The Disgrace of Soft Dollars

Investment funds are lining their pockets by inappropriately charging billions of dollars of expenses to investors.

Whitney Tilson
Whitney Tilson
Mar 19, 2004 at 12:00AM

Massachusetts Financial Services Co. (MFS), the oldest and 11th-largest mutual fund company, announced this week that it has stopped paying brokers in "soft dollars." I can hear the yawns across America, but this is an important issue because investors are being bilked out of billions.

Soft dollars (don't you love such benign-sounding euphemisms?) are excess trading commissions that funds pay to brokerage firms, which are then rebated to the funds in the form of investment research and software, Bloomberg terminals, magazine subscriptions, and the like. These are expenses that in almost all cases would be paid for by the fund out of its management fee income, but instead are shifted to the fund's investors via inflated trading costs.

These costs are especially insidious because they're nearly invisible. Do you know how much your mutual funds spent last year on trading costs and commissions? Would you know how to find this information? According to an excellent column on high fund costs by fellow Fool Robert Brokamp, "To find out how much a fund pays its broker -- money that comes straight out of the fund shareholders' pockets -- an investor must dig through the fund's Statement of Additional Information, which is filed with the SEC, or the semi-annual filing of form NSAR. Raise your hand if you've heard of these documents."

In short, the general counsel of mutual fund giant Fidelity was exactly right when he admitted that soft-dollar payments are among the "least visible" and "least understood" expenses for investors.

Soft dollars in practice
To see how soft dollars work, let me tell you about my recent experiences looking for office space in Manhattan. A good setup for four to five people can cost as much as $10,000 per month, which is a significant cost for a small money-management firm like mine. I can cut this cost substantially, however -- perhaps by $5,000 per month -- if I agree to do enough trading at full brokerage commissions with certain firms that have office space available.

Here's how the math works: If I pay six cents per share commission rather than the two cents I might otherwise pay, the broker pockets an extra four cents per share. If I buy or sell only 125,000 shares each month with the broker, the extra four cents adds up to $5,000, which the broker returns to me via a break on my rent. (While technically this rent rebate may not be called soft dollars, that's merely semantics as the impact is the same -- the cost is being borne by investors).

As with most funds, the partnership agreements that govern my funds explicitly permit soft dollars, and I certainly have strong incentives to use them since every dollar I save on rent is one more dollar of pretax profit.

So why am I not leaping at a soft dollar-subsidized rent deal? Because I'd be screwing my investors! They already pay me a 1% management fee, which is supposed to cover all of my expenses. Paying inflated commissions so that my broker will pay expenses like rent (or a Bloomberg terminal, third-party research, etc.) would simply be shifting costs that are supposed to be paid out of the management fee to my investors in the form of hidden, extra commission charges.

I won't go so far as to call using soft dollars stealing -- as discussed below, it's typically disclosed, at least in the fine print -- but it's pretty darn close.

Billions at stake
Lest you think this is a minor issue in the grand scheme of things, think again. An article in The Wall Street Journal this week reported that "Mutual funds and other institutional investors paid about $12.7 billion in commissions in 2002, about half of which was compensation for research and other forms of soft-dollar services, according to the latest numbers from research firm Greenwich Associates." Another study showed that commissions were inflated to an even greater degree. Richard Strauss of Deutsche Bank (NYSE:DB) concluded that 40% of the commission paid by a fund company relates to research, 45% to execution, and the rest (15%) goes to third-party research and computer aids.

This is consistent with back-of-the-envelope math: Funds pay an average of five cents per share commission at the major brokerage houses, yet according to another Wall Street Journal article, "Most Wall Street firms acknowledge that only about two cents [e.g., 40%] of the standard five-cent commission goes toward trading execution."

This adds up to big numbers. If half of the $12.7 billion in commissions paid by mutual funds (not even counting the billions generated by hedge funds) are used to pay for research and other services that should be paid from management fees, then mutual fund investors are paying roughly $6.3 billion that they shouldn't be! That's about $21 for every man, woman, and child in this country. As I was saying, big numbers...

