Issues in Mutual Fund Soft-Dollar Trades

Abstract

The purposes of this article are to explain the nature, use, and costs of mutual fund soft-dollar trading, including the legal “safe harbor,” “soft dollars,” “bundled commissions,” trade disclosure, agency conflicts, 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 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 requiring separation of soft dollars from total trade commissions.

Opaque soft dollar commissions and former bundled distribution commissions exacerbate agency conflicts between fund advisers and shareholders. The conflicts include excessive and more costly soft dollar commissions that bring financial benefits to both fund advisers and brokers.

Fund advisers are motivated to use soft dollar commissions to increase complexity and to obfuscate research payments. Soft dollar commissions are opaque and have a positive impact on investor inflows, 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 inflows.

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 statement of additional information (SAI), the shareholder annual report, and for SEC online 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 (c) broker soft-dollar payments to fund advisers.

Agency conflicted 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 broker 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 30 (25) basis points higher than costs of full-service broker trades for buys (sells).

The average mutual fund pays 27 basis points in brokerage commissions per 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.

Keywords: mutual funds, brokerage commissions, soft-dollar trades, safe harbor, bundled soft dollar commissions, agency conflicted soft-dollar trades, trade costs, transparency, opaque, expensed research and distribution payments, investor inflows

JEL Classification: G2, G23, G28