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Let's say a mutual fund has two expenses: A $1,000 Bloomberg machine and a $3,000 (market rate) trade. What they should do ethically is pay $3,000 for the trade, and $1,000 for the Bloomberg machine. Instead, they pay $6,000 for the trade, and get comp'd the Bloomberg machine.

This is not necessarily how it works. Lets say Vanguard needs 20 Bloomberg machines for its analysts. Vanguard goes to Bloomberg and finds out the cost of those 20 machines, say $1,000/machine/month so $20,000 X 12 = $240,000 total. Now Vanguard has 2 choices:

(1) It can pay Bloomberg directly and itemize the charge and therefore raise their expense ratio based on this $240,000 (charging the customer more).

(2) Vanguard can go to Goldman Sachs and enter into a "Soft Dollar" arrangement. When this happens, the 3 parties involved (Vanguard, Bloomberg, and Goldman Sachs) all sign contracts stating that Goldman Sachs will pay Bloomberg the $240,000 on behalf of Vanguard. This contract also states that Vanguard will pay this $240,000 (plus some multiplier, say 20%, for a total of $288,000) by way of "soft dollar" commissions. Now, here is how soft dollar works:

Vanguard does a trade and uses Goldman Sachs as the broker. Vanguard pays a commission on this trade which is negotiable. Now Vanguard can pay a "hard dollar" commission, which means every cent is just profit for Goldman Sachs. OR, Vanguard can pay a "soft dollar" commission, which means all the commission for this trade will be applied to the $288,000 that Vanguard "owes" Goldman Sachs. The commission rate is always negotiable, and Vanguard can choose to do this specific trade with any other broker if the commission is better. However, because of the Soft Dollar contract, Vanguard must pay $288,000 in commissions to Goldman Sachs at some point during the year. More often than not, Vanguard will do much more business with Goldman Sachs above and beyond the $288,000.

To me, soft dollars are not such a horrible thing.
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