New York – Jack Bogle, former chief executive of Vanguard, has written a scathing attack on soft dollars, recently published in the Financial Analysts Journal. Soft dollars are not a new topic for Bogle, well known for his iconoclastic views of the fund industry, but the timing of the article is interesting, as most industry observers had assumed that soft dollars have taken a back seat to other concerns in Washington.
Bogle’s article, “The End of ‘Soft Dollars’?”, published in the March/April 2009 edition of the Financial Analysts Journal, labels soft dollars as ‘indefensible’ and ‘harmful’ to clients of institutional managers. One of Bogle’s key arguments is his concern that soft dollars are being used to make payments to brokers for the distribution of fund shares. This is an unusual allegation, at least since 2006 when the SEC implemented 12b-1(h) prohibiting pay-to-play. Does Bogle know of industry wrongdoing, or is he dredging up old material? He mentions enforcement cases in 2003 and 2005, and notes that sanctioned firms continue to generate high commissions. He cites David Swensen’s skepticism in Unconventional Success that pay-to-play has been eliminated.
This is a difficult subject precisely because of the lack of transparency around soft dollars. In our own experience, there can be discrepancies between how the broker vote ranks research and the ultimate allocation of commissions, but this can be explained by execution services provided by brokers. Typically the traders ultimately determine the commissions, and they are inclined to trade with counterparties that provide quality execution services. Further, some of the trading counterparties that garner high commissions do not distribute mutual funds. Nevertheless, the opacity of soft dollars makes pay-to-play allegations hard to definitively refute.
Soft Dollars & Research
Bogle also presents arguments against the research rationale for soft dollars. He estimates mutual fund trading volume of $7.5 trillion in 2007, $3.8 trillion of stock purchases and $3.7 trillion in sales, well above the $5.5 trillion value of stocks held. He doesn’t say it directly but the implication being that soft dollars encourages active trading to generate commissions for payment.
His primary argument is that soft dollars undermine funds’ fiduciary responsibility by making research paid by soft dollars seem like a free good. We agree that the lack of a market mechanism has created substantial inefficiencies in the research market. Bundled commissions created the inefficiencies. While fostered and nurtured by soft dollars, bundled commissions are not necessarily the same as soft dollars. Bogle acknowledges that commission sharing arrangements are providing more transparency but believes that CSAs and CCAs are a temporary expedient.
Bogle is skeptical of the value of external research in general. This is not surprising given his passionate and long-standing advocacy of passive investing. His argument, however, is nuanced. He believes that internal, proprietary research has value: “…the value of mass-marketed Wall Street research has a half-life measured in moments and…proprietary institutional research has at least some potential to add value to those lucky enough to capitalize on it…” He argues that mutual funds have the wherewithal to expand their own proprietary research. Bogle calculates that mutual funds received $70 billion in aggregate fee revenues in 2008, of which $4 billion (6%) went to investment supervision and research.
These are topics near and dear. First, as we have pointed out on numerous occasions, the fastest growing segment of alternative research is what we call the primary sector, consisting of tools to assist analysts and PMs in doing primary research. Examples include expert networks, channel checkers, custom survey providers, data mining firms. The growth of this segment confirms the trend toward internal proprietary research that Bogle discusses, although it has been driven primarily by hedge funds rather than mutual funds. We remain bullish on this segment’s prospects despite a turbulent 2009.
Second, the fund industry has long signaled its intention to increase internal research activities, although its actions have typically fallen short even during bull markets. Now the trend is in the opposite direction, with layoffs and cutbacks across the board. Investment staff had been relatively less impacted that other buyside staff, but they are not immune. In the current context, it is hard to imagine funds expanding research staff.
Bogle concludes that soft dollars are doomed: soft dollars “will eventually come to an end because of higher fiduciary standards, more complete disclosure, and greater governance independence of funds from their managers.” He cites commission sharing arrangements as a positive development although he is skeptical of their longer-term efficacy in preventing the downfall of soft dollars.
The natural question is why he has taken up the cudgel against soft dollars at this moment in time? Soft dollars seem to be a dormant issue. It has been five months since the comment period closed on the SEC’s proposed guidance to fund directors on soft dollar disclosure, and those that have met with SEC staff on the topic say that there seems to be no timetable for release of final guidance. Bogle clearly has an eye on fund boards, which we believe are taking a greater interest in the soft dollar topic, SEC guidance notwithstanding.
We doubt that substantial changes are likely without regulatory action, and the SEC has tended to lag other regulators such as the UK’s FSA and France’s AMF on the topics of commission disclosure and transparency. Perhaps Bogle is aware of winds of change in Washington, or hopes to fan a breeze by his advocacy…
Bogle’s article can be found at http://www.cfapubs.org/doi/abs/10.2469/faj.v65.n2.1