The practice of money managers using so-called "soft dollars" to pay for research with trading commissions dates to the 1700s, but is potentially putting the buy side at odds with their investors, according to a report by advisory firm Woodbine Associates.
The report, entitled " Soft Dollars and Bundled Services: Practices, History, and Controversy, " points out that there are two types of soft dollar arrangements currently in use: commission sharing arrangements (CSAs) and client-commission arrangements (CCAs).
CSAs typically involve a fund advisor negotiating with a sell-side firm to pay a base execution rate for trades, with a portion set aside for research. In a CCA, on the other hand, any amount a fund manager pays above the trade execution is placed into a pool to pay the broker for research.
But these arrangements open up a slew of potential conflicts of interest between fund managers and their investors, according to Woodbine, which cited information from the Securities and Exchange Commission in its report.
The report notes that soft dollar arrangements might disguise the true cost of managing a portfolio, and enable the investment manager to charge advisory fees that don't fully reflect the cost of management. They might also give the investment manager an incentive to compromise their fiduciary obligations and trade a fund's portfolio in order to earn soft dollar credits.
"The investor may not get the full benefit of everything they're paying for," Woodbine principal Matt Samelson said in an interview. "And they may be charged for things that they get no benefit from."
Despite this, Samelson says there's been no push from the investment community to reform these practices. Firms that use soft dollars are usually mutual funds and retirement plans, he explains. But in most cases, the folks charged with doing what's best for investors often don't have the knowledge or resources to bring about change, Samelson explains.
"Frankly it's like if you're talking about TCA (transaction cost analysis), execution quality and commissions to a retirement fund and their board of trustees. A lot of them are not really going to understand it," Samelson contends.
There's also the potential for abuses like the misuse or misallocation of products, the report says. "It's not that the practice itself is dirty, but there's a long history of abuse," Samelson says. "It's probably as clean as it's ever been right now and part of that is thanks to regulatory guidance on the matter. But every time a report is undertaken, there's always abuses, intentional or unintentional."
The report also argues that U.S. regulators are basically powerless to prohibit the use of soft dollars since the practice is so deeply rooted in the nation's securities laws. Further compounding matters is the lack of political will and desire within the industry to abandon soft dollar arrangements.
Because of this, the report says soft dollars are likely to be part of the equity landscape for the foreseeable future.