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Sins of commissions
Despite nearly five years of postbubble reforms, Wall Street's biggest conflict of interest -- the use of so-called soft dollars -- has been left all but untouched and siphons millions from individual investors every day.
Wall Street is, not without reason, awash in reforms -- of corporate accounting, stock research, mutual fund trading. But untouched by the wave of litigation, legislation and regulation is a practice that is arguably the most damaging to investors and certainly the least understood by them: mutual fund companies' pervasive, hidden use of customers' money to pay brokers for buying and selling stocks in funds and then using what amount to kickbacks from those commissions to buy everything from analyst reports to data feeds to office furniture.
What's wrong with this "soft-dollar" scheme? It hurts individual investors in mutual funds, depressing their returns -- the commissions paid come straight out of their portfolios -- while padding the profit margins of fund companies and brokerage houses. Investors aren't told how much of their money is spent this way or what fund companies buy with it.
Unlike the damage done by an analyst's heaping praise on a lousy company or a CFO's cooking the books, the ill effects of soft-dollar usage aren't easy to understand. The practice isn't even illegal. But the harm is real. And the amount of money involved is staggering.
Institutional investors paid about $11.4 billion in commissions on U.S. stock trades in 2004, according to data provided by consulting firm Greenwich Associates. Typically, funds allocate about 70 percent of their commissions to buy research and other non-trading services. That equals approximately $8 billion in soft dollars annually.
But the damage to investors likely far exceeds that sum. In a 2003 study, "The Economics of Soft-Dollar Trading," economist Benn Steil and consultant Diego Perfumo calculated that soft-dollar usage contributes to inflated commission rates and other trading inefficiencies that cost mutual fund shareholders 70 basis points of return. Applied across the $4.8 trillion that the Investment Company Institute (ICI) says is now held by U.S. stock funds, that adds up to $33.6 billion lost by fund shareholders each year. That's far more than the $19.7 billion that fund investors pay in annual management fees, which, according to fund researcher Morningstar, average 41 basis points. Put simply, an individual who invests $10,000 in a fund that returns 8 percent annually for 30 years should wind up with $100,626 at retirement but will actually have just $81,506 because of soft dollars, using Steil's and Perfumo's analysis.
To put the damage in perspective: In a 2002 settlement investment banks ponied up $943 million to compensate for the losses of investors who followed compromised analyst recommendations over a period of three years. The late-trading and market-timing scandals exposed in 2003, involving funds that let big investors rapidly trade and take advantage of stale prices after markets closed, cost mutual fund shareholders $4.5 billion, according to one study.
"It's a giant kickback scheme," contends Steil, the Andre Meyer senior fellow in international economics at the Council on Foreign Relations, who has studied institutional trading extensively. "The fund companies, brokers, data vendors and technology companies all win. And the individual investor loses."
F. Jack Liebau Jr., a former Vanguard fund manager who has become intimately familiar with the soft-dollar system during two decades in the money management industry, is even more emphatic: "It's really larceny on a massive scale. The mutual fund industry has high enough margins as it is without abusing client commission dollars." The president of two-year-old Liebau Asset Management in Pasadena, California, stipulates that commissions at his firm be used solely to pay for executing trades.
So why do fund companies persist in employing soft dollars? For a start, because their use is perfectly legal. Under a 1975 amendment to federal securities laws, fund companies can use commissions taken out of shareholders' assets to pay not only for trades but also for what is loosely defined as "research."
This catchall covers bona fide analyst reports as well as a plethora of items offered up by brokers and third parties, such as technology vendors, that might be better classified under the rubric of "fund company operating costs": computer hardware and software, communications technology, conference fees and on and on. In some cases, fund companies have used client commissions to pay for rent, utilities and airfares.
By rights, such costs ought to be borne by fund companies themselves -- this is ostensibly why they charge up-front management fees -- not fobbed off on their clients. It's the customers' money that the fund companies spend so freely, after all, often on items that don't directly benefit the customer and without disclosure.
"Funds can use soft dollars to lower their stated costs of operations," observes Senator Jon Corzine, the former chairman of Goldman, Sachs & Co. who last month was elected governor of New Jersey. "In most cases it's not disclosed, and it's coming right out of the pocket of the investor. I don't think that's the right thing to do."
