Issues in Mutual Fund Soft-Dollar Trades

Issues in Mutual Fund Soft-Dollar Trades The Journal of Index Investing 2011.2.2:76-85. Downloaded from www.iijournals.com by JOHN A HASLEM on 08/25/11. It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.

JOHN A. HASLEM

JOHN A. H ASLEM is Emeritus Professor of Finance in the Robert H. Smith School of Business at the University of Maryland in College Park, MD. [email protected]

“… ‘[S]oft dollars’ as ‘when you use other people’s money to buy something for yourself. Hard dollars is when you take it out of your own pocket.’ ” —Morton Klevan [1997]

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utual fund use of soft-dollar trades has important implications for regulators, fund shareholders, fund advisers, and brokers (broker–dealers). Soft-dollar trades create higher costs and conf licts of interest between fund advisers and their shareholders. In soft-dollar trades, the soft dollars are the incremental soft-dollar commissions mutual funds pay for research produced or provided by brokers. These commissions are higher than the lowest commissions available elsewhere for simple trade execution. In this case, funds may be said to pay for research with soft dollars or to simply be paying up with higher commissions. In return, the soft-dollar brokers make direct partial soft-dollar rebates of research produced or provided to fund advisers. Mutual funds purchase two types of research—proprietary and third party. Soft dollars are primarily used to acquire proprietary research. Soft-dollar brokers prepare proprietary research and fund advisers acquire it by paying soft-dollar commissions. Brokers do not sell proprietary research but provide it (often routinely) to fund advisers as a prima

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ISSUES IN MUTUAL FUND SOFT-DOLLAR T RADES

facie free good. The practice whereby brokers charge funds soft-dollar commissions to cover the costs of research is called bundled pricing, or here, bundled soft dollar-commissions. It is easiest to fathom bundled pricing in its unbundled state by subtracting soft dollars from softdollar commissions. Mutual funds also use soft-dollar commissions to obtain third-party research, which is obtained from providers independent of soft-dollar brokers executing the trades. Brokers arrange to buy and provide the research for fund advisers and are often reimbursed based on conversion ratios, or in hard dollars. Conversion ratios indicate the relative amounts of soft-dollar commissions required to obtain research credits—that is, the agreed ratio of soft-dollar commissions to receive one dollar in third-party research. As discussed, soft-dollar rebates represent the research provided to fund advisers. Mutual fund use of soft-dollar commissions allows mutual funds to bypass expensing research in management fees. Soft-dollar trades financially benefit both fund advisers and brokers at the expense of fund assets and returns. Fund advisers may direct funds to make excessive soft-dollar trades to reap the benefits and/ or to meet target allocations of soft-dollar payments to brokers. There is also the issue of more costly trade execution in soft-dollar trades. Soft-dollar commissions and trade execution costs are significant components of

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The Journal of Index Investing 2011.2.2:76-85. Downloaded from www.iijournals.com by JOHN A HASLEM on 08/25/11. It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.

total fund-trading costs. Lemke and Lins [2004] provide much useful information on soft-dollar brokerage. The purposes of this article are to explain the nature, use, and cost of soft-dollar trading, including the safe harbor, soft dollars, soft-dollar commissions, bundled soft-dollar commissions, soft-dollar rebates, trade disclosure, agency conf licts, and empirical trading costs. THE SAFE HARBOR

In the early 1970s, the U.S. Securities and Exchange Commission (SEC) studied whether to require unfixing the minimum brokerage commissions that had existed for nearly 200 years. During that era, brokers competed for investment manager trades by providing brokerage services and proprietary and third-party research. The history of the safe harbor is detailed in U.S. SEC [1998, 2003, 2005, 2006] documents. As this era drew to a close, brokers and investment managers faced an uncertain world of competitive brokerage commissions, which they feared would require them to select brokers based solely on available lowestcost commissions, and any violation would be a breach of fiduciary duty. The SEC considers fund directors to have a continuing fiduciary responsibility to oversee commission practices. Investment managers also feared broker research reports would be more difficult to obtain, and brokers feared they would not be compensated in commissions for the research they provided or produced. The strong response of investment managers and brokers was to lobby the U.S. Congress to the effect that any new law would enable them to continue past practices of commissions for research. With passage of the Securities’ Acts Amendments of 1975, Congress came to the aid of investment managers and brokers by creating the safe harbor for investment managers under Section 28(e) of the Securities Exchange Act of 1934. The safe harbor protects investment managers from liability for a breach of fiduciary duty solely on the basis that they paid more than the lowest commission rates to receive broker research. However, this exclusion also requires investment managers to make good faith determinations that commissions are reasonable with respect to brokerage and commission services received. To appreciate the importance of the safe harbor exemption, it should be noted that general fiduciary principles require investment managers to seek the

