Payments have a fairy tale vision of becoming

Payments for brokerage services provided to clients are tightly controlled and monitored by many different agencies. These dollars, soft dollars, are retained on a trade to be used for research services that provide a primary benefit to the client.

Soft Dollar Arrangements

During a trip to the grocery store in most states, the cost of your items is totaled for you, and tax is added to the bill. Most of us simply pay the total and do not think twice about the taxes paid. Some individuals understand the tax structures and perhaps even how the tax dollars are allocated and spent.

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For states with sales tax, individuals do not have a choice as to whether they pay sales tax or not.Now think about an investor who is trying to understand the cost of an investment as well as the expected return they will earn. Investors play a big part in their own financial plan, however, there is nothing wrong with looking to an expert for help with such an important decision.

Being rich is a common investment goal, but what that really means in dollars and cents differs from one investor to the other.
Suitcase full of money

Many individuals have a fairy tale vision of becoming rich by investing. While the associated goods and services paid for are seemingly straight-forward (like our groceries), payments for commissions and fees (similar to the taxes on our grocery bill) are not always fully understood by investors. Investors can manage their own financial planning or hire a brokerage firm to provide services.

Brokerage firms understand how the market structure works, the fees and cost of different services and what factors will have an impact on overall financial planning. A broker’s expertise, access to research, and market data makes them a valuable resource to their clients.

Soft Dollars

Soft dollars, also known as brokerage, include any dollars retained on a trade to be used for services for the client’s benefit.

When brokerage firms pay for research services through commission revenue rather than a direct payment, this arrangement is termed soft dollar payments. In contrast, payments made by advisers for products or services with their own money, not commissions, are called hard dollars. The Security and Exchange Commission (SEC) reports show that more than 40 percent of commissions are used to obtain research and other services that will benefit the investment adviser, and around 90 percent of advisers engage in soft dollar arrangements. The costs of research or bundled services is not always fully disclosed by the fund but rather included in the cost of each trade, having an impact on the long-term performance of an individual’s financial plan.

Why are Soft Dollars Important?

Some investors would argue that the end result is the same; whether using soft dollars or hard dollars, the investor still bears the cost. The structure of soft dollars and the difficulty associating a direct cost with these payments highlights the challenge of managing such hidden costs. Unlike taxes, which are imposed on individuals at a set rate, soft dollars must be allocated based on the product used or the percent of a service specific to a client’s benefit.

While the use of soft dollars provides a positive impact on investor flows, the bottom line impact is lower fund performance.That is all the more reason that soft dollars are outlined in Section 28(e) of the Securities Exchange Commission Act of 1934. This section provides clarification around the use of account transaction commission dollars to pay for research services. The use of these dollars can have a major impact on an investor’s ability to analyze trading cost. Soft dollars can be hidden in these costs, and while the use of soft dollars is not illegal, the use of soft dollars has many rules that govern their use. Many different organizations help maintain standards around the use of soft dollars and the associated risks.

Risk with Soft Dollar Transactions

A conflict of interest results when an investment broker directs the use of soft dollars for services and research that may support investment decision-making that benefits themselves, their firm, and other clients, in addition to the client whose commission dollars are being used. Soft dollars are not like management fees, which have a set value. Soft dollars differ from one investment manager and brokerage firm to another and have the potential to result in conflicts or abuse. Investors may never truly know what percentage of their cost is the actual investment versus the soft cost. Wall Street activity is tightly monitored and under great scrutiny at all times.

As investors continue to be fearful of financial fraud, the industry is pushing for reform, in particular as it relates to soft-dollar transactions.

Wall Street

To mitigate these associated risks, several different agencies have rules and guidelines that are accepted as industry standards for measuring compliance by brokers or money managers.

The CFA Institute, formerly The Association for Investment Management and Research, is the leading global institute governing and promoting ethics and integrity, education and excellence in investment management. The CFA Code of Ethics and Standards of Professional Conduct are further supported by the Soft Dollar Standards. The Soft Dollar Standards focus on the client and provide guidance on ethical use of client brokerage and commissions. Other organizations such as the Association for Investment Management and Research have also published standards to clarify the use of soft dollars and ways to avoid potential abuses and protect investors.

Lesson Summary

Expenses associated with investments managed through brokers and money managers can be classified as soft dollars or hard dollars. Soft dollars can be spent on research and services that will be used in the investment making decision process. Fund management must be paid through hard dollars and these dollars are easily tied back to the fund’s expense ratios.

Soft dollar costs are difficult to allocate to funds in advance. Brokers and investment managers are accountable to a high standard of ethics and full disclosure of any benefits earned through soft dollars. Think back on the taxes charged on our grocery store trip: the taxes collected can be used for purposes that may not directly benefit each individual tax payers. Most taxes go to education, transportation, health care, corrections and providing low income assistance. Unlike our taxes, soft dollars can only be spent when the primary use is for an individual client’s benefit and not related to fund management.


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