Soft Dollar Arrangements
Soft dollar arrangements are usually made where investment advisors get research or other brokerage related services from a broker or dealer in return for routing their transactions through that broker-dealer.
Stock traders will be familiar with the fees applied for executing trades with their broker but this fee is made up of 2 separate charges. The brokerage firm charges for the trade execution as well as a commission for the brokerage services. These fees are called soft dollar arrangements and can impact long-term investment returns.
Soft dollar arrangements have the potential to yield high returns for a firm's clientele by providing them access to more comprehensive investment research or services than they could get without having a soft dollar arrangement in place.
History of Soft Dollars
Soft dollars were legally approved when commission rates were de-regulated on May Day 1975. The Securities and Exchange Commission passed Section 28(e), which was an amendment to the Securities Act of 1934. The SEC refer to them as "commission dollars" in the document.
After the deregulation of commission rates, soft dollars had to be approved. As per the regulation, investment advisors that use soft dollars have to use their credit to give legal and suitable guidance to the account manager receiving the soft dollars.
The rulings about soft dollars were legislated because legislators feared that the removal of fixed commissions would bring competition to a business that had never experienced such competition before.
The primary motivators were the fears of a pricing free fall and that managers would violate their obligations because of low returns. The underlying objective was to make sure that the retail investor’s interests were safeguarded by ensuring that brokers and researchers benefited mutually.
Inside A Soft Dollar Arrangement
Let's assume that an institutional trader pays their brokerage firm commission of four cents per share. The actual charges may be two cents per share for each trade.
The other two cents are soft dollars that will pay for additional services the brokerage offers. For instance, the institutional investor could get access to in-house research, hardware, software, or trading analysis in return for paying the higher fees.
Research from brokers covers the fundamental, technical, and economic analysis of listed companies, daily or other periodic market updates, industry analysis, industry reports, and projections.
Both of these options are not an issue for the Securities and Exchange Commission (SEC), provided that certain conditions are satisfied. The SEC is open to soft-dollar transactions as long as the investor gets their executed trades on time and commissions are within reason.
Advantages of Using Soft Dollar Arrangements
Soft dollars have several benefits for the investors that use them. The main advantage is that they offer access to a more extensive range of market research.
For example, investment managers can use the research that they get through using soft dollars to make decisions and trades that will profit all of their investors.
Soft dollar supporters claim that removing this practice could affect investment research and decision making by investment advisors and end up reducing the investment bottom line for their clients.
Disadvantages of Soft Dollars
The majority of fund managers, like mutual fund managers and wealth managers, pay the soft dollar costs from their investors' money. This means that people investing in these funds are paying the fees of research and other services included in the soft dollar arrangement.
However, the average investor does not know about soft dollar arrangements. The additional cost of these arrangements is simply assumed to be part of trading costs, which affect the fund's long-term performance and returns.
Most mutual funds disclose the costs of hard research in their management fee breakdown. However, in many cases, these costs are paid through soft dollar arrangements.
This form of payment can be seen as a misrepresentation of information to the investors. Another disadvantage is that using soft dollar arrangements does not allow investors to make an accurate cost or yield analysis when selecting the fund to invest in.
The risk return balance is not measurable in specific terms for soft dollar arrangements. Since the arrangements are fluid, one fund manager would get a different service from another fund manager. This lack of clarity means investors can get a raw deal if their fund manager does not have a profitable soft dollar arrangement.
These disadvantages are severe enough that a growing movement exists to stop using them. While they are in everyday use at present, this lack of transparency and clarity is causing them to be seen in a negative light.
Example of Soft Dollar Arrangements
A mutual fund offers to buy research from a brokerage firm by running trades through the brokerage. Let’s assume that the fund is a large-cap value fund, and it wants to get research from ABC Brokerage Firm.
The fund agrees to a soft dollar arrangement that involves it routing trades that will earn the brokerage a minimum of $12,000 commissions for brokerage services in exchange for the research. Now, if the firm wanted to buy the research outright, all it had to do was buy it from the brokerage by paying $11,000 in hard dollars (cash)
Please note that soft dollar arrangements can be confused with directed brokerage arrangements. However, directed brokerage involves that an account manager is expected to route trades through a specific dealer/broker. This is done in exchange for the broker agreeing to pay some specific fund expenses. Such deals should be disclosed in the fund prospectus and perhaps in a footnote for the fund fee charges.
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