Is Soft Dollar Remuneration a Conspiracy Theory?

Conspiracy theorists seem to lurk around every corner these days, imparting their less-than-logic-backed views and offering little evidence. The complex world of finance and managed assets provides ample opportunity for cynics and simpletons alike to assert similar claims — that institutions have rigged the system against them — often crying speculatively, “my broker makes more money for himself than he does for me!” Aiding their argument is an array of mysterious terms used by industry insiders such as “imputed interest,” “negative correlation,” and “disintermediation.”

When investors comprehend a difficult financial concept more fully, instead of yielding to the first flattering tongue that explains the term, they can better decide with whom they will entrust their family’s wealth. This article will attempt to clarify one of those complex financial terms – “soft dollar remuneration.”

Does Greenleaf Trust use soft dollars?

No. Greenleaf Trust does not accept any form of soft dollar remuneration and, thus, remains unclouded by potential conflicts of interest. Our asset management process, developed by our well-resourced in-house research team and grounded in an investment policy to assure a disciplined and unbiased approach, keeps our focus on the best interest of our clients.

What is soft dollar remuneration?

Remuneration is simply money paid for a work or service. Soft dollars are the benefits provided to an asset manager by a broker-dealer as a result of commissions generated from financial transactions executed by the broker-dealer for client accounts or funds managed by the asset manager. Wow, really? Say that again in plain English, please. Okay, it is the practice of overpaying for trade execution, in exchange for which a broker-dealer provides research and other benefits to the advisor.

Every advisor begins with an industry-imposed standard (sometimes at a fiduciary level) to seek the best price, execution, and relationship with brokers for their clients. Advisors are always free to purchase additional research and benefits directly for their clients (with hard dollars) or they can receive those services through trading arrangements with broker-dealers (with soft dollars). Make no mistake, there is no escaping the real cost of the research – it just depends on who is paying the bill.

A common example to illustrate the use of soft dollars would be if you decided to rent office space in a building for, say, $5,000 per month. You need an industrial printer that would normally lease for $500 per month. As the owner, you can choose to pay the lease cost with cash (hard dollars) and perhaps see your profit decline by that amount. You might also be offered an arrangement with the leasing company where they would credit you all or some of the $500 on the lease (soft dollars) if you agree to purchase all your ink cartridges through them at a higher than market price. The real cost for both approaches is $500 per month. Your business can either realize less profit by paying the expense directly or pass the cost on to their clients through the soft dollar arrangement

How often is it used and by whom?

One of the challenges with soft dollar activities is the blurred definition – what exchange of services actually constitute soft dollars?

In 2017, the Securities and Exchange Commission reported that 42% of financial advisors and 40% of funds engaged in soft dollar activities. This is somewhat reduced from 2010 when another study found that 40% of total brokerage commissions involve soft dollars and 75% of mutual funds used soft dollars (Gao and Livingston, “Brokerage Commissions: High Costs of Owning Mutual Funds,” 2010).

While soft dollar practices have been around for decades, regulators continue to uncover disclosure and compliance issues with regard to investment advisors utilizing such arrangements. This is probably why the European Union, following the 2008 financial crisis, began cracking down on the use of soft dollars and eventually banned their use. In the 14 months since the ban, it was noted by Andrew Bailey, the chief executive of the Financial Conduct Authority, that the “vast majority of managers now fund research out of their own pockets instead of using client funds.”

Will the EU ban on soft dollars have an effect on the practice in the US? Hard to tell, but while the brokerage community remains divided on the issue, the SEC is listening. The change could be coming sooner than expected.

What is the argument for using soft dollars?

With increased scrutiny from regulators and the trend away from such practices, an investment manager purporting to offer trusted fiduciary responsibility and transparency had better have a good reason to engage in soft dollar relationships.

The prevailing reason put forth by advisors is that they will have access to better research for their clients. Critics of this justification often charge that the soft dollars are used for more than just research, including computers, travel or other activities that have nothing to do with client services. One SEC study found that 28% of soft dollar benefits were being used for non-research products and services by the advisors. Whatever the allocation, advisors could also simply pay for the research from fees already being collected.

Advisors also rely on the fact that such arrangements are properly disclosed. Even if disclosure regulations are stringently followed, the exact details of the soft dollar use and their impact on the investor can be difficult to discern. In fact, Whitney Tilson at the Motley Fool wrote, “the general counsel of mutual funds giant Fidelity was exactly right when he admitted that soft dollar payments are among the ‘least visible’ and ‘least understood’ expenses for investors.”

What is the argument against using soft dollars?

In soft dollar arrangements, the brokerage commissions are generally higher than they would normally be and, over time, investment performance can suffer by the higher cost.

These arrangements can also create incentives for a manager to conduct activities that are not in the client’s best interest – overpaying for trades and research or trading more often than is necessary. Even though disclosed, a typical disclosure notice might read as follows: “This arrangement also may create an incentive for the advisor to select a particular broker to execute a trade based on the advisor’s interest in receiving such research at a reduced cost.” In such an environment, how can an investor know with certainty whether or not soft dollars contributed to a particular trade in their account?

Soft dollars are not easily determinable nor are they equal among investment managers. The investor never knows what portion of their transaction costs are applied to the soft dollar services or their actual investment. Higher cost trades drag on returns and often the investor remains in the dark.

Summary

The investing public tends to have a negative perception of soft dollar arrangements. They are difficult to understand and people prefer that advisors pay expenses out of their profits (i.e., from client fees) rather than from the pockets of investors. Now more than ever, investors are seeking absolute trust in their financial professionals.

Greenleaf Trust strongly believes in aligning ourselves with our clients’ best interest. We avoid potential conflicts of interest by refusing soft dollar remuneration or fee rebates from any of the investments in our client portfolios. By maintaining an objective, transparent and conflict-free standard, our clients are better served.

So, is soft dollar remuneration a conspiracy theory? Like most conspiracies, it depends to whom you put the question. However, the growing movement to curtail or eliminate such practices would indicate that investors are becoming more aware of their options, especially in an era of increased transparency, and are making decisions accordingly.