Soft Dollars: What Do The Players Think?

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As mentioned a few weeks ago, the views on soft dollars are extremely varied depending on your background.  The following blog tries to outline some of the primary reasons for these differing views:

Some of the largest money managers hate soft dollars.  A number of large buy side firms have come out against the use of soft dollars explaining that they prop up commissions, thereby hurting investors and supporting Wall Street.  What these money managers fail to mention is the real reason soft dollars anger them so much is because the major brokerage firms have historically refused to lower their commission rates below a certain point explaining that a portion of the commissions they charge the buy side (though they can’t say exactly how much) covers the brokerage firm’s costs of producing the research that money managers get as a bundled part of their service.  Of course, the problem here is that some money managers don’t value Wall Street research as much as Wall Street is charging for it.  The short-term solution to this sticky problem is to go elsewhere to trade.  As a result, many large money managers rely on ECNs versus full-service brokerage firms where they pay commission rates between .85 to 1.0 cent per trade (versus 5.0 to 5.5 cents with full-service firms).  The long term solution is to push for the complete ban on soft dollars.

Some of the smaller money managers say soft dollars are necessary to “level the playing field”. Smaller money managers explain that they don’t have the economies of scale (i.e. assets under management) to build their own research capabilities like large money managers can.  They argue that soft dollars allow smaller money managers to purchase the best research (including both Wall Street and independent research) by using a portion of trading commissions versus paying for this research using cash that would come out of their own fees.  They support this practice by pointing out that soft dollars have actually helped investors as 7 out of the top 10 performing money managers were actually the small shops that rely on the research capability provided through the soft dollar mechanism.  The interesting question here is, will these money managers change their tune once they get large enough that they can afford to build their own research departments, and then realize that the amount they are paying Wall Street for their research makes no economic sense.

Independent research firms explain that soft dollars are the “life blood” of research. Indy research firms generally argue that eliminating soft dollars would destroy the independent research industry.  This view is based on the fact that between 80% to 90% of all independent research is paid for through the use of soft dollars.  Indy firms’ primary fear is that banning soft dollars would result in a drastic reduction in many companies revenue and would prompt a number of smaller research providers to go out of business.  This viewpoint is completely understandable as independents expect that forcing money managers to pay for research using hard dollars (cash) would prompt them to reduce their overall use of research — a development that is extremely disconcerting to the indy community.  This fear is also based on the notion that if money managers were forced to ration their purchase of research, they would likely choose to pay Wall Street due to the broad range of services obtained from the investment banks.

Soft Dollar Brokers (need I say more) think soft dollars are good for investors as they help promote competition in the financial markets. As might be expected, soft dollar brokerage firms understandably say the current soft dollar regime should be maintained.  They argue that soft dollars facilitate the development of numerous small independent research firms and enable small money management firms to compete with the larger ones.  The promotion of research that is competitive to Wall Street’s is seen as a benefit to all investors.  In addition, soft dollar brokerage firms argue that competition on the asset management front also benefits investors.  They go on to explain that their role in the process is to sell and market independent research firms’ services and to facilitate payment for these services by enabling money managers to pay for these services by utilizing their commission dollars.

Academics reason that soft dollars promote overpayment for both execution and research services.  While there is a wide range of study on the topic, most academics agree that using soft dollar commissions to pay for research (and a variety of other items) enables money managers to “outsource” the payment of these products and services to the investor as commission expenses come directly out of the assets of a fund and is not included in the “expense ratio” of a fund (and therfore it is not deducted from the fees investors pay managers to manage their money).  They argue that this arrangement provides very little incentive for money managers to truly seek “best execution”, or to make sure they are paying the lowest price for the most appropriate research services required to maximize their returns.  Academics calculate that money managers pay too much for execution services, they buy too much research, and they overpay for those research services.  As a result, they posit that all soft dollars expenses should be made transparent to investors at least, or outright banned.  Some even go so far as to suggest that the real problem is that commission costs need to be treated as an expense of the fund — a move that would require managers to raise the fees they charge for their investment management services.  This, some academics argue, would clearly align money managers interests with the interests of the investors whose money they invest.

Wall Street firms don’t say much about soft dollars except that it would be too complex to unbundle their research from their trading services. This is a strange argument as most Wall Street firms have spent a great deal of time and attention over the past few years in understanding their costs on a department by department basis and “right sizing” these departments.  Of course, the real concern for Wall Street firms is that if they put a price on their research, some investors would choose not to pay for it because they don’t want or need it, others would argue it is too expensive, while some would want to pay for discreet research components and not others.  The ultimate result would be less overall “research revenue” — a development that would lead to even further reductions in coverage, outsourcing, and layoffs.  These developments would further highlight the untenable cost structure and the lack of a viable business model that plagues most Wall Street research departments today.  In fact, some observers suggest that a few investment banks have seen the writing on the wall and secretly hope that soft dollars will be banned as this could be used as a specific reason to exit the equity research business altogether.  This would leave these firms free to focus on proprietary trading.

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