paying for brokerage research

As part of an EU overhaul of the financial industry, the UK has recently concluded an inquiry into pricing practices for mutual fund and other products offered to individual investors.  Press commentary is that the good luck for an industry with a bewildering array of prices (much higher than in the US) and little link between cost and value is not having been referred to the law enforcement authorities for criminal prosecution.

One big issue has been “soft dollars,” that is, paying brokers higher than usual commissions in return for their research, or for trading machines, or even newspapers–items that customers generally believe (and rightly suppose, in my view) they are paying for through management fees.   …but no!

Asset managers have been proclaiming that this is a weighty and complex issue, that the don’t know how to proceed.  They’ve generally been gnashing their teeth.

To me, this is all somewhat comical.  For decades, firms that do business in the US have been following an SEC mandate to keep meticulous records of the amount of their soft dollar expenses and what is being paid for.   The general rule was that if you stayed in line with industry practice, meaning doing whatever Fidelity did, you’d be ok legally.  They know exactly what they’ve been doing.  Also, the EU inquiry (see the link above) has been going on for three years.

There are two real issues:

–there’s a lot of money at stake, and

–handling the potential outcry from customers when they realize they’ve been paying twice (management fee + soft dollars) for research expenses.

An example:

A mutual fund has $50 billion in assets.  It turns those assets over at the industry average of 50% per year.  That means $50 billion in buys and $50 billion in sells.

Let’s say: the average stock trades for $40; the soft-dollar markup is $.02 per share; and the markup is taken on 20% of all shares traded (maybe slightly high, but the math is easier).

So, the fund “service” includes giving up $10 million a year of customer money on brokerage commissions in order to get the management company free goods and services.  That’s even though they’re collecting something like $250 million in management fees from the same customers.

disclosure vs. restructuring

Internally, I think disclosure is the lesser of the two issues.  The more difficult one is that industry revenues are stagnant or falling and by far the largest expense of any investment manager is salaries.  So, whose pocket does the lost soft dollar revenue come out of?

Vanguard, this decade’s Fidelity

Just prior to the 2007 financial crisis, Fidelity decided to turn up the competitive heat on fund management rivals by declaring it was unilaterally going to stop using soft dollars.  This time around, it’s silent so far.

Last week, Vanguard made a similar announcement.


the death of research commissions?

Investors in actively managed funds pay a management fee, usually something between 0.5% – 1.0% of the assets under management yearly, to the investment management company.  This is disclosed in advance.  It is supposed to cover all costs, which are principally salaries and expenses for portfolio managers, securities analysts, traders and support staff.

What is not disclosed, however, is the fact that around the world in their buying and selling securities through brokerage houses, regulators have allowed managers to pay substantially higher commissions for a certain percentage of their transactions.  The “extra” amount in these commissions, termed soft dollars or research commissions, is used to pay for services the broker provides, either directly or by paying the bills to third parties.  Typical services can include written research from brokerage house analysts or arranging private meetings with officials of publicly traded companies.  But they can also include paying for third-party news devices like Bloomberg machines–or even daily financial newspapers.

Over the last twenty years, management companies have realized that instead of supplementing their in-house research with brokerage input, they could also “save” money by substituting brokerage analysts for their own.  So they began to fire in-house researchers and depend on the third-party analysis provided to them by brokers   …and funded by soft dollars rather than their management fee.

For large organizations, these extra commissions can reach into millions of dollars.  Yes, the investment management firm keeps track of these amounts.  But they are simply deducted from client returns without comment.


This practice is now being banned in Europe.  About time, in my view.  Strictly speaking, management companies may still use soft dollars, but they are being required to fully disclose these extra charges to clients.  Knowing that clients would be shocked and angered if they understood what has been going on, the result is that European investment managers are abandon soft dollars and starting to rebuild their in-house research departments.

What’s particularly interesting about this for Americans is that multinational investment managers with centralized management control computer systems–which means everyone except boutiques–are finding that the easiest way to proceed is to make this change for all their clients, not just European ones.

The bottom line: smaller profits for investment managers and their brokers; much greater scrutiny of soft dollar services (meaning negotiating lower prices or outright cancelling); and higher returns for investors.

what will a soft dollar-less world look like

Yesterday I wrote about an EU regulatory movement to eliminate the use of soft dollars by investment managers–that is, paying for research-related goods and services through higher-than-normal brokerage commissions/fees.

Today, the effects of a ban…

hedge funds?

I think the most crucial issue is whether new rules will include hedge funds as well.  The WSJ says “Yes.”  Since hedge fund commissions are generally thought to make up at least half of the revenues (and a larger proportion of the profits) of brokerage trading desks, this would be devastating to the latter’s profitability.