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lowest cost execution for trades and to limit the use of client assets for their own benefit. And, for investment managers not to do so creates significant conf licts of interest with clients, which may motivate them to disregard their obligations for best-execution trades. Mutual funds are the subject in the following discussions. In 1976, the SEC ruled the safe harbor does not apply to products and services “readily and customarily available” to the general public, such as newspapers, periodicals, directories, computer facilities and software, government publications, electronic calculators, quotation equipment, office furniture and equipment, airline tickets, and business supplies. Fund advisers were also directed not to require trade execution brokers to make give ups—advisor commission costs directed partly to a broker other than the one who executed the trade. Broker soft-dollar payments to fund advisers must be based solely on trade execution. In 1986, the SEC amended the “readily and customarily available” standard to interpret the safe harbor more broadly. The “lawful and appropriate assistance” standard was adopted to supplement the statutory standard for “brokerage and research services” within the safe harbor. The limitation on products and services offered commercially was dropped. Safe harbor research was redefined to include products and services appropriate to the “decision-making responsibilities of investment managers.” In the case of mixed-use products and services, their costs are to be allocated in “good faith” and nonresearch items are to be paid in hard dollars. Proper use of the safe harbor requires mutual funds to report soft-dollar commissions and to limit them to research services, but abuses are not uncommon. The SEC’s [1998] inspection finds 35% of examined brokers use soft-dollar commissions to pay fund advisers for items unrelated to research. And, 28% of fund advisers enter into soft-dollar trades for items not legally documented, such as home computers and theater tickets. But, since 1976 the SEC has pursued only nine cases of soft-dollar abuse. Until 2001, the SEC interpreted the safe harbor to include only research and brokerage services obtained from brokers acting in an “agency” basis. This interpretation was changed to include fees paid for “riskless principal transactions” executed at the same price and reported under the now FINRA’s trade reporting rules. In a letter to SEC Chairman, William H. Donaldson (SEC [2003]), the Investment Company Institute (ICI)

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urged the SEC to issue new interpretive guidance and rules for soft-dollar payments and the safe harbor: “Section 28(e) should be revised to exclude the following products and services from the Act’s safe harbor: 1) computer hardware and software, and other electronic communication facilities used in trading and investment decision making; 2) publications, including books, periodicals, newspapers, and electronic publication available to the general public; and 3) third-party research services.” These safe-harbor revisions would ensure softdollar rebates of traditional overhead and expenditures would be excluded and would limit the safe harbor to research products and services produced and provided directly by brokers receiving bundled soft-dollar commissions. Further, those revisions would make it easier for mutual fund shareholders to understand fund costs and would reduce fund adviser incentives to engage in unnecessary soft-dollar trading—both very important. The ICI recommends Section 28(e) safe harbor be revised closer to its original purpose—a narrow provision that permits mutual fund advisers to consider both the broker’s “intellectual resources and trade execution capabilities” in allocating fund trades. The ICI also recommends that Section 206(4) of the Investment Advisors Act of 1940 be revised to prohibit mutual fund advisers from paying soft-dollar commissions for products and services outside the Section 28(e) safe harbor. Such an action would provide more fund shareholder transparency in broker compensation and more equitable treatment of brokers. The ICI’s proposal might also be motivated to reduce the likelihood that soft-dollar trading might be prohibited. Prohibition of soft-dollar trading is, of course, the better solution. In 2005, the SEC proposed the scope of the safe harbor should include several requirements. First, the “lawful and appropriate assistance” standard of 1986 should continue. Second, research services should be restricted to “advice, analyses, and reports,” which excludes physical items that do not express knowledge or reasoning, such as computers. Third, “brokerage services” should include products and services that relate to trade execution from order transmittal to recordation on mutual-fund shareholder accounts. Fourth, mixed-use soft dollars should be allocated and documented as “eligible” and “ineligible” and for fund advisers to make “good faith” determination of commissions as reasonable relative to the value of brokerage and research services. Fifth, brokers should be financially responsible for 78

