Reformers Take a Hard Look at ‘Soft Dollars’

Wall Street regulators pushed hard for stock research reforms after revelations that in-house analysts at major brokerages were touting stocks to help their investment banking colleagues, and not their clients.

Now, another aspect of stock research is coming under increasing scrutiny: the use of so-called soft dollars by mutual funds to pay brokerages for research and other services.

Soft dollars work like this: Rather than pay a penny or two a share to trade a stock on an electronic system, a mutual fund pays a brokerage firm 5 cents a share. In exchange for the higher payment, the brokerage gives the fund an array of services, primarily stock research done by in-house or independent analysts.

Soft dollars are big business, accounting for $1.24 billion, or 11%, of the $11.3 billion in total stock commissions last year, according to research firm Greenwich Associates.

Tying research costs to trading commissions has huge benefits for fund companies but harms investors, critics say. Because trading costs do not have to be included in reported management fees, companies can also exclude research expenses from those fees, potentially luring investors who believe expenses are lower than they actually are.

That’s because trading expenses are subtracted directly from a fund’s assets, resulting in lower returns, but the amount deducted doesn’t show up in reports to fund shareholders.

“It is legalized theft,” said Benn Steil, a senior fellow at the Council on Foreign Relations, who is an expert on trading issues. “I’m not saying management firms shouldn’t buy independent research. They should just use their own money.”

Investors also suffer, critics say, because fund managers have no incentive to keep trading costs low and might actually boost their trading activity to qualify for extra soft-dollar benefits.

The critics say fund firms should include research costs in their management fees.

If the current amount of soft-dollar expenses was included in management fees, a typical annual fee of 1% of assets would jump to 1.7%, Steil estimates. But if companies indeed had to include the cost of research in management fees, the firms would operate more efficiently and increase a 1% fee to only 1.18%, Steil said. That would reduce fund investors’ total costs -- hidden and otherwise.

Proponents of soft dollars counter by saying they are crucial to the survival of independent research. Everyone agrees research is important, they say, but no one wants to pay for it.

The alternative to soft dollars would be to raise management fees, and fund companies would rather forgo research than do that, they say. “Is anybody on the planet arguing that asset management fees should go up?” said Scott Cleland, chief executive of the Precursor Group, a small research firm.

But less research would hurt investors by depriving fund managers of vital information, advocates say.

“There would be more Enrons and WorldComs because there would be no one watching the store,” said Lee Pickard, a Washington lawyer who represents soft-dollar proponents.

There is little doubt that third-party research would be cut if soft dollars were curtailed.

A survey by researcher Thomson Financial found that soft dollars account for 41% of the total spent by funds on independent research. If fund companies were to pay out of their own pockets -- and raised fees to make up for their added cost -- total independent research spending would tumble 24%, Thomson found.

“At the end of the day, the burden of paying for research will fall to investors,” said Scott Rosen, a Thomson senior vice president. “The only question is should it fall through fees charged directly by portfolio managers or by a reduction in fund performance?”

Though long criticized, soft dollars have existed for decades with the blessing of Congress.

In the days of fixed trading commissions, brokerages offered research to lure customers. When it deregulated rates in 1975, Congress said funds could pay excess trading commissions to continue getting research.

But apparent abuses have occurred. A 1998 Securities and Exchange Commission probe found some investment advisors using soft dollars for questionable purposes -- such as paying for rent, cellphones, legal expenses and hotels -- keeping their reported management fees down at the expense of unwitting investors.

Soft dollars are once again drawing scrutiny from regulators, in part because the mutual fund market-timing scandal has spotlighted a raft of questionable trading habits.

The SEC recently set up an internal task force to study soft dollars, and its examiners are conducting a sweep to determine whether abuses exist. The National Assn. of Securities Dealers, a brokerage industry regulator, also has formed a task force.

Most observers doubt that soft dollars would be banned, but some companies are beginning to tighten their policies regarding use of soft dollars.

Fidelity Investments recently announced that it would stop using soft dollars to pay for market data services. Instead, the fund giant will pay $40 million to $50 million out of its own pockets this year for the services.

Fidelity will continue to use soft dollars to acquire research but will consider further steps if rivals do the same, said Eric Roiter, general counsel of the firm’s investment management unit.

“It’s a start,” Roiter said. “We don’t want to get too far out in front of the rest of the industry.”

Last year, he said, Fidelity paid about $815 million in stock commissions, of which $160 million went to soft dollars. About $30 million was for independent research, he said.

Wall Street investment banks have the most to lose from any significant changes in soft-dollar spending, because their commission revenue would fall sharply.

A study by Bear Stearns & Co. said annual earnings at four major companies -- Goldman Sachs, Merrill Lynch, Morgan Stanley and Lehman Bros. -- could sink by an average of 11%, or a combined $1 billion, if soft dollars were eliminated.