Looking at traditional money managers,

 $10 billion under management

in yesterday’s example, I concluded that a medium-sized money manager might collect $50 million in management fees and use $2.5 million in soft dollars on research goods and services.  This is the equivalent of about $1.6 million in “hard,” or real dollars.

My guess is that such a firm would have market information and trading infrastructure and services that cost $500,000 – $750,000 a year in hard dollars to rent–all of which would now be being paid for through soft dollars.  The remaining $1 million or so would be spent on security analysis, provided either by the brokers themselves or by third-party boutiques (filled with ex brokerage house analysts laid off since the financial crisis).

That $1 million arguably substitutes for having to hire two or three in-house security analysts–and would end up being distributed as higher bonuses to the existing professional staff.

How will a firm pay the $1.6 million in expenses once soft dollars are gone?

–I think its first move will be to pare back that figure.  The infrastructure and hardware are probably must-haves.  So all the chopping will be in purchased research.  The first to go will be “just in case” or “nice to have” services.  I think the overwhelming majority of such fare is now provided by small boutiques, some of which will doubtless go out of business.

–Professional compensation will decline.  Lots of internal arguing between marketing and research as to where the cuts will be most severe.

smaller managers

There’s a considerable amount of overhead in a money management operation.  Bare bones, you must have offices, a compliance function, a trader, a manager and maybe an analyst.  At some point, the $100,000-$200,000 in yearly expenses a small firm now pays for with soft dollars represents the difference between survival and going out of business.

Maybe managers will be more likely to stick with big firms.


If history is any guide, the loss of lucrative soft dollar trades will be mostly seen more through layoffs of researchers than of traders.

publicly traded companies

Currently, most companies still embrace the now dated concept of communicating with actual and potential shareholders through brokerage and third-party boutique analysts.   As regular readers will know, I consider this system crazy, since it forces you and me to pay for information about our stocks that our company gives to (non-owner) brokers for free.

I think smart companies will come up with better strategies–and be rewarded with premium PEs.  Or it may turn out that backward-looking firms will begin to trade at discounts.

you and me

It seems to me that fewer sell-side analysts and smaller money manager investment staffs will make the stock market less efficient.  That should make it easier for you and me to find bargains.




the demise of soft dollars

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.

foreign trades

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.

hedge funds

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







making it clearer who pays for investment research

paying for research information

Who pays for the investment research that professionals use in managing our money?

We do, of course.

But this happens in two ways, one of them not transparent at all.

management fees

–We pay management fees, out of which the management company pays for its portfolio managers and securities analysts.  That’s straightforward enough.

research commissions aka soft dollars

–We also permit, whether we know it or not, our managers to pay higher commissions, or to allow higher bid-asked spreads, on trades they do with our money.  They are so-called “research commissions” or “soft dollars.”  These are not so transparent.  It’s our money, and it does to pay for  the manager’s newspaper subscriptions, Bloomberg machines, brokerage research reports…

In 2007, there was a movement afoot in the US, spearheaded by Fidelity, to eliminate soft dollars and have management companies pay for all its research out of the management fee income paid by customers.  This effort fell victim to the recession.

EU financial authorities have now revived the idea.  They’re proposing to ban research commissions completely–that is, they will demand that investment managers obtain the lowest price and best execution on all trades–that is, they won’t permit a certain portion to be paid for at, say, double the going rate in return for access to the work of the brokerage house security analysts.


According to the Financial Times, smaller investment management firms could have their operating income cut in half if they had to pay for all the research they get out of their own pockets.

But that won’t happen.  Every investment manager, big or small, will go over the list of research providers with a fine tooth comb and eliminate sources whose value is unclear but who are being paid anyway because it’s “just” a soft dollar payment.

I think there will be three main consequences of European action:

1.  Pressure for the US to follow suit will be enormous.  Balking by US managers will open the door for UK-based specialists on the US market to gain business from domestic managers.

2.  Analysts who produce original research will be much more highly prized;  those who do more prosaic “maintenance” research will be replaced by robots (not a joke, more a question of how quickly).

3.  The overall size of sell-side research will continue to shrink, not just boutique firms but at the big brokers as well.


insider trading, hedge funds, expert networks and skilled securities analysis (ll)

In yesterday’s post, I wrote about what insider trading and expert networks are.

Why have expert networks flowered over the past decade and been especially favored by hedge funds?

hedge funds

When I started working in the stock market in 1978, it was common for both brokerage houses and large institutional investors in the US to have extensive staffs of analysts.

