On Wednesday, the SEC agreed to publish guidance concerning the use of "soft dollars" by investment managers. Monetary luddites might ask: "Soft dollars? Haven't they all been soft since President Nixon abolished convertibility into gold?"
In fact, soft dollars refer to a practice in which part of the trading commissions money managers pay to brokers are "refunded" back to them in the shape of investment research or other services that can include Bloomberg screens or even office rent. This poses a number of problems that may ultimately be harmful to investors.
For one, the bundling of services creates opacity surrounding the true cost of trade executions, interfering with the manager's duty to seek best execution on behalf of his investors. Furthermore, it creates an incentive for investment managers to get their investors to purchase goods and services out of their trading commissions, rather than from the fund management fees they receive (for an expanded discussion of this, read Whitney Tilson's manifesto, "'The Disgrace of Soft Dollars'').
The SEC will not be banning soft dollars, but it is clarifying what is acceptable practice. To do this, it will apply two criteria: content and use. Regarding content, commissions may only be used to pay for "eligible research services," which includes research reports and market data. Mass-market publications, such as an office subscription to TheWall Street Journal, are excluded (office rent and travel expenses are a fortiori improper).
The second criteria addresses ''mixed use'' items that can have dual use in investment research and managing the investment firm. Performance measurement software falls in this category because it can generate analysis in support of investment decision-making as well as firm reporting and even marketing. In such cases, the money manager must make a "reasonable allocation of client commissions in accordance with the eligible and ineligible uses of the items."
The SEC has chosen to act with a light touch and it is perhaps best so, since some market participants have taken the lead in dismantling the soft dollar apparatus. In November of last year, it was reported that mutual fund giant Fidelity had reached an agreement with Lehman Brothers (NYSE: LEH ) to unbundle research and trade executions. Fidelity now pays Lehman an estimated $7 million a year for its research and $0.02-$0.025 cents per share in commissions (the industry average at the time was $0.036 cents per share). Since then, Fidelity has put in place similar arrangements with Deutsche Bank (NYSE: DB ) and Thomas Weisel (Nasdaq: TWPG ) . In its prospectus for yesterday's IPO, the Cowen Group (Nasdaq: COWN ) disclosed in the risk factors section that it is party to two ''unbundling'' agreements.
At this time, it's not clear that ''unbundling'' will become an industry-wide trend. A recent report by research firm Greenwich Associates suggests that following several years of cuts, the use of soft dollars has now stabilized. If you are a mutual fund or hedge fund investor, you'd be well advised to check your investment managers' policy regarding the use of soft dollars.
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