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Just read an article on these and still unclear on how these work...apparently this allows fund companies to keep the publicized operating expenses but use funds to pay higher commissions to brokers in return for more business? NADR is looking into it but I'm not sure of the impact for us small time investor like myself...
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The fees are paid to small firms for research. These firms are independent, unlike those that have investment banking branches. Therefore, their advice is likely to be fairly objective, although of course they still can be wrong.

Those firms are an important source of good information, according to people like Kudlow and Cramer.
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Soft dollaring is yet another reason to buy common stocks instead of mutual funds. It works like this- A mutual fund can pay an inflated
commission to a broker and in return get a kickback from that broker.

So for, example, Vanguard has a choice of buying 100,000 shares of GE for one of its funds through Goldman Sachs, which charges $.06/share in commissions and has a soft dollaring arrangement with Vanguard, or through a generic broker charging $.03/share with no soft dollaring.

Vanguard chooses Goldman, paying $6,000 for the trade instead of $3,000. In return, Goldman agrees that $1,000 of the commission will be soft dollared, that is, Goldman will provide $1,000 of some service to Vanguard. For this to be legal, the thing of value must generally involve investment research. So, for example, Goldman pays the annual fee for one of Vanguard's Bloomberg machines.

There are endless variations on such kickbacks. For example, institutional customers who play the soft dollaring game may demand their money management firm trade through certain brokers so that they, the client, can get comp'd. Unfortunately we individual investors can't call Fidelity and demand a kickback for the .034 shares of Starbucks they traded on our behalf! Clients also force brokers to make donations to nonprofits with a portion of the soft dollared trades.

And just as brokers kickback reasearch services to mutual funds, mutual funds may kickback trade volume to brokers who, for example, provide a useful research report about a stock. Portfolio managers actually have voting computer systems with an annual comp budget they spend through the year.

You don't hear much about soft dollaring in the media, and what you do hear is often wrong, since very few people really understand how it works.

Nick

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Here is a decent article about how the "soft dollars" are spent.

http://www.trendmacro.com/a/luskin/20031222luskinSMC.asp

The indepent researchers, since they are not tied to any of the big brokerages, are capable of giving objective advice.

"I'm talking about independent securities analysts; the ones who make a living not by being superstar salesmen for investment-banking services, but rather by making investors money by being right. And a lot of the time, that means making tough calls that are very different than the happy-talk that radiates endlessly from Wall Street.

For instance, there's Mark Roberts, of Off Wall Street Consulting Group. Roberts has become famous for being just about the only analyst to have had a Sell rating on Enron as early as May 2001, well before the bottom fell out.

How about Howard Schilit of the Center for Financial Research and Analysis. Schilit warned about Microstrategy in October 1999, and the stock fell by 95% -- the first of the major corporate scandals. He pointed to dubious accounting at Biovail last July, and the stock fell nearly 50%."

Note that Goldman strongly recommended Enron up to the very last.

"Most independent analysts are paid with what's referred to as "soft-dollar commissions." With soft dollars, big institutional investors -- including mutual-fund managers -- don't write checks to the independent analysts directly, but instead instruct their brokers to pay the analysts for the research. Why do the brokers agree to foot the bill? Because in exchange for brokers paying for the research, the big investors commit to sending the brokers enough trading commissions to make it worth their while. It's a clean, explicit contractual arrangement. In effect, the cost of the independent research is built into the commissions."

The objection to soft dollars is really a power grab from the big brokerage houses.

"Scandal or not, it's going to put independent analysts out of business. Why? Because the ICI is only asking the SEC to ban soft-dollar commission to pay for independent research like that of Roberts, Schilit, Tice, Cleland -- and my own firm. The big Wall Street brokers will be allowed to go on just as before and pay for their own in-house research with soft dollars. So how are the independents going to compete when investors have to dig into their own pockets to pay them -- but can still pay for Wall Street firms' in-house research out of commission dollars that were going to get spent anyway?

Is it just a coincidence that the big Wall Street brokers come out on top, thanks to the mutual-fund industry's attack on independents? Maybe not. The big Wall Street brokers are the ones whose sales forces are responsible for the majority of mutual-fund sales year in and year out."

For some examples of the good work done at Goldman and elsewhere, see

http://www.actwin.com/kalostrader/Analysts.html

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You don't hear much about soft dollaring in the media, and what you do hear is often wrong, since very few people really understand how it works.