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brokerage and research services provided and also directly involved in “effecting” (executing) trades. Public comments then led to the 2006 guidance. The SEC’s 2006 interpretation of safe harbor added to the 2005 proposal. Research on the market for securities, including trade analytics, and advice on market conditions and strategies are included in the safe harbor. Market, financial, economic, and related data are also included, but mass-market publications are not eligible. Brokers “provide” research if they prepare it and are financially obligated to pay for it, but they are not obligated to pay for research that lacks specified attributes. Brokers are involved in “effecting” a trade if they execute, clear, or settle the trade, and perform one of four specified functions in allocating other functions to another broker: 1) financial responsibility for trades; 2) maintaining trade records; 3) monitoring and responding to comments concerning trades; and 4) monitoring trades and settlements. Over the past 35 years, soft-dollar trades and safeharbor requirements have been a case of continuing debate and revision. The basic issue, of course, is whether soft-dollar trades should be prohibited. Thus far, the brokerage and mutual fund industries have been successful in defending the use of soft-dollar trades—costly trades without transparent disclosure that reduce fund assets and performance. SOFT-DOLLAR COMMISSIONS

In addition to the acceptance of the ICI’s proposal in SEC [2003], it would also serve mutual fund shareholders for the SEC and Congress [as to Section 28(e)] to “unbundle” soft dollars and soft-dollar commissions. Fund shareholders would then benefit from higher performance and transparency. Research costs could also be properly accounted for in fund expense ratios as management fees would be and conf licts of interest with shareholders reduced. In 2004, the SEC prohibited “bundled distribution” commissions—“directed brokerage.” As discussed by Lemke and Lins [2004], those arrangements also often involved customer sponsors of pension plans (plan-sponsor-directed brokerage). Directed brokerage arrangements required mutual fund advisers to direct a portion of their trades to be executed by particular brokers. In return, the brokers rebated 40% to 50% of the resulting

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commissions directly to the fund (commission recapture), or they paid for specified fund services (expense reimbursement). These services have a wide scope and include political and economic research, custodial services, investment consulting and advice, educational and professional seminars, and fund performance measurement and evaluation. There were also more sophisticated, directed brokerage arrangements, in which one broker served as administrator and conduit to the other participating brokers. Each broker rebated a portion of its fund commissions back to the fund. Gao and Livingston [2010] discuss Fidelity’s 2005 decision to cease use of soft dollars, which separated trade execution from research in trades with Lehman Brothers. Thereafter, Fidelity paid Lehman only for trade execution. However, Fidelity paid Lehman $7 million in fund advisory fees for research, which was included in the expense ratio’s management fees. Following that decision, Vanguard, MSF Investment Management, Bridgeway Funds and American Century soon followed. Unbundled soft-dollar commissions would be the most desirable in the industry, excepting complete prohibition of soft-dollar trades. Edelen, Evans, and Kadlec

Edelen, Evans, and Kadlec [2010] discuss the decline in the percentage of sample mutual funds that use soft-dollar commissions. Soft dollars are not individually itemized in reports to regulators. Soft-dollar trade practices have received increased examiner scrutiny, including pressure to unbundle soft-dollar commissions. The funds using soft-dollar commissions have become more conservative in qualifying research for inclusion in soft-dollar trades. The channels available for mutual fund expenses vary significantly in transparency. Research and distribution payments are more transparent when included as management fees in expense ratios, or as 12b-1 fees. The soft dollars in opaque soft-dollar commissions (and formerly directed brokerage commissions) bypass the expense ratio and are charged directly against fund assets. Transparency plays an important role in mutual fund performance. Soft dollars for research are more negatively related to fund performance than expensed research for similar services. For each 10 basis point increase in the cost of bundled soft-dollar commissions,

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fund performance declines by a significant 21 basis points. The advisory fee component of fund management fees has an insignificantly positive impact on fund management, while the nonadvisory component (largely distribution) has a significantly negative impact. Formerly bundled distribution commissions are three times more negatively related to fund performance than expensed distribution payments. Opaque soft-dollar commissions and formerly bundled distribution commissions exacerbate agency conflicts between mutual fund advisers and shareholders. The conf licts include excessive and more costly softdollar commissions that bring financial benefits to both fund advisers and brokers at the expense of shareholders. Additional soft-dollar trades may also be required to meet fund broker targets for soft-dollar commissions. The lesser reporting precision of soft dollars may also reduce fund efficiency, with the related costs of adverse selection and excessive trading. Mutual fund investors respond differently to softdollar commissions than to expensed research payments. Expensed research is transparent and has a negative impact on investor inf lows. Soft-dollar commissions are opaque and have a positive impact on investor inf lows. There are differences in competitive implications of the expensed research and distribution payments versus soft-dollar commissions and former distribution commissions. Mutual fund advisers are motivated to use bundled soft-dollar commissions to increase complexity and to obfuscate payments. Bundled soft-dollar commissions are opaque and have a positive impact on investor inf lows, but at the expense of lower fund performance. Expensed research and distribution payments are significantly less detrimental to fund performance, but their greater transparency has a negative impact on investor inf lows. Those issues are strategic considerations of fund advisers. SOFT-DOLLAR TRADE DISCLOSURE

With or without unbundling soft-dollar commissions and until the prohibition of soft-dollar trades, the SEC should require mutual funds to disclose two sets of information in the Statement of Additional Information (SAI), the shareholder annual report, and regulatory reports: 1) payments to non-soft-dollar brokers for, (a) brokerage commissions, and (b) trade execution costs (inclusive); 2) payments to soft-dollar brokers for,


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(a) soft-dollar commissions, (b) soft-dollar trade execution costs (inclusive), and (c) broker soft-dollar rebates to fund advisers. Those disclosures in the shareholder annual report would alleviate the need for investors to rummage through the SAI and SEC on-line files for information, which most do not do.