At work here is a classic "other people's money" conflict. As the CEO of one leading mutual fund company admits: "As long as somebody else is paying for them, then I'm going to buy a Bloomberg terminal for everyone at the firm. If we had to pay for them ourselves, I'd cut back drastically."
In sum, the soft-dollar system promotes a host of ills. Among them:
* EXCESSIVE TRADING. Because commissions are tied to transactions, funds can create soft dollars simply by trading more often, thereby driving up transaction costs and capital gains taxes and depressing fund performance.
* INEFFICIENT TRADING. Technologically advanced brokerages and exchanges can execute block trades for less than one penny per share while also slashing so-called implicit costs, such as the impact that big orders have on stock prices during execution. Yet funds routinely trade with less-efficient brokerages at higher rates so that they can buy soft-dollar goodies, trifling with their fiduciary obligation to seek the lowest-cost executions for clients.
* MISALLOCATION OF RESOURCES. Much of what funds can legally buy with commissions, such as trader workstations and market-data services, may benefit fund management companies and their other clients just as much, if not more, than the clients whose commission dollars are being spent. Some money managers have used commissions to compensate brokerage firms for selling their funds to retail investors and to ensure that they receive big swaths of shares in hot initial public offerings.
* INADEQUATE DISCLOSURE. Many individuals carefully track disclosed management fees and expense ratios when shopping for the right fund. But neither measure includes commission spending. Funds must disclose only that they're able to use commissions to buy research, not how much they spend or what specifically they are procuring with shareholder money.
* VICTIMIZATION OF UNSOPHISTICATED INVESTORS. Big pension plans often press investment managers and brokers to limit soft-dollar use. Some even receive rebates called commission recaptures. But individual mutual fund shareholders have no idea how the game works and can't protect themselves.
Defenders of the system -- and they are a powerful, determined bunch -- argue that soft dollars are so much a part of Wall Street's infrastructure that even the most well intentioned reform could pose serious risks to the health of the stock market and perhaps to capitalism itself. By this reasoning, cutting off the supply of commission dollars would dampen demand for research, ultimately reducing analyst coverage of public companies, depressing fund returns and making it harder for corporate America to raise capital. Only a few giant fund complexes would have enough hard cash to continue buying outside research or to pay for their own in-house analysts, diminishing competition and causing small managers to wither away.
Grady Thomas, CEO of Interstate Group, a soft-dollar brokerage owned by investment bank Morgan Keegan, issued just such a warning to the Senate Banking Committee during a hearing on soft dollars last year. "Denying investment managers the use of portfolio commissions to purchase research would have a devastating effect on the securities markets and investors," he said.
Or as Michael Udoff, associate general counsel for the Securities Industry Association, puts it: "Are soft-dollar arrangements abused? Sure. There are lots of potential conflicts in the securities business. But you can't get rid of all of them, because you'd have no business. You've got to manage them."
A spokesman for the ICI voices that group's support: "Congress and the Securities and Exchange Commission have long concluded that soft dollars, when used appropriately, can and do benefit investors and the securities markets."
Others, however, think that this conflict is big enough that it deserves to be eliminated, not managed.
"Soft dollars are one of several techniques used by the mutual fund industry to disadvantage investors," says David Swensen, chief investment officer for Yale University's $15.2 billion endowment. "Arguments in favor of soft dollars are without exception cynical and self-serving." Swensen, whose endowment's annualized return at Yale over the past decade is 17.4 percent, shuns soft dollars in his trading activities.
Marvin Mann, chairman of the independent trustees for the funds run by Fidelity Investments, the world's biggest mutual fund group, agrees. "Ultimately," he says, " it will be a better deal for investors if soft dollars go away."
Toward that bold end Fidelity struck a deal with Lehman Brothers in October to pay commissions to the brokerage for trading only. Fidelity will pay separately -- using the firm's, not its customers', funds -- for Lehman's equity research.
"We strongly believe that it's time for the investment industry to reexamine the use of soft dollars for research," says a Fidelity spokesperson. "If this arrangement is successful in lowering commission costs for our funds, we expect to engage in discussions to bring about similar situations with other brokers."
In private, many other senior mutual fund and brokerage executives acknowledge the problems with soft dollars, though they have resisted reform for decades and most continue to do so. In any case, the skeptics among them point out, Fidelity can afford to make this gesture because it has enormous cash flow and a big in-house research department.
