A year ago, Fool contributor Whitney Tilson wrote a piece on a time-honored Wall Street practice: soft dollars. Basically, this is when institutions, such as mutual funds, pay excessive commissions (yes, that's correct) to brokerage firms. In return, the brokerages provide research, software, and other goodies.
Thus, instead of a mutual fund deducting this from their management fee, the costs are included in overall trading costs (which are automatically deducted from a fund's net asset value). Unless you spend a lot of time reading a mutual fund's prospectus, you're likely not going to know what its true trading costs are.
But, of course, it's you -- the investor -- who pays for all this.
So given the increased regulatory scrutiny on Wall Street -- such as with the investigations by New York Attorney General Eliot Spitzer -- soft dollars have been coming under fire recently. And increasingly, it's safe to assume that the practice will start to diminish.
In fact, this week, Fidelity indicated that it will now pay for research from Lehman Brothers (NYSE:LEH). Hey, as one of the world's largest mutual funds, brokerage firms could lose a lot of business if they continue to use soft dollars. To be sure, failing to acknowledge Fidelity's move, or that of others, would probably result in a loss of trading revenue that is by no means small for Lehman and other large brokerages.
It stands to reason that Fidelity may be just anticipating that regulators will eventually disallow soft dollars. This could lead other big mutual fund companies to follow suit, as well.
For investors, this is certainly very good news. Under the old way, soft dollars were a win-win situation for Wall Street. Brokerages got hefty commissions. Portfolio management companies didn't have to pay for these costs (that is, from their management fees). Rather, the money came out of investors' pockets.
Without soft dollars, investors will get a much better idea of the true cost of funds. What could possibly be wrong with that? Nothing yet, but consider an interesting question, which may or may not play out: In the absence of soft dollar practices at Fidelity, will management fees at mutual funds increase to cover the costs of research, effectively rendering this a draw?
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Fool contributor Tom Taulli does not own shares of companies mentioned in this article.