Gao and Livingston

Gao and Livingston [2010] confirm that improved mutual fund disclosure is needed. Soft dollars should be included in expense ratios and in the shareholders’ annual reports. Mutual funds should also be required to disclose 1) soft dollars, 2) details of soft-dollar arrangements, 3) soft-dollar trades and non-soft-dollar trades, 4) soft-dollar commissions and non-soft-dollar trade commissions, and 5) brokerage commissions for each dollar of soft-dollar trades and for each dollar of nonsoft-dollar trades. This disclosure is quite inclusive. The study finds that 40% of mutual funds disclose the use of soft-dollar trades and 45% of funds disclosing use of soft-dollar trades reveal both total brokerage commissions and total soft-dollar commissions. In general, however, funds do not disclose total portfolio transactions and total soft-dollar transactions. Mutual funds reporting use of soft dollars tend to be larger funds that pay higher brokerage commissions, expense ratios and loads, and nonmanagement fees, but have lower management fees and portfolio turnover. Lower management fees are consistent with the use of soft dollars and reduced internal research expenses. Funds disclosing soft dollar use have slightly higher returns than funds not disclosing their use. Other Studies

According to Baxi [2003], questions directed to mutual fund advisers should focus on 1. the benefits received from trade execution–only brokers; 2. distinguishing the use of trade execution–only and soft-dollar brokers; 3. policy statements on use of soft-dollar arrangements; 4. the percentage of soft-dollar trades and commissions for each share on execution–only trades and on soft-dollar trades; 80

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5. total brokerage commissions for trade execution– only and soft-dollar trades for each portfolio; 6. quality of trade execution by trade execution–only brokers and by soft-dollar brokers; 7. explaining how investors are better served by the use of soft-dollar trades. It is legitimate to ask if soft-dollar trades may lead to fraudulent behavior. Dimmock and Gerken [2011] explain that the use of soft-dollar commissions does not predict fraud, but it may represent a conf lict of interest. The mutual fund advisers who are most likely to commit fraud are those with funds that appeal to unsophisticated investors who are relatively easy to exploit. SOFT DOLLARS AND AGENCY CONFLICTS

Gao and Livingston [2010] find that approximately 40% of total brokerage commissions involve soft dollars, and 75% of mutual funds use soft dollars. As discussed, soft dollars are the incremental soft-dollar commissions funds pay for research produced or provided by brokers. The higher soft-dollar commissions increase broker compensation for sales of mutual fund shares, and they also provide mutual fund advisers with direct soft-dollar rebates of research. Blume [1993] finds softdollar rebates “almost always” or “always” include fundamental research (28%), expected earnings data (32%), and macroeconomic services (21%). SEC Examination Report

The SEC [1998] finds that 71 of 75 (95%) brokers in the report engage in soft-dollar trades or (former) directed brokerage arrangements. Funds pay soft-dollar commissions to receive credits for research that are generally determined by use of conversion ratios. Of the 75 brokers, 70 (93%) use commission conversion ratios ranging from 1.2:1 to 5.1:1 dollars in commissions for each dollar of research. The average conversion ratio is 1.7:1, which indicates that mutual funds receive a soft-dollar credit of $1.00 for each $1.70 they pay in soft-dollar commissions—one credit thus represents almost 60% of each $1.70 in soft-dollar commissions. The size of the conversion ratio depends on the volume of the broker trades and the types, size, and difficulty of trades.