It's easy to see why money-management firms are reluctant to get off this gravy train. MFS estimates that its new policy will cost it $10 million to $15 million per year, and Fidelity, the largest fund company in the country, estimates that it pays about $275 million annually in soft-dollar research.

The excuses
The fund industry does try to defend these soft-dollar arrangements. Here are the four biggest rationalizations I've heard:

1. Research benefits investors
The most common defense of soft dollars is that they are mostly used to pay for research and information services that help fund managers make better investment decisions, which in turn benefits shareholders. I have two problems with this argument. First, I question whether Wall Street research helps managers generate better returns (in fact, I think most of it is worse than useless, but I'm hardly an expert since I almost never read it).

But my main objection is who ends up paying. If a fund manager believes that access to certain research (or a Bloomberg terminal, etc.) will result in superior investment returns, then he/she should by all means pay for it -- but this is precisely the type of expense that should be paid for out of the management fee!

2. It's disclosed
Another defense of soft dollars is that their use is disclosed in fund prospectuses. My answer: So what? Does anyone really read those dense documents? Even if investors did, how many would have the foggiest notion what soft dollars were? The reality is that the overwhelming majority of investors have no idea that they're in effect being charged a significantly higher fee than they think.

3. It's OK to pay for good execution
A recent article in Barron's defended soft dollars by arguing that in the case of big trades by large funds, "Unless the executing broker takes great care to disguise the underlying source and character of the trade, the dilution of portfolio returns from price impact can overwhelm any savings from low-cost brokerage services. Investors are better off if the manager pays the broker a higher commission to take greater care in executing trades."

Well, no kidding, but what does this have to do with soft dollars? In some cases, when I have a difficult order in which a trader might spend days carefully buying an illiquid stock without running it up (or selling it without crashing it), I'm quite happy to pay a higher commission than usual. But this has nothing to do with soft dollars or expenses that would otherwise be paid for out of my management fee.

4. That's the way it's always been done
When all the rationalizations are stripped away, the only defense I hear is that "this is the way it's always been done, and everyone else does it." Sorry, but that's not good enough for me -- and it shouldn't be for you either.

An analogy
Here's the question I would pose to any fund-management company that uses soft dollars. Let's say your funds' auditor came to you and whispered, "Pssssst! Instead of paying me the usual $1 million this year to audit all of your funds, instead pay me $2 million. [Audit expenses, like commissions, are typically paid by the fund, not out of the management fee.] Then, I'll give you a $900,000 credit that you can use to pay for pretty much whatever you want related to your business: a research analyst that we'll hire so you don't have to, office space, etc."

I think any self-respecting fund-management company would be outraged and immediately reject such an offer. Yet I see no difference between this and the current soft-dollar system -- other than the starting point (e.g., the soft-dollar gravy train is already well established), which is what humans naturally anchor on, especially when it is in their self-interest to do so.

So what can you do about this? First, call your money managers and ask if they use soft dollars and what they pay, on average, in commissions. If the answers are yes and/or more than three cents per share (unless there's a really good explanation for paying more), tell them that you object to soft dollars and/or paying high commissions in exchange for research and threaten to close your account.

Second, some firms do not use soft dollars -- for example, Vanguard never has, and now MFS doesn't -- so consider investing your money with such firms. Finally, contact your senator and congressperson. A mutual fund bill that cleared the U.S. House of Representatives last year would require greater disclosure of soft-dollar arrangements while a bill introduced in the U.S. Senate would ban them altogether. Neither bill appears likely to pass, given the lobbying clout of the investment-management industry, so phone calls could help a lot.

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Whitney Tilson is a longtime guest columnist for The Motley Fool. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback at To read his previous columns for The Motley Fool and other writings, visit The Motley Fool is investors writing for investors.