Nick,

I don't mean this to be catty, but I honestly did not come up with any understanding of this phenomenon from your message, either. For one thing, I quickly lose track of the conversation when "soft dollar" is turned into a verb.

Other things are not clear to me as being evil, or even unusual:

Vanguard chooses Goldman, paying $6,000 for the trade instead of $3,000. In return, Goldman agrees that $1,000 of the commission will be soft dollared, that is, Goldman will provide $1,000 of some service to Vanguard.

Again, the term has turned into a verb, which doesn't help. But besides that, I would need a clearer understanding of how this process differs from the standard practice, common throughout all industries, of being able to charge a higher price by offering a "value-added service."

Superficially, we might think that a mutual fund simply buys and sells securities. But in true economic terms, every business transaction is an exchange of *value*. Sometimes the value is "soft" in the sense that it is merely perception -- like the yuppie image of Starbucks that allows them to overprice their coffee. Obviously, buyers think the image has enough value to offset the extra cash involved.

Okay, so what is actually going on when a mutual fund buys a stock? I think many people here have echoed my notion of mutual funds, which is that I don't mind paying an expense fee in return for the manager doing the stock-picking for me. He/she is almost certainly going to do a better job than I could do, given the time and resources I have available to devote to it. And that is worth money to me.

From what I can tell in these messages, some brokers charge more for a stock transaction but give back more value to the buyer, in the form of research that helps the buyer. And the buyer is the fund manager -- the very person who I am paying to get me the best possible results. If he/she makes a calculation that the service is worth the money, then I would not object.

Before I get upset over it, what I'd want to hear/see is some clearcut evidence that managers of funds I own are *wasting* my money. And the way that could happen is if the "value-added service" they get does NOT ADD VALUE. Well, I think that would require looking at each specific transaction, and finding out if a researcher helped a fund choose better stocks and buy them at more appropriate times, than would otherwise have happened. If, by way of a given transaction, a fund achieves .1% better performance for me, and the manager has spent .1% more fee to get it, that seems fair to me.

If you can be more precise -- perhaps cite specific cases with documentation or something like that -- of cases that are blatant featherbedding or whatever, then I'd be glad to hear about it. I am glad to hear that the SEC is putting the heat on, and I'm glad to see some of my funds dropping their fees a little bit because of that heat. But I don't want to get all worked up over yet another issue, without knowing for certain that it is worth my concern. So, thanks for any help! :-)
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Perhaps a little more clarity on where my question orginated from...

http://www.ohio.com/mld/charlotte/business/7578928.htm

Here are some excerpts that made me concerned...

"Last year, mutual funds and other institutional investors paid about $12.7 billion in commissions, according to research firm Greenwich Associates, and about $4.5 billion of that went toward research and other items purchased with soft dollars. But soft-dollar costs aren't included in a fund's expense ratio and usually aren't broken out by fund companies for investors to see. "

"...1998 report found one fund manager who spent soft dollars to buy a computer that was operated exclusively by his family, which used it to play video games. Other advisers, the SEC said, used soft dollars to pay telephone bills, rental-car costs, to install anti-static carpeting and to buy theater tickets."

It talks about soft dollar fees and the problem with clarifying "investment research".

I don't mean to blow up this issue as the media has a tendency to make mountains out of mole hills and I suspect (or maybe hope is more appropriate) that the firms collecting soft dollars are in fact spending those dollars on specific research. I agree those that add specific "value" are deserving of a profit of some sort. The "value" in this case has been defined as "investment research" which I think makes this a grey area according to the article above.

My guess is the SEC is going to add more stringent definitions of "investment research" which I think would make sense for all of us just as they're pushing fund companies to do a better job of disclosing fees.

The dollars discussed are significant but to a small timer like myself I'm guessing this only amounts to pennies on my portfolio. Is there anyway to tell?

Also, since I primarily invest in index funds wouldn't this be a moot point? (Nick - you brought up Vanguard which prompted the question)

Nick you also referenced "...yet another reason to buy stocks instead of mutual funds". Can you point me in the direction of where the other reasons for this might be? Just curious.

Thanks!

Jesse
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Hi Jesse,

At first glance, I am troubled because the so-called "soft dollar" issue is indeed a media-ready slogan if I ever heard one. It's easy to say and lends itself to repetition without actual understanding. Honestly, I've managed to get through a few years of investing without ever hearing it before, so I wonder how many folks in everyday life really grasp it.