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The bad news is that 35% of the examined brokers provide products and services to mutual fund advisers that are clearly not related to research or trade execution, such as rent, computer hardware, and CFA examinationreview courses. The SEC has not penalized more than a few brokers. The report finds that 62% of brokers have verbal soft-dollar arrangements with mutual fund advisers. Rather than use written arrangements, some brokers utilize client letters, letters of intent, or product confirmation letters. The balance of the brokers use written soft-dollar arrangements, but the agreements are most often between brokers and independent contractors or third-party vendors rather than between brokers and fund advisers. Some brokers using verbal agreements do so because they believe using stated minimum amounts of soft-dollar commissions each period would make it difficult to demonstrate that funds receive best execution trades. Soft-dollar arrangements may have fixed lives, indefinite lives, or no set time agreement. In other cases, mutual fund advisers and brokers agree on base commissions, and then they determine how much funds are to pay in soft dollars to receive the desired research. Soft-dollar trades particularly favor mutual fund advisers that outsource much or all of their fund investment research. Funds that do their own research without paying soft-dollar commissions are competitively disadvantaged by the inclusion of research costs in management fees, but they do provide transparent disclosure. Very importantly, mutual funds are subject to classic principal–agent problems where fund advisers and managers, relative to shareholders as principals, have only partial stakes in fund financial performance. Shareholders cannot give full attention to monitoring fund advisers and managers, because the costs would be prohibitive. As a result, fund advisers may fail to carry out their fiduciary duties and/or consume amounts of fund assets as compensatory perks. Agency costs derive from shareholder delegation of discretion to fund advisers and managers. Dollar losses arising from conf licted fund adviser and manager decisions are effectively opportunity costs to shareholders. Mutual fund agency problems are manifested in a number of ways. There are fund advisers that appear to value proprietary soft-dollar research, but as a prima facie free good, they may not make considered use of it. Still, soft-dollar commissions have higher opaque costs, which reduce fund assets and performance.

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Most mutual fund sources apparently believe proprietary soft-dollar research to be of minimal value. Fund advisers that use proprietary soft-dollar research may also agree with this position, but because it is at first glance a free good, they may not consider it important or costly enough to make changes. To the extent mutual fund advisers do value proprietary research, it would generally cost them less if purchased in hard dollars and recorded in expense ratios as management fees. But, this would increase the transparency of research expenses. Mutual funds direct more trades to brokers with whom they have soft-dollar arrangements, even though they cost more in opaque soft-dollar commissions and trade execution costs. Higher soft-dollar commissions are normally expected to exceed the hard-dollar value of the research. Mutual fund advisers with soft-dollar arrangements may make excessive trades or agree to higher softdollar commissions to compensate brokers for soft-dollar research that would otherwise not be purchased. Agency-conflicted financial rewards to mutual fund advisers and brokers from soft-dollar arrangements must be considered important based on their history of widespread and frequent use. Fund advisers paying soft-dollar commissions are likely motivated to bypass recording research in expense ratios as transparent management fees. Fund advisers are motivated further to meet their broker target allocations of soft-dollar commissions. Soft-dollar brokers are also motivated by more frequent and higher priced soft-dollar commissions, and also by higher revenue from trade execution. Soft-dollar trade execution is less likely to provide funds with best execution trades. Agency-conf licted soft-dollar trades may be characterized as higher cost trades that provide financial benefits both to mutual fund advisers and brokers, but which reduce fund assets and performance. Soft dollars are not expensed in transparent management fees, but rather are included in opaque transaction costs. The results of agency-conf licted soft-dollar trades are: 1. lower transparent costs expensed in management fees; 2. higher opaque soft-dollar commissions; 3. higher opaque trade execution costs; 4. higher opaque research directed to fund advisers;


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5. opaque reductions in fund assets and performance from higher soft-dollar commissions; 6. and opaque reductions in fund assets and performance from higher trade execution costs. Advocates of soft-dollar trades say independent research firms depend on survival from soft-dollar trades to sell their research. Soft-dollar arrangements may also encourage soft-dollar brokers to provide improved trade execution and to help build trust with funds. Funds also target amounts of soft-dollar commissions to brokers in exchange for special services, such as data, investment news, and IPO allocations. Horan and Johnsen

Horan and Johnsen [2000] are advocates of softdollar trades. Mutual fund advisers pay targeted amounts of soft-dollar commissions to brokers based on three conditions: 1) ability to provide high-quality trade execution; 2) value of research provided; and 3) reciprocal trust between the two parties. The ability of funds to perform relatively well relies to a large extent on relationships of trust with soft-dollar brokers, and paying up in softdollar commissions is a necessary part of the process. Further, mutual fund and broker trust is an effective mechanism for funds to maintain exclusive property rights to proprietary research. But, paying up in soft-dollar commissions alone does not create trust. Reciprocal trust extends to the broker’s stewardship of information shared by fund advisers. The increased number of soft-dollar brokers has increased cost competition for fund trades, and thereby provides an extended pool of potentially trusted brokers that funds can target for soft-dollar trades. The first response to those arguments is that if soft-dollar trades are desirable, why does the industry oppose making them transparent? CFA INSTITUTE