As the sell side continued to rebuild itself and improve its analytic capabilities after the 1973-74 recession, buy side firms worked out that they could save money by shrinking their own staffs and rely on brokerage house research instead.  Better still, from their point of view, they could pay for access to the brokers’ analysts through commission dollars (“soft dollars”), a tab picked up by money management clients, rather than paying analysts’ salaries out of the management fees clients paid them.

Control of brokerage firms gradually passed into the hands of traders, who regard research as a cost center that produces no profits.  They did what seemed the obvious thing to do and began to lay off analysts.  During the Great Recession of 2008-2009 the steady trickle of layoffs became a torrent–and gutted the major brokers’ analysis capabilities, particularly in equities.

The professional disease of analysts is that they analyze everything, including their own jobs.  Senior people have long known that they’re vulnerable in a downturn, especially since they all are compelled to have assistants who earn a small fraction of what they do–and who can sub for them in a pinch.  Their response?  –in many cases, the senior people hire assistants who look good in business attire and can present well to clients, but who have limited analytic abilities.  As far as I can see, this defense mechanism protected no one during the fierce downturn recently ended.  It may be harsh to say, but “place holder” assistants may be all that’s left in some research departments.

If the cupboard is pretty bare in brokerage house research departments, do hedge funds build their own?

Some have.  But–and this could be nothing by my own bias–a lot of hedge funds are run by former brokerage house bond traders.   Traders and analysts are like the athletes and the nerds in high school.  Very different mindsets.  So hedge funds that are run by traders, and that have a trading orientation, don’t have the temperament or the skills, in my opinion, to build research functions of their own.  They also want information that’s focused strongly on the very short term.  (Is it a coincidence that the subjects of the recent FBi raids are all run by former bond traders?)

They can’t get it from brokers.  They can get it from independent boutique analysts.  But were better to get information about, say, the upcoming quarter for Cisco than from a Cisco employee visiting as part of an expert network.

securities analysis

I wrote yesterday about the immense amount of information publicly available to a securities analyst.  In the US, companies are required to make extensive SEC filings, in which they report on the competitive environment, the course of their own business and the state of their finances.  Some firms hold annual analysts’ and reporters’ meetings–sometimes lasting several days–in which they try to explain their firms in greater detail.  There are trade shows, brokerage house conferences on various industries and–in many cases–specialized blogs that discuss industries and firms.  Publicly traded suppliers, customers and the firms themselves hold quarterly conference calls, in which they discuss their industries and their results.  The internet allows you to reach competitor firms around the world.

Companies also have investor relations and media departments that provide even more information for those who care to call.  Many times these departments also organize periodic trips to major investment centers to meet with large shareholders and/or with large institutional investors.  The talking points for these trips are scripted in advance.   My experience is that the company representatives attempt to create the impression that questioners in the audience have penetrating insights and are forcing the company to answer tough, and unusual, questions.  And people on my side of the table are usually more than happy to believe that this is true.  But in reality the companies tell basically the same things to everyone.

Still, the idea that anyone who obtains inside information is “infected” by it and becomes a temporary or constructive insider as a result has made profound changes, I think, in the way companies and analysts interact.

Let me offer two examples:

1.  In my early years, I ended up covering a lot of smaller, semi-broken companies that senior analysts didn’t want.  It’t actually a great way to learn.  Anyway, I had been talking regularly for about a year with the CEO of a tiny consumer firm that was flirting with bankruptcy.  This CEO was understandably downbeat and our talks were rather depressing.

Then rumors began to circulate that a Japanese firm was interested in buying the firm at a high price (in reality, anything greater than zero would have been a high price).  I called the CEO a couple of days later to prepare for my next report.  He was very cheerful, didn’t have a care in the world, actually joked his way through my questions.  I didn’t need to ask about the potential takeover.  His whole demeanor told me that the rumors were true.

Did I have inside information?  Twenty years ago, the answer would have been no.  I was just a skilled interviewer drawing inferences from the conversation.  Today, I don’t  know.  I suspect the answer is yes.

2.  I’m in a breakout session with the CFO of a company which has just presented at a brokerage house conference and is answering follow-up questions from analysts in a smaller room.  Someone raises his hand and says that for a number of reasons he thinks this quarter the firm will miss the earnings number it has guided analysts to.  He requests a comment.  Most people know the questioner–or at least can read his name badge.  He comes from a hedge fund that is rumored to be short the company’s stock.

The CFO clears his throat, takes a sip of water and says there’s no reason to think the firm won’t easily make its guidance.

