‘Soft Dollars’ Raise Conflict-of-Interest Issues
Mutual fund investors have enough to be concerned about just in the way the stock and bond markets have been acting of late.
But here’s another subject that might warrant some additional attention: “soft dollars.”
This term describes the tendency of professional money managers to use commissions generated from their stock and bond trading to pay for investment research help. The practice is widespread among mutual funds.
For example, a brokerage might agree to provide $50,000 worth of research reports to a mutual fund if the portfolio manager commits to sending $100,000 worth of commission business to the firm.
Few fund groups have the time, money or personnel to do all of their own research, especially now that more managers are looking to invest in markets around the globe. Besides, a manager has to place trades anyway, so using soft dollars could be cheaper than shelling out $50,000 in cash.
Yet critics say the practice also extends to other goods and services beyond just research--to everything from mutual fund legal fees and computer software to financial magazines. Even if a brokerage doesn’t produce such items, it can still pay for them on behalf of a fund, assuming the manager agrees to send so much business its way.
The Securities and Exchange Commission won’t allow a fund management company’s rent, payroll and other overhead expenses to be paid for in this manner. But the practice is acceptable on items such as investment software that can be used to help run a fund, even if the management company benefits more than shareholders.
Investors are saddled with “hidden charges, via the commission stream, which pay basic operating costs of business,” complains critic Harold S. Bradley, a vice president and director of trading at Twentieth Century Mutual Funds in Kansas City, Mo.
“People are paying bills they don’t even know they’re paying,” he says.
The practice raises conflict-of-interest questions. If a fund manager must direct so many commission dollars to a certain brokerage to get, say, a computerized quotation service, will he or she be able to get the fund’s orders executed at the best price? And might such a practice tempt him or her to trade excessively?
It’s worth noting that trading costs aren’t limited to the roughly 6 cents a share in commissions that mutual funds pay to buy or sell. They also include more nebulous outlays in the form of dealer spreads or a brokerage’s ability to execute a big order at an optimal price.
While many agree the potential for conflict of interest exists, not everyone agrees sins are being committed.
“The law is pretty clear that soft dollars can’t be used for something that would be a conflict of interest,” such as overhead expenses, says Stephen E. Cavan, senior vice president and general counsel for Massachusetts Financial Services in Boston.
Actual abuses have been rare, he says.
In the event that soft dollars are used, say, to purchase investment software that can help a manager do a better job for the fund, then the practice may be justifiable, he says.
And even when brokerage commissions help pay for non-research outlays such as a fund’s printing bill or legal expenses, this still benefits shareholders, not the management company, says Cavan.
Yet Bradley counters that such payments would understate a fund’s true expenses and its “expense ratio,” making comparisons among rival portfolios less meaningful.
In fact, fund trading costs in general don’t show up in the expense ratio or in the “fee table” in the prospectus. Yet all of these costs will affect a fund’s performance numbers. Bradley feels that the impact of soft dollar trading should be disclosed to shareholders.
The Washington-based Investment Company Institute, the national trade organization for fund companies, disagrees. It argues that such information would not be useful to shareholders and would simply lengthen prospectuses.
“The institute strongly believes that, if any additional disclosure requirements concerning brokerage practices . . . are proposed, such disclosure should be to fund boards,” ICI General Counsel Paul Schott Stevens wrote in a letter to the SEC last year.
The SEC is certainly aware of the potential for conflicts of interest with soft dollars. The agency’s staff has proposed that management companies outline their trading practices and the impact on fund performance as footnotes in the prospectus.
But the SEC staff has also recognized certain soft dollar benefits for mutual funds, such as helping them gain access to more and better research.
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Mutual funds that hold Japanese stocks were the top fund category during the first quarter, helped by currency factors. Slightly more than half of the Japanese market’s 22% gain over the 12 months through March 31 was attributable to the yen’s rise against the dollar, says the Vanguard Group in Valley Forge, Pa. But lest you overrate currency factors in international investing, Vanguard says the impact was much less in Hong Kong, Australia, Britain, France and Germany. In those markets, currency factors affected returns to the tune of only about two percentage points on average.
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The Investment Company Institute is circulating a press release on “frequently overlooked” mutual fund facts, Part 2 . Many of the supposed misconceptions were already covered in a similar release in October, but a few are worth mentioning, or at least repeating.
* Most of the new money entering mutual funds isn’t coming from certificates of deposit. “Contrary to frequent (but incorrect) reports, most of the people investing in mutual funds are not new to funds,” the trade group says.
* A good chunk of mutual fund assets is held in long-term plans such as IRAs and 401(k) programs. The institute estimates that almost $450 billion of the industry’s $2-trillion asset base is in retirement accounts.
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For the past year, Fidelity has been waiving its 3% sales charge on nine international funds, with the grace period scheduled to expire May 31. But the Boston-based giant says it will maintain its current no-load policy indefinitely on five of those funds: Fidelity Canada, Diversified International, Europe Capital Appreciation, Japan and Worldwide.
Mutual Fund Trading Costs
Mutual funds buy or sell cheaply, paying an average commission of 6 cents a share. But that’s only one type of transaction cost. The following elements are not disclosed to shareholders but can exert a bigger impact on performance.
* Dealer spreads. Every stock has both a bid and an asked price. The manager buys at the higher price, the asked one, and sells at the lower price, the bid. The difference, or spread, can be a significant cost component, especially with smaller, infrequently traded stocks.
* Transaction-size effects. A manager who wants to buy or sell many shares in a hurry can move the price of a thinly traded stock. Big orders send signals that something may be happening with the stock, and the dealer will adjust the price accordingly.
From: “How Mutual Funds Work,” by Albert J. Fredman and Russ Wiles ($15.95; New York Institute of Finance).