The CFA Institute [2004] attempts to reduce the negative aspects of soft-dollar commissions by providing ethical standards for its use. Soft-dollar practices are clarified by emphasizing basic fiduciary responsibilities and by promoting higher standards of conduct. This clarification includes 1) definition of soft-dollar arrangements; 2) definition of soft-dollar research; 3) enhanced 82

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disclosure of soft-dollar arrangements; and 4) statement of compliance with safe harbor requirements. SOFT-DOLLAR TRADING COSTS Conrad, Johnson, and Wahal

Conrad, Johnson, and Wahal [2001] are the first to provide specific evidence on the differences in costs of trade orders directed to soft-dollar brokers. The primary focus is to estimate percentage differences (as basis points) in trading costs (not costs for each dollar of assets) directed to soft-dollar brokers relative to full-service brokers. A unique data set is used to analyze the $260 billion in proprietary trades of 38 institutional investors for four quarters in 1994, 1995, and 1996. The data include identif ication information on trade orders, broker releases that include trade prices and commissions, and the trades that result. Total trade costs include both brokerage commissions (explicit costs) and market impact execution costs (implicit costs). Both are economically significant. Investment managers usually try to minimize trade costs, which are a very important component of portfolio performance. Results of the analysis of average implicit and explicit trade costs as percentages of dollar trade order size for both soft-dollar brokers and full-service brokers follows in Exhibit 1. The study finds that soft-dollar brokers have higher implicit, explicit, and total trade costs than full-service brokers. The larger difference in implicit trade costs is the major cause of the difference in total trade costs. That both implicit and explicit costs of soft-dollar trades are higher than costs of full-service broker trades is an important finding. Soft-dollar brokers also have the second highest total trade costs among all types of brokers.

EXHIBIT 1 Average Implicit and Explicit Trade Costs as Percentages of Dollar Trade Order Size

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Trade order size is defined in dollars (security closing price times number of shares traded) and also in number of shares traded. Both security closing prices and number of shares traded (volume) are highly correlated with total trade costs. With the exception of alternate brokers, the size of trades (in dollars and in share volume) directed to soft-dollar brokers are generally the largest. Soft-dollar brokers also have higher order fill rates than other types of brokers. Security prices are similar among types of brokers, but they are higher for soft-dollar trades. There are differences in difficulty and types of trade orders among types of brokers, and among those differences dollar and volume trade order size are highly correlated with trade execution costs. There are substantial differences in implicit trade costs. Institutional investors frequently direct smaller size trade orders in large-cap stocks to soft-dollar brokers. Trades are also more expensive for smaller institutional investors, and total trade costs are higher when the fixed costs of trading are larger. There is also considerable variation in incremental implicit trade costs over time. Implicit costs are higher for trades that are large relative to normal trade volume due to the effects of liquidity or adverse selection. Implicit trade costs are significantly impacted by investment manager investment style. There are also substantial differences in characteristics of the different types of brokers. The most complete analyses of implicit and explicit trade costs control for differences in investment style of institutional investors and capture differences in types of brokers. The results find that explicit costs of soft-dollar trades are only one basis point higher than costs of fullservice broker trades for both buys (sells). Further results estimate implicit costs of soft-dollar broker trades to be 29 (24) basis points higher than the costs of full-service brokers for buys (sells). Taken together, estimates of soft-dollar broker total trade costs are 30 (25) basis points higher than costs of full-service broker trades for buys (sells). Those results provide the most conservative estimates. Implicit costs of larger trade orders are higher, because it is more difficult to execute those trades at favorable prices. An analysis of larger (90th percentile) trades for each type of broker estimates implicit softdollar broker trade costs are 41 (30) basis points higher than the costs of full-service broker trades for buys (sells). Thus, for larger trades, implicit costs of soft-dollar trades are larger than the costs of full-service broker trades.

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An important issue is whether soft-dollar rebates of soft-dollar commissions are large enough to offset incremental implicit trading costs. The Plexus Group estimates 50% to 60% of soft-dollar commissions are rebated as soft dollars. Broker soft-dollar rebates to fund advisers go as high as 70% for extremely large funds. Assuming 60% of soft-dollar commissions are rebated as soft dollars, 52% (66%) of soft-dollar broker buys (sells) continue to have higher incremental costs. Following rebates, it is estimated that incremental explicit costs of soft-dollar trades fall to 13 (10) basis points for buys (sells), relative to base incremental implicit softdollar trade costs of 29 (24) basis points for buys (sells). Thus, even with soft-dollar rebates, incremental implicit soft-dollar trade costs remain higher than those of fullservice brokers. But, it is possible for soft-dollar rebates to outweigh incremental implicit costs for a given trade. In conclusion, incremental trading costs vary considerably over time, but the costs of soft-dollar trades are generally higher than the costs of full-service broker trades, and are consistently higher than those of other types of brokers. Gao and Livingston