Since it is a real term, I thought it worth finding somebody to explain it to me. The search turns into a mini history lesson. First, at http://www.ssbb.com/hedge2.html we discover that the SEC made an effort in 1995 to require investment advisers to expand the disclosure they provide regarding their "soft dollar" practices. Proposed Rule 204-4 and proposed Form ADV-B would have required registered investment advisers to report to their clients annually on their brokerage practices, including soft dollar arrangements.

For reasons not clear in that article, the SEC dropped that clampdown effort in 1996.

Six years later, in what seems to be a reversal of attitude, the SEC was described in a different article as trying to *expand* the range of activities protected under "safe harbor" provisions in securities law, which specifically includes the use of soft dollars. Interestingly the article (at http://www.cybersecuritieslaw.com/wslawyer/stone.htm) seemed to complain that the SEC was not lenient enough!

And now, in 2004, the regulatory pendulum has swung back once again. The government is once again concerned about this topic and about the safety of investors. So I can't help wondering what are the chances that, five years from now, some other schmuck on a discussion board somewhere will be doing research like I am now, and discovering that nothing was ever really cleaned up in 2004 either. <LOL> Well, I guess the New Year has not made me less cynical!

Given the variance of opinions as mentioned above, and the fact that the SEC has not even been consistent in its attitude about this topic, I wonder how much to worry over it. After all, there have been a lot of really blatant abuses of the fiduciary responsibilities of fund management, particularly those in which major investors got preferential treatment over everybody else. It's basically the same as insider trading -- white collar thievery -- and it gets my dander up.

By contrast, although I'd like to see it cleared up, the "soft dollar" thing looks like a more ambiguous target. At worst, it seems that some fund companies may have made more money off you and me than they told us. Also, some brokers made more money off us than we knew about.

Okay, but did we still manage to make money from owning the funds being managed by those people? Some of us did, especially in 2003, for instance. And did the biggest mutual fund losses in recent years come because of "soft dollars?" Heck, no.

The biggest losses came from crappy stock picking, especially during difficult economic times. "Soft dollars" just added some insult to the far more painful injuries caused by boneheaded, overpaid fund managers. Who is to blame for the fact that all the bad-performing funds kept making money and getting new customers? Well, sooner or later don't we have to blame the customers for allowing it to happen? Shouldn't people in unions or other organizations be pestering their pension fund managers for investing in underperforming funds?

The situation reminds me of people who complain about gasoline prices but do not accept any blame for buying inefficient automobiles. By going along with the crowd, they create a cycle of supply and demand that becomes self-perpetuating. And since our leaders are so obsessed with radical laissez-faire capitalism, they refuse to regulate such energy abuse, even though it is a key to our economic malaise.

So, since we seem indifferent to the waste of money on imported oil, as just one example, why should we be so bugged about the waste of money on Wall Street? We seem to be a wasteful, inefficient society in many respects. I bet that at least a few of the small investors obsessing over mutual fund performance are also carrying credit card debt at exorbitant interest rates -- and losing more money that way than they are because of soft dollars that add half a percentage point of expense to their IRA or something like that.

Now, to be clear: yes, I am happy to see regulators uncovering the really egregious violations of trust. Yes, I think the structure of mutual fund companies should be easier to understand and that the financial statements should be held to a higher standard. I just think that the issues are much larger than "soft dollars." I also think investor education should be addressed as a public policy issue.

After all: I suspect that many investors barely understand things like alpha, beta and R-squared -- measurements that can actually tell them something concrete about the performance of the mutual funds they own. To throw this "soft dollar" term at them, hard on the heels of other quasi-news stories about "market timing" and so on, just confuses them.

http://thomas.loc.gov/cgi-bin/query/z?c108:S.1822: has the official text of the Senate's "Mutual Fund Transparency Act of 2003" and the law does not contain the phrase "soft dollars." However, you'll find that term in other places where the text of the law is paraphrased.

It is also mentioned in reference to other legislation, for example, at http://www.cuna.org/gov_affairs/legislative/issues/mutualfunds_rpt110403.html

The page comes from the Credit Union National Association, but the words come from Arthur Levit, the Former Chairman of the SEC, who testified on the “Mutual Fund Integrity and Fee Transparency Act” then before the House of Representatives. He lamented that

...investors don't even get what they pay for when they buy into a mutual fund. The culture, he testified, that contributed to this result is a culture of hype and salesmanship instead of safety and preservation. He urged the industry to recognize the grave threat these problems represent to its health and embark on substantive reform along with the SEC... with regard to soft dollars, he recommended that investors should know what commissions they are paying and what the money is going towards.

