By Adam Grealish
Pervasive, but rarely mentioned, soft-dollar transactions are an opaque and conflict-ridden practice that can lead to lower returns for investors.
A relatively hushed practice in asset management, soft dollars are benefits to an investment manager—broadly defined as “research”—that a broker provides in exchange for commission-generating trades.
Because no monetary transactions actually occur, everyday investors may not realize the impact soft dollars can have on their investments. But that status quo is changing. As advisors, if we desire to go to market offering trust, fiduciary responsibility and transparency, it’s imperative that we reconsider decisions to engage in soft-dollar relationships.
Here’s an analogy: Imagine you’re mailing a letter to a relative across the country. How would you send it? Would you consider buying the mailman a first-class plane ticket to deliver your letter, where he could enjoy a glass of champagne along the way? As absurd is that may sound, some investors inadvertently do something similar when advisors execute trades on their behalf.
Often called “the investment industry’s answer to frequent-flyer miles,” 42 percent of financial advisors and 40 percent of funds engage in soft-dollar activities (according to the Securities and Exchange Commission), and usually, they do so without investors knowing about the practice. That’s exactly why the EU recently moved to restrict these research benefits in European markets. With greater regulation comes greater investor awareness. Advisors should pay attention to these shifting winds.
Why The Industry Should Pay Attention to Soft Dollars
Investment managers will route trades through high-commission brokerage channels—even though cheaper options are available—in order to gain free access to soft-dollar benefits like industry reports, expensive data services and even conference tickets.
Soft-dollar transactions can occur in two places: with financial advisors and with investment funds, such as a mutual fund. Basically, anytime a financial professional has discretion to choose how to buy or sell shares, soft dollars could be in play. There are three major problems with these scenarios that advisors should consider as they make decisions about soft dollars in the future.
1. Lack of Transparency
Unlike other investment expenses, which are generally clearly stated, the details of soft-dollar transactions are not widely published. Funds do not include soft-dollar expenses as part of their expense ratios, and advisors only need to disclose if they use soft dollars, but they do not need to quantify the amount.
Instead, the cost of soft-dollar transactions simply shows up in lower performance. High-cost trades drag on returns, and many investors are none the wiser. While the lower returns may not cause immediate disappointment among your clients, as a business practice, it certainly doesn’t help achieve long-term satisfaction.
Counterarguments in favor of soft dollars often cite the value of research for helping add value to client investments. But according to one SEC study, 28 percent of soft-dollar benefits were being used for non-research products and services by advisors. Advisors should carefully (and honestly) consider if there’s any actual scenario where soft-dollar activities do translate to added value for their clients.
2. Drag on Returns
Studies have shown that soft-dollar trades result in higher execution costs, which hurt investor returns. Not only do soft-dollar trades cost more in commissions, but they also tend to have more market impact.
John Haslem of University of Maryland found that the total trading cost for soft-dollar transactions was approximately 0.3 percent higher than a full-service broker. The same study found that a 0.01 percent increase in brokerage commissions is associated with a decline of approximately 0.05 percent in fund returns.
3. Conflicts of Interest
Investment managers have discretion over how much to pay up for trading, as long as the manager determines that the rate is “reasonable in relation to the value of the brokerage or research services.”
According to the Financial Industry Regulatory Authority: “Because a manager can use client commission dollars to obtain research and other services that the manager otherwise would have to pay for from its own assets, there could be incentives for a manager to enter into brokerage arrangements that may not serve a client’s best interests.”
Such arrangements include: overpaying for trades, overpaying for research and trading more often than is necessary in order to generate more soft-dollar benefits. Additionally, mutual funds may use soft dollars generated from one fund to pay for services benefiting a different fund. In this case, investors in the first fund shoulder the cost of soft dollars, but do not receive any benefit.
And none of this information is actually beyond the reach of the individual investor. Advisors must disclose if they use soft dollars in their annual Form ADV filing. The SEC compiles a useful spreadsheet of all the registered investment advisors in the United States and their current soft-dollar status (see column labeled “8G1” which corresponds to the soft-dollar question on Form ADV).
Investment fund companies are also required to disclose whether they use soft dollars. Unlike financial advisors, however, they also have to provide the dollar value of soft-dollar transactions. This can be found in a fund’s supplemental Statement of Additional Information, or SAI, and is often labeled as “soft dollar brokerage” or “brokerage in exchange for research.”
In general, index funds and exchange traded funds have not been using soft dollars. However, it’s never a bad idea to check your funds specifically.
If you had never heard of soft dollars before, you’re not alone. In an informal poll of industry veterans and coworkers in my more than 10 years in finance, I’ve met very few people who are familiar with the practice.
Still, ignorance of soft-dollar activities is no excuse for advisors who claim to have clients’ best interest at heart. Now more than ever, investors seek absolute trust in their financial professionals. As advisors plan for the future, they should prioritize their clients’ trust above the dicey benefits of soft dollars.
Adam Grealish is a quantitative portfolio analyst at Betterment. Prior to joining Betterment, Adam founded Roletroll, a natural language processing startup and was a vice president at Goldman Sachs, where he traded macro credit products. Adam holds an honors degree in economics from University of Chicago.