What would be the benefits if other fund companies kicked the soft-dollar habit? They would use commissions to pay only for trade execution, while dipping into their own pockets to purchase "research." Such unbundling would force fund managers to be more disciplined about what they buy and what they pay for it. It would encourage them to purchase only the best, most trustworthy research and to trade with only the most efficient counterparties. Commission rates and implicit transaction costs would decline substantially. Investors would save billions.
The story would not have such a happy ending for financial firms, however. Abolishing soft dollars would alter the way Wall Street works more profoundly than any action has since commission rates were deregulated in May 1975. In 2004, Bear, Stearns & Co. analyst Daniel Goldberg estimated that an outright ban on soft dollars would instantly cut the earnings of Goldman and Merrill Lynch & Co. by 15 percent. The soft-dollar-padded profit margins of asset management companies -- then about 35 percent on average -- would have fallen to the high 20s, estimated Deutsche Bank analyst Richard Strauss.
In essence, the money put back into investors' purses would come out of the profits of mutual fund firms, brokerage houses, market-data companies, independent research boutiques and a host of other financial service providers that have lots of lobbying clout in Washington. And only Congress has the power to make soft dollars illegal. No wonder it is the third rail of Wall Street politics.
Indeed, during a series of hearings on mutual fund conflicts in March 2004, several witnesses urged lawmakers to ban soft dollars. But the Senate Banking Committee, through which any such legislation must pass, instead asked the SEC to study the issue. In October, after 20 months of consultation with industry professionals, the agency proposed only minor changes to rules about what can legally be bought with client commissions, a move supported by the SIA and the ICI.
"Getting rid of soft dollars is the right thing to do," says Barbara Roper, director of investor protection for the Consumer Federation of America. "But there are too many vested interests that will keep it from happening."
HOW DID WALL STREET WANDER INTO THE SOFT-dollar swamp? The system had innocent enough beginnings. In December 1959 a new firm called Donaldson, Lufkin & Jenrette became the first to provide institutions with in-depth research reports on individual stocks. To help the start-up get off the ground, co-founder William Donaldson came up with a clever idea: DLJ bought a seat on the New York Stock Exchange and accepted trading commissions instead of cash as payment for its analysts' work. Money managers had to trade anyway, he reasoned, and they would be more willing to give his firm a chance if they didn't have to pay cash for its reports. With high minimum commission rates fixed by the New York Stock Exchange, the strategy proved lucrative, and the rest of Wall Street rushed to copy DLJ by building research departments.
In the mid-1970s two pieces of federal legislation changed everything. First, in 1974, Congress passed ERISA, which established a fiduciary duty on the part of money managers to obtain the best price and commission rate when trading on behalf of clients. The following year lawmakers abolished fixed commission rates. A companion measure permitted investment managers to continue to "pay up" beyond the lowest prevailing commission rate, but only for research to improve investment performance. Thus the safe harbor underpinning soft dollars -- known as section 28(e) for the amendment to the Securities and Exchange Act that created it -- was born.
Money managers and brokers soon began pushing the boundaries, and before long the SEC significantly broadened 28(e)'s scope to fit industry practices. In 1986 the SEC reinterpreted the safe harbor to include anything useful in investment decision making. The door was now ajar for funds to buy everything from computers and market-data services to legal and consulting advice with soft dollars.
In December 2001 the SEC opened up another frontier. The agency had defined commissions as fees paid to brokerage firms for executing trades as a fund's agent. Effectively, this made soft dollars off-limits on the Nasdaq Stock Market, where firms filled customer orders primarily from their own inventory of shares -- as a principal in the trade. Instead of charging commissions, Nasdaq dealers profited from the spread between what they paid for a stock and what they sold it for. In its ruling the SEC said that certain "riskless principal" trades, in which dealers fill customer orders at zero spread and charge a fee -- essentially a commission -- could be included in soft-dollar arrangements. And so Nasdaq trading became part of the soft-dollar game.
At the time, U.S. markets had been gradually moving from fractional to decimal pricing of stocks. That caused spreads to collapse and prompted several brokers, led by Goldman, to start executing Nasdaq orders as riskless principal trades -- and to charge commissions. The upshot was that the average commission paid on Nasdaq soared from 1.1 cents per share in 2000 to 4.2 cents per share in the 12 months that ended June 30, according to Elkins/McSherry, a New York company that analyzes transaction costs. In comparison, the average commission on the NYSE in 2002 was 4.8 cents per share. Today it is 4.6 cents. Rather than protest an effective spike in their Nasdaq trading costs, fund managers, cushioned by soft dollars, went along for the ride.
