This is the first of two posts. Today’s lays out the issue, tomorrow’s the implications for the investment management industry.
so long, soft dollars
“Soft dollars” is the name the investment industry has given to the practice of investment managers of paying for research services from brokerage houses by allowing higher than normal commissions on trading.
Well understood by institutional, but probably not individual, clients, this practice transfers the cost of buying these services–from detailed security analysis of industries or companies to Bloomberg machines and financial newspapers–from the manager to the client. In a sense, soft dollars are a semi-hidden charge on top of the management fee.
In the US, soft dollars are reconciled with the regulatory mandate that managers strive for “best price/best execution” in trading by citing industry practice. This is another way of saying: whatever Fidelity is doing–which probably means having commissions marked up on no more 15%-20% of trades.
In 2007, Fidelity decided to end the practice and began negotiating with brokers to pay a flat fee for research. As I recall, media reports at the time said Fidelity had offered $7 million in cash to Lehman for an all-you-can-eat plan. Brokerage houses resisted, presumably both because they made much more from Fidelity under the existing system and because trading departments were claiming credit for (and collecting bonuses based on) revenue that actually belonged to research.
theWall Street Journal
Yesterday’s Wall Street Journal reports that the EU is preparing to ban soft dollars in Europe for all investment managers, including hedge funds, starting in 2017.
not just the EU, however
Big multinational money management and brokerage firms are planning to implement the new EU rules not just in the EU, but around the world.
Other jurisdictions are likely to follow the EU’s lead. Doing so also avoids potential accusations of illegally circumventing EU regulations by shifting trades overseas.
soft dollars in perspective
in the US
Let’s say an investment management firm has $10 billion in US equities under management. If it charges a 50 basis point management fee, the firm collects $50 million a year. Out of this it pays salaries of portfolio managers and analysts, as well as for research travel, marketing, offices… (Yes, 12b1 fees charged to mutual fund clients pay for some marketing expenses, but that’s another story.)
If the firm turns over 75% of its portfolio each year, it racks up $7.5 billion in buys and $7.5 billion in sells. Plucking a figure out of the air, let’s assume that the price of the average share traded is $35. The $15 billion in transactions amounts to about 425 million shares traded. If we say that the manager allows the broker to add $.03 to the tab as a soft dollar payment, and does so on 20% of its transactions, the total annual soft dollars paid amount to $2.5 million.
Generally speaking, commissions in foreign markets are much higher than in the US, and soft dollar limitations are …well, softer. So the soft dollar issue is much more crucial abroad.
Then there are hedge funds, which are not subject to the best price/best execution regulations. I have no practical experience here. I do know that if I were a hedge fund manager I would care (almost) infinitely more about getting access to high quality research in a timely way (meaning ahead of most everyone else) than I would about whether I paid a trading fee of $.05, $.10 (or more) a share.
We know that hedge funds are brokers’ best customers. Arguably, banning the use of soft dollars–enforcing the best price/best execution mandate–with hedge funds would be devastating both to them and to brokerage trading desks.
translating soft dollars to hard
When I was working, the accepted ratio was that $1.75 soft = $1.00 hard. I presume it’s still the same. In other words, if I wanted a broker to supply me with a Bloomberg machine that cost $40,000 a year to rent, I would have to allow it to tack on 1.75 * $40,000 = $70,000 to (the clients’) commission tab.
Tomorrow, implications of eliminating soft dollars