So... back to that WSJ article you cited: it cited things like a fund manager who used soft dollars to buy a computer that was not used for business, but instead was used by his family for games. Wait -- is that what we're supposed to be all bugged about?

How much could this computer possibly have cost? Totally decked out, maybe two grand? A typical executive expense account is probably padded with two grand worth of bogus business dining and travel every year. Couldn't the writers come up with better examples?

Let's think about this. That expense account is also "soft dollars" that go into their employer's tax returns, and show up as a deduction. Which means, that company pays less than its share to help run the government -- leaving you and me and other, more honest people, to pay more.

Basically, it's the same problem. The general population pays more, to pad the pockets of a few who bend the rules.

We need to see "soft dollars" cleaned up *everywhere* -- not just Wall Street. But I guess it's one place to start. Let's see just how much cleaning is really done, when it's all over.

Thanks very much for the article reference and the reply!
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I don't mean this to be catty, but I honestly did not come up with any understanding of this phenomenon from your message

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.

Note that:
a) The customer was overcharged $2,000.
b) The $1,000 Bloomberg expense is now hidden, not expressed in the fund Expense Ratio as it should be. The fund paid 3X as much as it should have in order to hide the cost.

It's sneaky stuff, on par with mutual funds silently sucking their expense ratios from your account without itemizing the charge. Can you name any expenses you paid last year besides fund fees that weren't itemized on a bill somewhere?

Nick
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Jesse,

Yes, your Vanguard index fund portfolio manager is soft dollaring, but it's less of a problem with such funds since they trade less, and have an index they must mirror (almost) exactly, which is an incentive to keep costs down. Yes, in the case of Vanguard index funds, esp large caps like the S&P 500, it probably isn't costing you much. Request an SAI (Statement of Additional Info) from your fund provider, which breaks out the commissions paid. Their prospectus won't disclose this.

And keep in mind, brokers also comp fund employees indirectly for trading with them. If your fund manager played any golf this weekend, or ate at a five star restaurant, there's a good chance it was courtesy of a broker. All perfectly legal, of course.

I have a bias toward stocks over funds for a few reasons, including the recent issues that have come to light: (late trading, soft dollaring, etc). But also for tax reasons- when a fund incurs a capital loss, I can't deduct it against my taxes. When I sell a stock and take a cap loss, I can. Fund cap gains, on the other hand, are passed through to shareholders, and I can't control them. Also, with stock trades costing $5-$7 these days, the low-cost diversification advantage of funds is diminished.

But don't get me wrong, if you don't have the inclination to pick stocks, Vanguard is a perfectly fine way to invest, especially in a retirement account. It's only when you move to high fee funds with a large amount of trading activity which don't track an index that abuses (naturally) occur.

Nick





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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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This is not necessarily how it works.

While my explanation was simplified, in the end this is exactly how it works. Portfolio managers have a tendency to overpay for commissions to get comps. There is clearly a moral hazard here.

More often than not, Vanguard will do much more business with Goldman Sachs above and beyond the $288,000.

It may or may not (you have no idea), but regardless I want my fund manager to pay the lowest transaction costs on each trade, not be tied down to fulfilling soft dollaring obligations.

Vanguard "owes" Goldman Sachs

Precisely.

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

I'm not sure "horrible" is the right word, but "sneaky", "unethical", and certainly "undesirable" come to mind.

Imagine you've hired a contractor to build your dream house on a Time & Materials basis. There are two lumber yards in town. Yard A charges $2 per board foot and offers no soft dollaring. Yard B charges $4 per board foot and has signed a soft dollar arrangement with your contractor, who must buy $10,000 of lumber from the yard in return for a new toolbox and a subscription to Contractor's Digest. Now, as you say, maybe our contractor was going to do $10,000 worth of business with Yard B anyway, and all this isn't going to cost you a penny. But I have a feeling your house is going to end up costing more than it should have.

Then there's the issue of abuse of the soft dollared goodies themselves. To reprint the quote above:

"...1998 report found one fund manager who spent soft dollars to buy a computer that was operated exclusively by his family, which used it to play video games. Other advisers, the SEC said, used soft dollars to pay telephone bills, rental-car costs, to install anti-static carpeting and to buy theater tickets."