The fund management business, meanwhile, had been changing profoundly. In the 1980s fund companies had discovered that they could boost profits by spreading the costs of managing money across a wider array of large portfolios. A number of them grew from small shops overseeing a single fund into fund complexes overseeing hundreds of billions in assets for individual investors. Accordingly, they needed to buy and sell stocks in ever-larger quantities, and doing so efficiently became much more difficult.
All of this exacerbated soft-dollar conflicts. As scale became more important, fund companies could use commissions from one portfolio to buy goods and services that benefited others and defrayed their overhead. Many asset managers were tempted to use commissions to pay brokerages for fund sales. And implicit transaction costs grew exponentially with the size of trades.
Donaldson, who served as SEC chairman from February 2002 until this past June, is troubled by how his creation has evolved. "It was a convenient thing back when we first started," he tells Institutional Investor. "But a lot has changed in the industry since then. Practices today, and the disclosure of them, deserve some careful examination."
Even Harvey Pitt, Donaldson's antiregulatory predecessor, thinks reforms of the safe harbor are in order. "It was appropriate at a point in time, but it no longer makes sense in today's environment," says Pitt, who according to sources authored the legislative safe harbor that created soft dollars as an SEC attorney in 1975. (Pitt declines to comment on that.) "It has been badly abused by a lot of people, and it has caused potential conflicts of interest that are difficult."
ONE REASON SOFT DOLLARS CAN BE SO DIFFICULT for investors, not to mention regulators and journalists, to fathom is that they come in two varieties, with key differences.
The first and most prevalent kind by far is "proprietary" soft dollars. These are accepted by full-service brokerage houses, like Goldman, Merrill Lynch. and Morgan Stanley, in exchange for the research and other services that they bundle with trade executions.
The other is the "third-party" variety, in which smaller brokerage firms execute trades, keep part of the commissions and funnel the rest -- the soft dollars -- to other entities that provide the fund manager with ancillary goods and services. Among the biggest recipients of the third-party dollars are technology and financial information vendors like Bloomberg and Reuters Group, as well as independent research boutiques that lack trading desks and thus rely on commissions filtered to them through larger brokerages. Major brokerage houses often form separate subsidiaries -- like Merrill's Citation Group unit -- to handle this business. The biggest brokerage in the third-party business, and thus the biggest conduit of this type of soft dollars to outside service providers, is Bank of New York's BNY Securities unit, which in April struck a deal to acquire a key competitor, Lynch, Jones & Ryan, from Instinet Group.
Both types of "softing" typically involve funds paying commissions of about a nickel per share. Roughly two of those five cents are allocated to the cost of executing the trade. The remainder goes toward the array of nontrading services that fall under the legal rubric of "research." Another way of looking at this dual use of commissions is what's known on Wall Street as the soft-dollar "credit" system. For every dollar of research services they wish to receive, fund managers must direct $1.40 in commissions to the brokerage that provides or pays for those services. (Arrangements vary, but a 1-to-1.4 ratio is the industry average, according to Greenwich Associates.)
In a typical example, a fund company might want to buy an order management system, essentially a tool for organizing and routing buy and sell orders for all of its individual portfolios. Such systems can cost about $30,000. The management company can write a check for that amount to the vendor or direct $42,000 in commissions to a soft-dollar broker (that's 840,000 shares at a nickel per) to earn the $30,000 in credits to pay for the technology. The soft-dollar broker, in turn, executes the trades, pays the fund company's bill with the system vendor and keeps the remaining $12,000 for itself. One buy-side trader tells II that when he attempted to pay for such a system in cash recently, the vendor's sales representative seemed stunned, explaining that all of his customers in the past had had him send the bill to a soft-dollar broker.
In such instances fund companies have no incentive to use their own cash or negotiate for better prices. And they're buying technology that clearly can be considered operating overhead that assists with the management of all portfolios, not just those whose trades paid the bill.
"Fund groups are using their shareholders' money to subsidize their operating costs," says Raymond Killian, CEO of Investment Technology Group, a New York agency brokerage that accepts commissions only for executions. "It's pretty elementary to see that it's not right."
