Soft Dollars

Explained:

Soft dollars are a controversial inducement brokers offer investment managers to place trades through them. A broker sets aside a portion of the commissions it receives from an investment manager. The investment manager is allowed to spend these "soft dollars" on third-party research, financial data or other services that can aide its investment decision making.

Brokers have long provided investment advice, research or other services to clients—including investment managers—as an inducement for them to trade with those brokers. The extra services cost money, so brokers who provide them tend to charge higher commissions. Soft dollar arrangements are a natural extension of this. Soft dollars allow the broker to "outsource" the extra services it offers an investment manager. Rather than limiting an investment manager to using the broker's own research, soft dollars allow the broker to offer the investment manager research or services from any third party the investment manager chooses. The investment manager selects and receives the services, and the broker pays for them. The investment manager's clients, who pay the brokers' commissions, are not generally informed about specific soft dollar purchases.

Soft Dollars Can Pose a Conflict
Exhibit 1

Soft dollars can pose a conflict because the investment manager selects the broker and directly benefits from the soft dollars while it is the investment manager's client who pays the commissions that fund the soft dollars.

It is argued that clients of an investment manager benefit from soft dollars because the research or services soft dollars buy enhance a manager's ability to make sound investment decisions. A counterargument is that clients would be better served if there were no soft dollars and investment managers simply increased their fees to cover the cost of directly purchasing the research or other services the soft dollars buy. This would provide greater transparency and eliminate opportunities for abuse.

Abuses have long been associated with soft dollar arrangements, which have occasionally been used to purchase goods or services unrelated to improving investment decisions—things like office administration, carpeting, office rents, membership dues, travel and even entertainment. Critics see soft dollar arrangements as little more than kick-backs to investment managers.

Soft dollar arrangements are regulated by the Securities and Exchange Commission (SEC). Broker commissions are considered client assets, and any fiduciary expending client assets must do so for the exclusive benefit of the client. A fiduciary who pays excessive commissions in order to secure products or services should be able to demonstrate that those products and services were for the exclusive benefit of clients, although a lack of reporting requirements makes this need somewhat theoretical. Section 28e of The Securities Exchange Act of 1934 provides a "safe harbor", identifying qualifying research that can be presumed to be for the exclusive benefit of clients. Under the safe harbor, qualifying research includes:

... advice, either directly or through publications or writings, as to the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or purchasers or sellers of securities [or] ... analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts ...

Most investment managers limit soft dollar expenditures to remain within the Section 28e safe harbor. Hedge funds, as largely unregulated entities, are rumored to not so limit themselves.