Nick
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Then there's the issue of abuse of the soft dollared goodies themselves.

I agree with you whole heartedly on this one and this is what the SEC needs to stop.

I'm not sure "horrible" is the right word, but "sneaky", "unethical", and certainly "undesirable" come to mind.

That may be the way you see it, but I wouldn't use any of those terms as long as the fund does not abuse the soft dollar goodies.

Let's continue with your contractor analogy.
Yard A charges $2 per board foot and offers no soft dollaring. Yard B charges $4 per board foot and has signed a soft dollar arrangement with your contractor, who must buy $10,000 of lumber from the yard in return for a new toolbox and a subscription to Contractor's Digest.
I think $2 and $4 is way overblown, but if you used $2.00 and maybe $2.05, I'd say this a better analogy to the financial world.

Now, as you say, maybe your contractor was going to do $10,000 worth of business with Yard B anyway, and all this isn't going to cost you a penny. But I have a feeling your house is going to end up costing more than it should have.
Say you used a contractor that bought its lumber from Yard 'A', but had to buy his own toolbox and subscription to Contractor's digest. How much does this cost? Does the new toolbox and subscription equal an extra 5 cents per board foot? What if Contractor's digest had an article on how to save money on insulation but your contractor didn't know about it b/c he couldn't afford the subscription? What if Yard 'A' is a small shop and may not be able to handle the amount of wood the contractor would need?


Soft Dollar agreements can be a bad thing, but when used "ethically", they can be a bonus to all parties involved.
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It's sneaky stuff, on par with mutual funds silently sucking their expense ratios from your account without itemizing the charge. Can you name any expenses you paid last year besides fund fees that weren't itemized on a bill somewhere?

Both my phone bill and my electric bill have a variety of taxes and surcharges, based on utility regulations, that I do not even begin to understand. Furthermore, my phone service has a lot of options, but the bill does not break them out every month.

The particulars are not exactly like the soft dollar thing, but the effect is the same: at any given moment, I can't possibly give you a clear idea about where every penny goes that I pay for my utility bills. Do I have time or energy to write to the PUC and pester them? Nope.

So as for soft dollars as an issue for concern -- right now, it's low on my list. I can see the potential for abuse, but I can also see that the SEC has been looking at the topic for years without ever clamping down. So I need somebody to come out with a much more authoritative and convincing explanation, and documentation of specific instances and dollar amounts, before I ratchet up my worry level over it.

It's not that I don't care about money. It's a matter of where I spend my time. Right now I am more nervous about the market taking a profit-taking plunge (and me losing big money that way) than I am about the possibility of losing a few bucks on undisclosed expenses here or there.

One more thing I meant to mention before. There *continues* to be malfeasance within the governance of many major corporations, and there are still potential abuses of STOCK trading, whereby investors are getting bilked every day. So I do not believe an investor necessarily gains any safety or protection by leaving mutual funds and trying to manage a pure stock portfolio.

Basically, I think EVERY investment has undisclosed risks or hidden expenses. Buy a house, and even a home inspection may not find stuff that ends up costing you a year later. So, like I said -- the soft dollar issue has obviously been raised before, and perhaps we will get more attention this time, or maybe not. But it won't change what I do with my money in the meantime.
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I'm not sure "horrible" is the right word, but "sneaky", "unethical", and certainly "undesirable" come to mind.


I completely agree with knows09 on this one. Soft dollar arrangements can be abused, but they can also be a good thing for all parties involved.

Here are a couple of examples of soft dollar arrangements in most people's every-day lives. I don't think anyone is terribly upset with these:

1. You buy a new car from Toyota. The car dealer quotes you a price of $25,000 and says there is a coupon book worth $1000 of maintenance coupons that you can use at their Service Dept thrown in for free. That coupon book is a soft dollar arrangement. Would the dealer knock off $1000 and remove the coupon book from the deal? Probably not. But buying the same car down the street at the same price doesn't get you the coupons.

2. You want to order a new video game. On Best Buy's website, it sells for $50. On GameStop's website, it sells for $52, but as a bonus you get the hint guide for free. Where do you purchase the game? Many people might find the hint book worth the $2 (they retail for $15); many others don't need or want the hintbook.

Soft dollar arrangements are not "horrible". They aren't "sneaky," "unethical," or "undesirable" either.

crad-
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