Soft-dollar-related abuses can extend well beyond the use of commissions to buy research and technology. Perhaps the most notorious example is so-called directed brokerage. First highlighted by II in a June 2003 article, this practice entails fund managers' using commissions to compensate brokerage firms for selling their funds to new investors. Fundholders aren't told of such arrangements, beyond some boilerplate disclosures in the fine print of fund annual reports. On the other side, brokers don't bother to inform their clients that they are taking money from fund companies to push certain funds, often without regard to quality or suitability.
After II's article appeared, the SEC and other regulators intensified their scrutiny of directed brokerage. Several brokerage firms and money managers, including Edward D. Jones, Massachusetts Financial Services Co., Morgan Stanley, Putnam Investments and various affiliates of Pacific Investment Management Co., settled charges that they had failed to disclose directed brokerage arrangements, paying more than $225 million in fines collectively. The SEC also passed a rule explicitly prohibiting such schemes: It took effect in October 2004.
Overactive trading is another soft-dollar malady. In 1950, before soft dollars existed, the average mutual fund turned over 25 percent of the shares in its portfolio annually, according to the Bogle Financial Markets Research Center. In 2003, says Morningstar, the average turnover rate was 110 percent. Today it is 97 percent, still four times the pre-soft-dollar level. True, much of that may stem from modern, quantitatively driven investing techniques and a pickup in market volatility. But an analysis of recent trading patterns that adjusts for these factors suggests that there may be another key reason for the heightened turnover: Funds that are sold primarily through outside brokerages trade more actively than those that are not. The average turnover rate for five of the top broker-sold fund families is 75 percent, according to Morningstar, compared with 59 percent for a comparable group of direct-sold families.
Soft dollars also can stymie trading efficiency. Although more and more trades are now handled using high-tech, "low-touch" methods that minimize overall transaction costs, the majority are still routed through old-fashioned brokerage desks, which provide soft-dollar rewards in return for inflated commissions. The problem here is that funds are bound by law to achieve the best possible trade execution for clients. In many cases, the most efficient brokerages don't provide the best -- or, indeed, any -- research and ancillary services. Likewise, the firms that provide superior research and pay for third-party goodies often aren't the best at executing trades. Many independent research firms have built mediocre trading desks solely because funds want to pay them with commissions. Soft dollars thus prevent fund managers from choosing the best in breed for both trading and research.
"A lot of the traders we deal with tell us that soft dollars are like handcuffs that prevent them from getting best execution," says Alfred Eskandar, director of corporate strategy for Liquidnet, a New Yorkbased electronic brokerage that lets institutions anonymously match block orders for 2 cents per share. The firm's volume has grown to 38 million shares a day in a little more than four years, but Liquidnet officials believe it would have grown even more if fund managers weren't bound by soft-dollar obligations. "We expect the Street to continue to more seriously consider unbundling," Eskandar says.
ITG chief executive Killian adds his own lament. "Come October and November every year, we hear a lot of fund managers telling us, 'Sorry, but I have to pay the bills,'" he says, referring to fund managers' having to route orders to their soft-dollar brokerages to pay for past research. "Historically, the fourth quarter has been a slow time for us as a result," he adds.
Those handcuffs cost fund shareholders dearly. Fully two thirds of the 70-basis-point drag on fund performance identified by Steil and Perfumo is attributable to inefficient trading.
Soft dollars are all but invisible to fund shareholders. Current law requires funds to report only the aggregate amount of commissions they pay annually. This information is contained in something called the Statement of Additional Information, an addendum to fund prospectuses that money managers are not required to distribute unless customers specifically ask for it. Contrast that with the management fees and other explicit spending that is included in a fund's published expense ratio. Regulators, including New York State Attorney General Eliot Spitzer, have pressed funds to reduce explicit fees while all but ignoring the much bigger problem of soft-dollar inefficiencies.
The lack of disclosure underscores an ugly truth about soft dollars: The system treats small investors the worst. General Motors Asset Management and a number of other pension plan sponsors are well known for monitoring their investment managers and brokerages for excessive soft-dollar use. Greenwich Associates estimates that institutional investors reclaim some $800 million in commissions annually through recapture programs.
Mutual fund shareholders, on the other hand, don't even know what soft dollars are. Even if they did, they don't have the leverage to persuade fund companies to minimize or eliminate the use of soft dollars -- or to demand rebates. As a result, it's their commission dollars that money managers employ most aggressively in the system.