I’ve known the CFO for a few years.  He only clears his throat and sips when he’s getting ready to say something that’s technically true, but is misleading  –in other words, a lie.

Do I have inside information.  Again, years ago the answer would have been no.  Today, I’m not sure.  If this were a private meeting with the CFO, I think it’s likely that I’ve got inside information.  But is a breakout session public disclosure?  Does it make a difference if the session is televised, so everyone can see what the CFO is doing?

My uncertainty changes my behavior.  How?

I probably no longer want a private meeting with top management of a company.  I probably don’t want the company to comment on my earnings estimates, or to give any indication that a non-consensus estimate I may have could be right.

I have to rely more on my independent judgment.  I want to be wary of any interaction with company management.  I don’t want any “help” with my estimates (not that I need any).

This is actually good news for individual investors, because the playing field between them and professional analysts has been leveled significantly.

Soft dollars–what they are and how their demise will affect professional equity managers

What they are

Soft dollars, sometimes also called research commissions, are commission or bid-asked spread payments (for over the counter securities) made at a higher than normal rate by investment managers to brokers as compensation for research services the broker provides.

Although investment managers are required to obtain the lowest cost and the best execution in their trading for their clients, the SEC created a safe harbor years ago that allows soft dollar commissions to be paid, providing that:

–services are genuinely for research, and

–clients understand this is going on.

The SEC has publicized the soft dollar issue a number of times and has given illustrations of types of services that are (like the broker’s own research, Bloomberg terminals, third-party research) that are allowable, as well as services (like transportation costs, furniture, rent) that are not.

Why is this an issue?

Two related reasons:

in paying commissions, the manager is using the client’s money, so he has an obligation to spend it wisely; also,

by using soft dollars, the manager is using client money for expenses that would otherwise come out of his management fee.

Who understands this practice?

Institutional investors understand the use of soft dollars very well.  In fact, some require their managers to direct a certain amount of commission business to brokers that the client designates, to satisfy soft dollar arrangements the client has entered into.  Retail investors?–not so much, I think.  For example, do you know what policies your mutual funds follow?  or how much of your investment money goes to buy services your manager uses?

Sizing soft dollars: a percentage of commission payments

Consider an investment management company that has $10 billion in equity assets under management.  If the stocks are all US (commissions are typically higher abroad) and the average price of a share of stock in the fund group’s portfolios is $40, then the group holds 250 million shares of stock.

Let’s say that the group turns over 80% of the portfolio yearly and that it pays the following commissions (including imputed commissions for NASDAQ trades):

electronic crossing networks        20% of volume                   $.015/share

soft dollar trades                               20% of volume                   $.08/share

“regular” brokerage trades             60% of volume                   $.04/share.

If we figure this out in dollars, the amounts are:

crossing networks               $600,000         11% of total commission expense

“regular” trades                 $1,600,000         30%

soft dollar trades               $3,200,000      59%.

A soft commission dollar doesn’t buy a hard dollar’s worth of goods or services.  A typical ratio is that 1.7 soft dollars equals one hard dollar.  Using this relationship, our firm’s $3.2 million soft dollars buys $1.9 million hard dollars worth of research services.. a boost to the manager’s profits

Let’s relate this to our hypothetical firm’s profits.  If we assume that the firm charges an average fee of 50 basis points on its $10 billion in assets and has a relatively constant 50% operating margin (I’m not saying this is the best way to analyze any company, but it is fast…and gives a reasonable ballpark number), then the company has operating income of $25 million.  Using soft dollar power supplied by client commissions raises the company’s operating earnings by about 9%.

The CEO of our investment company might comment that this $2 million adds up to only .002% of the assets under management, so that this practice really doesn’t affect investment performance by any noticeable amount.  (This would be sort of like saying that taking money is ok if you don’t get caught–not exactly a confidence builder in the speaker’s attitude toward fiduciary responsibility.)

On the surface at least, soft dollar trades appear to be no more or less profitable than “regular’ trades.  If processing costs are about $.015/trade, a $.04 trade yields a profit of $.025.  An $.08 soft dollar trade has $.047 in costs to provide services (figured at the retail price the investment manager would otherwise pay) + $.015 in processing costs,  so it yields a profit of $.018.  But brokers are in a position to bargain with suppliers for quantity discounts.  The SEC investigated the discount question about ten years ago and found that most brokers supplied the services at their cost, but that some charged a distribution fee.  Bernie Madoff has subsequently unveiled the limits of the SEC’s investigative skills, so it’s a safe bet that a short conversation with service providers would reveal that brokers universally take a substantial markup.

Why managers don’t highlight this practice Continue reading