Mutual Fund Soft Dollars: Hard on Investors
Mutual funds may do investment research in-house or outsource it to third parties and pay for it directly, with the cost being included in the expense ratio prominently disclosed to investors. Alternatively, the funds may use “soft dollars” – brokerage commissions in excess of base rates paid in exchange for research supplied by brokers. While it lowers investment returns, it is no longer included in the expense ratio. The funds must disclose the use but not the amount of soft dollars. While many funds disclose such amounts, they do it in the fairly obscure Statement of Additional Information and not in a retail investor-friendly language. Soft dollars are controversial, with proponents arguing that funds may reward brokers supplying superior research with more orders, and opponents arguing that soft dollars are used to hide costs and waste investors’ money.
Employing hand-collected data for a random sample of about 400 U.S. actively managed equity mutual funds, we find that, on average, funds paying higher soft dollar commissions perform poorly and assess higher management fees. Thus, mutual fund shareholders do not benefit the use of soft dollars. Larger and longer-serving boards of fund directors are associated with lower soft dollar commissions, while boards with higher proportions of directors with finance background – with higher soft dollars.
Investors should not consider the expense ratio an all-encompassing cost of mutual fund investing. Brokerage commissions are also passed onto shareholders. One should consult a Statement of Additional Information (SAI) to evaluate the fund’s brokerage costs. On the regulatory side, the Securities and Exchange Commission (SEC), which has been reluctant to outlaw soft dollars, may at least consider requiring investment companies to prominently disclose the cost of brokerage commissions in addition to the expense ratio and sales loads.
Yaman Ö. Erzurumlu and Vladimir Kotomin, 2015, Mutual Funds’ Soft Dollar Arrangements: Determinants, Impact on Shareholder Wealth, and Relation to Governance , Journal of Financial Services Research, forthcoming, doi 10.1007/s10693-015-0222-1.