"In the mutual fund context," says former SEC chief Pitt, now CEO of Washington-based consulting firm Kalorama Partners, "the responsibility for protecting shareholders has to fall on the board of directors, and particularly the outside directors. Many of these people are really unaware of the extent of their responsibility and may not have the substantial expertise to try and parse all of this."
Indeed, many mutual fund directors can hardly be said to be independent from fund management companies. Many board chairmen and directors are also employees of the big fund complexes and thus fatally compromised. The industry -- including Fidelity -- has fought against regulations that would require greater independence on fund boards.
A common misconception that understates soft dollars' impact is that they figure only in third-party business. This obscures the two most critical distinctions between the two models. One is that the third-party business is far smaller, accounting for 10 percent of commissions paid, compared with 90 percent for the proprietary model, according to Greenwich Associates. Just as significantly, third-party arrangements leave a detailed paper trail in the form of invoices from the service providers and account statements maintained by brokers for fund managers -- even if those documents are never seen by fund shareholders. Proprietary soft-dollar arrangements are far murkier. Often informal and rarely written down, they leave much more room for finagling. It is this variety of soft dollars that was used by money managers in directed brokerage schemes, for example.
This misunderstanding helped to derail reform efforts last year. The fund industry's main trade group, the ICI, proposed eliminating third-party soft dollars while leaving proprietary arrangements intact. Independent research firms and data vendors feverishly protested, and the ICI's idea -- along with any hope that all soft dollars would be abolished -- was scrapped.
THE MOST EFFECTIVE WAY TO PROTECT INVESTORS from soft-dollar abuses would be to do away with the 28(e) safe harbor and require fund managers to pay for everything except trade executions out of the corporate kitty. Some lawmakers wanted to do just that last year.
The Mutual Fund Reform Act of 2004, sponsored by Republican Senators Peter Fitzgerald of Illinois (now retired) and Susan Collins of Maine and Democratic Senator Carl Levin of Michigan, would have stricken 28(e) from the books. (Other co-sponsors included liberal Democrat Edward Kennedy of Massachusetts and conservative Republican John McCain of Arizona.) The legislators had judged that improved disclosure -- the solution proffered by many in the fund industry -- was inadequate. As a senior aide to Fitzgerald put it: "When we learned from people in the industry how soft dollars really worked, we literally could not believe it. I mean, it's flat-out stealing. And in this country we don't deter thieves by requiring them to more fully disclose that they're stealing. We make it against the law."
But as the bill was being debated, it encountered an onslaught of lobbying by soft-dollar defenders. The ICI played a critical role. After regulators had unearthed late-trading and market-timing irregularities by some mutual funds, the ICI quickly assessed which other fund practices might come under scrutiny. Not surprisingly, soft dollars topped the list. In a bid to get ahead of the issue, the institute in December 2003 announced a voluntary ban on third-party soft-dollar arrangements, touting its plan as a proactive step to protect investors.
Independent research firms and the brokerages that serve as their soft-dollar conduits went into a frenzy at the prospect of a ban on third-party soft dollars. The Alliance in Support of Independent Research, a Washington-based group representing research boutiques, tried to persuade key members of Congress that the ICI's plan would wipe out the burgeoning independent analysis business. Their case: If fund companies couldn't pay for research through commissions, they would no longer buy it at all. And they stressed that Wall Street brokerages' $1.5 billion settlement with regulators over research tainted by analyst conflicts expressly called for independent research as an antidote. BNY Securities and other beneficiaries of third-party soft dollars went so far as to urge reporters and legislators to stop using the term "soft dollars" and instead refer to the payments as "independent research commissions."
The hubbub sowed enough confusion and fear to stall Fitzgerald's bill and remove any chance that Congress would repeal 28(e). Few lawmakers understood the soft-dollar system, and with the wounds from Wall Street conflicts and corporate scandals still raw in the public's consciousness, no legislator wanted to be painted as an enemy of independent research. Congress deemed the SEC best equipped to impose more-limited reforms.
A more recent congressional effort, the Mutual Fund Transparency Act of 2005, introduced in May by Senator Daniel Akaka, a Hawaii Democrat, would require commission costs to be included in a fund's published expense ratio. But the Senate Banking Committee, led by Alabama Republican Richard Shelby, hasn't advanced the legislation.