Gao and Livingston [2010]’s analysis of soft-dollar trades includes hand-selected mutual fund brokerage commissions and soft-dollar data extracted from SEC filings, among other sources, for each of the years 2000 to 2007. The study is motivated by periodic SEC revisits to the issue of transparent disclosure of soft-dollar commissions, but the SEC has yet to provide the transparency investors are due, absent prohibition of soft-dollar trades. The average mutual fund is estimated to pay 27 basis points in brokerage commissions for each dollar of assets with an expense ratio of 134 basis points. Funds in the 90th percentile of brokerage commissions pay an average of 105 basis points for each dollar of assets, and those in the 10th percentile pay two basis points. The mutual funds are divided into five investment categories, including index, large cap, mid cap, small cap and mixed cap. Index funds are 50% larger than average large cap funds, and have the lowest brokerage commissions due to largest average size trades, less need for research, and less need to trade. Large-cap mutual funds have the lowest brokerage commissions among actively managed funds due to the largest asset and trade size. Large-cap funds also have the


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lowest portfolio turnover, suggesting scale economies in volume of market trades. Large-cap stocks are generally more liquid and therefore cheaper to trade than small-cap stocks. Those factors also provide more leverage in negotiating broker commissions. Bigger funds are also more likely to have larger in-house research capability, which may reduce the demand for soft-dollar research. The brokerage commissions for each dollar of assets and for each dollar traded are both positively related to expense ratios, including management fees and nonmanagement fees. High-cost mutual funds also spend more on commissions. First, equities that are costly to trade are also harder to analyze and more expensive to manage. Second, trades with higher commissions are often poorly monitored relative to funds with higher management fees and nonmanagement fees. Both commission measures have positive correlations with other fund expenses, 12b-1 fees, and loads. Economies of scale are indicated by significant negative correlations of commissions and fund assets. A one basis point increase in brokerage commissions is associated with a decline of five to six basis points in fund returns. The negative effect of commissions on fund returns is four times as large as the effect of expense ratios. This major point is not widely understood. The negative impact of expense ratios on fund performance is driven mainly by its nonmanagement fees component. Brokerage commissions become larger when mutual funds trade excessively either to gain additional soft dollars or to meet long-term soft-dollar arrangements, such as conflicts of interest with shareholders. These results are also consistent with more aggressive fund trading. Brokerage commissions for each dollar of assets are positively correlated to portfolio turnover, while commissions for each dollar traded are negatively correlated. The negative for each dollar correlation of commissions with portfolio turnover could result from scale economies of large volume trading and greater fixed costs in soft-dollar trades. The use of soft-dollar trades is correlated positively with portfolio turnover. Brokerage commissions for each dollar of assets are smaller for larger mutual funds and higher for funds with higher management and nonmanagement expenses. Funds that invest in securities difficult to trade require more trade management and pay higher brokerage commissions. Another explanation is that funds advisers overcharge for expenses. Brokerage commissions paid by mutual funds for each dollar of assets are quite consistent. Steady tar84

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geted commission payments are consistent with longterm soft-dollar arrangements. In turn, funds receive special services that include data, financial news, and IPO allocations. In conclusion, mutual fund brokerage commissions are a significant cost to shareholders. First, the average fund pays commissions of 27 basis points. Second, there is great variability in size of fund commissions, due to investment style and objective. Third, commissions are related positively to management fees and soft-dollar payments and exhibit significant economies of scale. Fourth, commissions have a significant negative impact on fund performance. This negative impact on returns is four times as large as that of total expenses. Fifth, 50% of sample funds use softdollar commissions for other than pure trade execution. Sixth, commissions should be included in the expense ratio and disclosed in the shareholder annual report. CONCLUSION

The purpose of this article is to explain the nature, use, and costs of mutual fund soft-dollar trading, including the legal safe harbor, soft dollars, soft-dollar commissions, soft-dollar rebates, trade disclosure, agency conf licts, and empirical trading costs. The safe harbor protects investment managers from liability for a breach of fiduciary duty solely on the basis they paid more than lowest commission rates to receive brokerage and research services. Soft dollars are the incremental soft-dollar commissions funds pay for research produced or provided by brokers. The SEC and Congress [as to Section 28(e)] should unbundle soft-dollar commissions by separating soft dollars from soft-dollar commissions. Opaque soft-dollar commissions and formerly bundled distribution commissions exacerbate agency conf licts between mutual fund advisers and shareholders. The conf licts include excessive and more costly softdollar commissions that bring financial benefits to both fund advisers and brokers. Mutual fund advisers are motivated to use softdollar commissions to increase complexity and to obfuscate research payments. Soft-dollar commissions are opaque and have a positive impact on investor inf lows, but at the expense of lower fund performance. Expensed research and distribution payments are significantly less detrimental to fund performance, but their greater transparency has a negative impact on investor inf lows.

