue in the short term, it impacts a fund’s long-term performance.
#2 – Conflict Of Interest
The investment manager decides the total amount of soft dollars payable. This can result in a conflict of interest. After all, there’s a chance that fund managers might be overpaying for trades, research, or paying for services benefiting another fund. Hence, investors might be in the dark while not benefiting from their investment.
#3 – Low Returns And High Costs
The arrangement can lead to higher execution costs and commissions, thus impacting investors’ returns.
Frequently Asked Questions (FAQs)
The main soft dollar benefit is that it can provide investment managers with extensive research. Money managers can utilize all the information obtained from the brokerage firm to generate higher returns, thus benefiting their clients.
In the case of such arrangements, money managers like mutual fund managers direct the commissions generated by a fund or client’s transaction to a brokerage firm or some other trading venue.
Investment managers can make such payments to a brokerage firm to cover the cost of services offered by it. The money managers make the payment from their clients’ accounts, i.e., through revenue commission. The brokerage firm accepts the payment for executing transactions instead of levying separate fees for services, research, or products.
Soft dollars are a way for investment managers to get services without needing to make payments for them directly. On the contrary, hard dollar arrangements require investment managers to pay cash to a brokerage firm for the services offered.
This has been a guide to What is Soft Dollars & its meaning. We explain it with examples, advantages, disadvantages, and comparisons with hard dollars. You may also find some useful articles here –