"There is no question that soft dollars have been abused by some money managers," says Shelby, stressing that abuses of the safe harbor shouldn't be tolerated. "At the same time, it is widely recognized that soft dollars provide benefits to investors, such as funding for independent third-party research. Independent research has earned a greater appreciation by investor advocates, and deservedly so, in the aftermath of the sell-side analyst conflict problems."
Some senior SEC officials say privately that they abhor soft dollars and would prefer that Congress simply eliminate them. But the agency has stopped short of making that recommendation publicly. In 1996 and 1997, SEC examiners conducted extensive compliance sweeps of funds and brokerages and in September 1998 produced a 60-page report that detailed soft-dollar abuses. Among them were fund managers' using commissions to pay for phone bills, employee salaries, rent and vacations. The agency's staff recommended significantly expanded disclosure of the arrangements in fund documents. The report garnered some headlines, but fund investors were too busy counting their bull market gains to pay it much heed. The commission never implemented those reforms.
In a more recent step, Donaldson two years ago created a soft-dollar task force to study the issue. The SEC group finally completed its work last month -- one year later than originally promised. Rather than recommend a repeal of 28(e), it issued yet another proposed reinterpretation of the safe harbor's scope. The proposal would exempt "physical items, such as computer hardware" from the safe harbor but would continue to allow funds to buy market-data and other research with commissions.
Critically, this would not exempt the analytics, news and market-data packages offered by research companies, such as Bloomberg. In recent years such companies have shifted from offering dedicated computer terminals to providing software that is installed on clients' computers and hooked up to the vendor's network.
"When we started this process, we had everything on the table, from [recommending] repeal all the way to doing nothing," says Larry Bergmann, the SEC associate director of market regulation who led the soft-dollar task force. "We didn't get the impression from the legislative action that there was a unanimous feeling that repeal was the road that the commission should take. So we decided to deal with the statute that we had and assume that Congress was still behind the notion of soft dollars but that there was a need for additional guidance on what fits into the safe harbor."
Regulators also have backed away from strict reforms in the U.K. Four years ago that country's Financial Services Authority asked former Gartmore Investment Management chairman Paul Myners to study various aspects of pension investing and make recommendations for new regulation. Myners seized on the conflicts inherent in soft dollars and suggested that the best way to ameliorate them was to require funds to pay commissions out of their own pockets.
Since Myners issued his report in March 2001, the FSA has forwarded a series of proposals on soft-dollar reform for industry comment. Its final rules on the matter, which go into effect next month, allow soft arrangements to continue but require that fund managers begin to specifically disclose and itemize the amount of commissions paid for trade execution and for various research items.
THE BENEFICIARIES OF THE soft-dollar system -- fund managers, brokerages, market-data firms and independent research houses -- have helped to defeat serious reform by propounding a series of self-serving arguments for maintaining the status quo.
One is the notion that outlawing soft commissions will render independent research extinct. True, making funds spend their own money might result in their buying less research overall. But such a move would also allow the best research to flourish. That's because soft dollars provide an artificial subsidy that allows funds to consume goods and services without regard for quality or price. Doing away with soft dollars would for the first time create a free market for investment ideas. If the boutiques that lack investment banking conflicts were truly generating superior work, they would excel. If they weren't, they would fail. Big Wall Street brokerages would be subject to the same market discipline.
"I think it would be refreshing," says John Brush, CEO of Columbine Capital Services, a quantitative research boutique based in Colorado Springs, Colorado. "I'm not saying that I necessarily want it to happen, because it could be painful for us in the short term. But over the long haul, I think we would probably fare better, because our research is better."
Even Reuters CEO Thomas Glocer is of like mind. "We think we probably would benefit by a total end to softing of all types," he says. Reuters would do well if money managers had to pay cash for its products, he reasons, because it offers products at a wide array of price points. That should enable the company to continue to appeal to customers who may decide to spend less if they have to use their own money instead of client commissions.
Adds Mann, the chairman of Fidelity's independent trustees: "It would put research on a market-based system. If the brokerage firms really created value with their research, funds would draft checks to pay for it. That would show up in the funds' expense statements. And competition would ensue between the brokers and the independents."
Only those who aren't producing quality research have reason to fear a move to hard dollars. "To suggest that independent research will die without soft dollars," says the Consumer Federation's Roper, "is to say that it's not worth buying in the first place."