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With or without unbundling and until prohibition of soft-dollar trades, the SEC should require mutual funds to disclose two sets of information in the SAI, the shareholders’ annual report, and for the SEC’s on-line files: 1) payments to non-soft-dollar brokers for (a) brokerage commissions and (b) trade execution costs (inclusive); 2) payments to soft-dollar brokers for (a) brokerage commissions and (b) trade execution costs (inclusive); and 3) broker soft-dollar rebates paid to fund advisers. Agency-conf licted soft-dollar trades may be characterized as higher cost trades that provide financial benefits both to mutual fund advisers and brokers and reduce fund assets and shareholder returns. Soft-dollar trades have higher implicit (market impact trade execution costs) and higher explicit (brokerage commissions) and total trade costs than full-service broker trades. The larger difference in implicit trade costs is the major cause of the difference in total trade costs. Explicit costs of soft-dollar trades are only one basis point higher than costs of full-service broker trades for both buys (sells), but implicit costs are 29 (24) basis points higher. Total soft-dollar trade costs are thus 30 (25) basis points higher than the costs of full-service broker trades for buys (sells). The average mutual fund pays 27 basis points in brokerage commissions for each dollar of assets with an expense ratio of 134 basis points. A one basis point increase in brokerage commissions is associated with a decline of five to six basis points in fund returns. The negative effect of brokerage commissions on fund returns is four times as large as the effect of expense ratios. REFERENCES Association of Investment Management Research. Soft-Dollar Standards: Guidance for Ethical Practices Involving Client Brokerage. Charlottesville, VA: AIMR, 1998. Baxi, Neeraj. “Paying Up: The Hidden Cost of Portfolio Management.” The Journal of Investing, Vol. 12, No. 3 (Fall 2003), pp. 76-81. Blume, Marshall E. “Soft Dollars and the Brokerage Industry.” Financial Analysts Journal, Vol. 49, No. 2 (March/April 1993), pp. 36-48. CFA Institute. Soft-Dollar Standards: Guidance for Ethical Practices Involving Client Brokerage. Charlottesville, VA: CFA Institute, 2004. FALL 2011

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Conrad, Jennifer S., Kevin M. Johnson, and Sunil Wahal. “Institutional Trading and Soft Dollars.” Journal of Finance, Vol. 56, No. 1 (February 2001), pp. 397-416. Dimmock, Stephen J., and William C. Gerken. “Finding Bernie Madoff: Detecting Fraud by Investment Managers.” Working paper series, SSRN, January 16, 2011. Available at http://ssrn.com/abstract=1471631. Edelen, Roger M., Richard Evans, and Gregory B. Kadlec. “Mutual Fund Commission Bundling: Disclosure and the Efficiency of Payment Mechanisms.” Working paper, June 10, 2010. Gao, Xiaohui, and Miles Livingston. “Brokerage Commissions: High Costs of Owning Mutual Funds.” Working paper, November 2010. Horan, Stephen M., and S. Bruce Johnsen. The Welfare Effects of Soft-Dollar Brokerage: Law and Economics. Charlottesville, VA: Research Foundation of CFA Institute, June, 2000. Kelvan, Morton. U.S. Department of Labour, PWPA Advisory Council, Working Group on Soft Dollars and Directed Brokerage, November 13, 1997. Lemke, Thomas P., and Gerald L. Lins. Soft Dollars and Other Brokerage Arrangements, 4th ed. Little Falls, NJ: Glasser Legal Works, 2004. U.S. Securities and Exchange Commission. “Inspection Report on the Soft-Dollar Practices of Broker-Dealers, Investment Advisors, and Mutual Funds.” Office of Compliance Inspections and Examinations, September 22, 1998. U.S. Securities and Exchange Commission. “Request for Rulemaking Concerning Soft Dollars and Directed Brokerage.” William H. Donaldson, Chairman, December 16, 2003. U.S. Securities and Exchange Commission. “Statement at the Commission Open House Regarding the Proposed SoftDollar Interpretive Release.” Christopher Cox, Chairman, September 21, 2005. U.S. Securities and Exchange Commission. “Part IV; Commission Guidance Regarding Client Commission Practices under Section 28(e) of the Securities Exchange Act of 1934.” Final Rule (17 CFR Part 214), July 24, 2006.

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