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Soft Dollars -- An Investment Wolf in Sheep's Clothing
It's unfortunate that a majority of investors don't know what "soft dollars" are, because this is a topic with important implications. Since most soft dollars are used to pay for investment research, let's start this commentary by looking at how money managers acquire research.
Basically, money managers--whether they manage individual client accounts or mutual funds--obtain research from one or both of two sources: (1) from within the money manager's organization and (2) from external sources. Internal research is typically unrelated to the topic of soft dollars, but research acquired from external sources is another story. When money managers pay for external research with their own hard cash, they are said to be paying "hard dollars." However, when managers receive external research in exchange for commission dollars paid by the managers' clients, these managers are said to be using soft dollars.
"[Soft dollar research] is usually priced several times higher than equivalent research quoted in hard dollars. Not surprisingly, money managers find it easier to pay higher prices when they are using somebody else's money."
Consider this example. Suppose the (fictitious) Aardvark money management firm has an agreement with the (fictitious) Zebra brokerage, where Aardvark's clients' accounts are located. According to this agreement, for every $100 in commission expense paid by Aardvark's clients to Zebra, Zebra agrees to furnish Aardvark with $50 of research or research-related services. On Wall Street, this would be called a soft dollar arrangement. On Main Street, it might be called a kickback.
A number of money managers justify their use of soft dollars by arguing that investment research is essential to managing client accounts. Indeed, it is. However, so are other expenses normally paid directly by the money manager, such as employee compensation, utilities, postage, phone service and so on. The argument that research is essential seems more like a smokescreen than a logical explanation of why clients must pay for one of their investment manager's costs of doing business. Other managers defend soft dollar payments by claiming that it is a standard industry practice (which, regrettably, it is) or by noting that their soft dollar practices are "fully disclosed." Neither of these arguments, however, strike me as being especially convincing.
Not only do soft dollar arrangements burden clients and mutual fund shareholders with expenses that should be their money manager's expenses, soft dollar programs can also create a conflict of interest. Can you see the potential for money managers not to seek the lowest commissions--or even to generate unnecessarily high commissions--in order to acquire external research? (Have you looked at portfolio turnover rates at mutual funds lately?) As a money manager, I find soft dollar research pretty easy to spot. It's usually priced several times higher than equivalent research quoted in hard dollars. Not surprisingly, money managers find it easier to pay higher prices when they are using somebody else's money.
Most soft dollar arrangements are not illegal--in fact, they are specifically permitted by law. However, it is hard to argue that soft dollar arrangements are typically in the best interests of clients. As a result, we at J. V. Bruni and Company do not pay for external research in this way. (Further, we place far greater emphasis on our own independent research than the external research that we do buy--with hard dollars.) I wouldn't be surprised if the practice of soft dollar payments is eventually prohibited. If it is, I also wouldn't be surprised to see money management firms that currently use soft dollar programs trumpet their newly found emphasis on hard dollar payments. Investors would be wise to ask if their managers were always so pure.