Not everyone agrees. "We think it would hurt the market, because the amount of research would be greatly reduced," said BNY's CEO, Joseph Velli, during a soft-dollar briefing his firm held last year. "This is so embedded in the infrastructure of the way things work that it would require so much effort and is probably not worth the effort to unbundle."
Such rhetoric -- call it the doomsday defense -- has been trotted out by entrenched intermediaries to fight a host of investor-friendly market reforms over the years. These include the deregulation of commission rates in 1975 and the move to decimal stock pricing in 2001. Both steps reduced costs dramatically for investors while causing much initial pain for Wall Street firms. But neither prompted the downfall of capitalism as we know it. If anything, they made the markets stronger and more vibrant by encouraging competition.
A more positive scenario is just as likely to unfold: Fund managers, free from the handcuffs of soft dollars, will direct trades solely on the basis of best execution. Low-cost agency brokerages and alternative trading systems will see an influx of business that has been artificially tied to higher-cost venues for years. Bulge-bracket firms will have to slash commissions to remain competitive. Their revenues will fall as a result, prompting reductions in their research, sales and trading staffs. The biggest firms have been able to afford $500 million research departments at rates of a nickel per share. At 2 cents or less, they will have to cut all but the best analysts.
Fidelity, widely regarded as the Street's biggest commission generator, is paying Lehman, the top firm in this magazine's All-America Research Team rankings for two years running, just $7 million per year for research under the two firms' October unbundling agreement. If Fidelity has determined that the top-rated brokerage's research is worth just $7 million annually, few firms are likely to conclude that they should pay more. Independent research boutiques as well as Reuters, Bloomberg and other providers of third-party services will face a similar revenue squeeze as money managers force them to reduce prices.
Asset managers of all sizes can do just fine without soft dollars. Consider Southeastern Asset Management, a Memphis, Tennessee, firm that Yale investment chief Swensen lauds for eschewing soft dollars in his latest book, Unconventional Success: A Fundamental Approach to Personal Investment. Southeastern has $32 billion in assets, a fraction of the hundreds of billions that the biggest fund groups manage. Its Longleaf funds, which are mostly closed to new investors, have handily beaten benchmarks for both the five- and ten-year periods ended September 30. Its $2.7 billion small-cap fund, for instance, has returned an annualized 13.51 percent for the past five years, compared with just 6.45 percent for the Russell 2000 small-cap index.
"If small investment management firms don't do their own high-quality independent research, they should vanish," says Swensen. "Alternatively, if small firms won't survive unless they use soft dollars, they don't belong in business."
Former Vanguard portfolio manager Liebau says his young firm doesn't pay for research with commissions and wouldn't be hurt a bit if soft dollars were abolished. "We're living proof that a small asset manager doesn't need soft dollars," he says.
It's true that outlawing soft dollars would probably cause many funds to raise their management fees. After all, fund companies have a legitimate need for research, technology and other nontrading services that are now softed, and their operating costs would rise as they paid for these items with their own money.
But two factors would militate against excessive fee increases. One is the fact that funds will simply buy less when they are using their own money. The other is that fierce fee competition in the money management industry (see this month's cover story, "The Price of success," page 46) ensures that fund groups could not simply institute huge fee increases to recoup all of their new out-of-pocket costs. Instead, funds would likely drive harder bargains with the suppliers of those services or accept slightly lower profit margins. The savings for investors would dwarf the extra money they would be obliged to shell out in up-front charges.
Moreover, funds that pay for valuable research that truly boosts performance would be able to justify passing along some of the cost to investors. Of course, investors would also be free to seek out lower-cost funds that still manage to deliver solid returns.
Steil and Perfumo estimate in their soft-dollar study that fund managers would need to raise fees by just 18 basis points to maintain their profit margins. The industry and those who regulate it, then, have two choices: Maintain a system that secretly skims $33.6 billion from investors, or do away with it and charge customers $6.3 billion up front for research that fund managers have deemed worthy enough to buy with their own money.
"I think if somehow we had the opportunity to reinvent the financial services industry, we might not put in place things like soft dollars," Paul Haaga, the head of giant asset manager Capital Group's American Funds unit, told II last spring, while Congress was debating mutual fund reforms. (Haaga was the ICI's chairman at that time.) "At the very least, they should be reasonably disclosed, but the issue deserves a look. Just because something isn't technically illegal doesn't mean it's right."