The issue of soft dollars has haunted regulators for over five decades. The regulators would like to do away with soft dollars, but the best they’ve been able to do is create regulations or standards for their proper use by regulated entities – asset managers and brokers. Plan sponsors are not regulated in this area but are guided by their duty to act only in the best interests of plan members. The use of soft dollars and their close cousin, directed commissions, by the investment community is so engrained in the system that eliminating them would significantly affect the workings and basic functioning of investment managers by reducing the scope of research and other services available for their investment decision-making process. It would also affect brokerage firms by cutting a significant income source: an estimated 30% to 40% of all equity trade commissions goes to finance soft-dollar research/services.
Third-party vendors would no longer receive payment through soft dollars to provide a specific and, perhaps, unique product or service to assist investment managers in their decision-making process. And it would reduce plan sponsors’ ability to lower overall pension-related costs or receive additional income through a commission recapture program. Eliminating soft dollars would also prevent consultants from administering directed commission arrangements with their clients.
In the 1990s, Benefits Canada published an article titled “Love ‘Em or Hate ‘Em, Soft Dollar Transactions Are Toast”. Around the same time, Glorianne Stromberg prepared a study (Regulatory Strategies for the Mid-‘90s – Recommendations for Regulating Investment Funds in Canada) that recommended “that soft-dollar arrangements not be allowed”. Despite both of these, according to Greenwich Associates, the soft-dollar component of commissions generated is higher today than it was 20 years ago in both Canada and the U.S.
In this article, I explain who the players are in the commissions landscape and how the issue of soft dollars affects them. As regulators seek to eliminate the practice, it is important to understand what the impact of this would be on all levels of investors – and to understand what questions to ask, especially for plan sponsors.
Soft dollar commissions: Who is paying for what?
Player 1 – Plan sponsors/investors
Portfolio security transactions generate commissions – it is a cost of doing business. However, as with any other expenditure from a fiduciary fund, these commission expenditures must be used by the plan sponsor (or fund trustees as the case may be) and the investment manager acting as an agent for the sponsor, for the exclusive benefit of the fund beneficiaries. This is a fiduciary duty. The plan sponsor must, therefore, direct commissions and has four options for doing so:
1) Delegating full authority to the investment manager(s) regarding the direction of transactions and resulting commissions – the most common arrangement;
2) Setting guidelines restricting payment by the manager to third-party service providers, or placing a maximum commission allocation (either as a dollar amount or as a percentage of the total over a specified time period) to all third-party research;
3) Direct payments from commission dollars to pay for appropriate research or service requirements of the plan sponsor that benefit the beneficiaries (not the sponsor); and/or,
4) Setting up a commission recapture program that will provide an income stream to the pension fund.
With commissions being used by the investment manager(s) to either enhance returns (access to research), reduce overall transaction costs (through “best execution”) or reduce expenses paid for by the plan itself, the end investor should have a negotiated commission arrangement in place with each money manager.
If a plan sponsor decides to direct commissions for its own use, there are issues to be considered. Plan administrators can satisfy specific financial obligations (e.g., performance measurement services, custodial services, actuarial and pension consulting, equity research, etc.) by directing a manager to allocate sufficient trades to a specified brokerage firm which would then use part of the related commissions to pay for the required services. Again, any selected services must be for the sole benefit of the plan beneficiaries. As such, a plan sponsor should have a well thought out and formally adopted policy on trades/commissions allocation that defines services to be paid for (and others that are to be excluded) and the beneficiary-driven rationale for doing so for each.
Some plan sponsors have also set up their own commission arrangements with brokerage firms in what is referred to as a “commission-recapture program”. With this arrangement, a percentage of the commissions generated comes back to the plan’s account as “income”. However, any such program implies that there is some “slack” in the system and that the manager is not getting full value for the commissions generated (in which case the manager should be faulted), or cannot themselves fully benefit from the services available (as could be the case where most or all of the manager’s research is internally generated).
Note that directed commissions cannot be commingled with commissions of other clients. As a result, if an investment manager has a block trade at a discount price, the directed commission trade might not get the same attractive fill. Estimates put the cost of transactions as being around 80% price-related.
A manager who is strongly encouraged to deal with a specific broker to fulfill an obligation to the plan sponsor might not get best execution on that specific trade, or might have to trade more frequently than needed in order to satisfy the plan sponsor’s financial expectations. On the other hand, an “acceptable” use of a directed brokerage arrangement is one where a new manager has been selected and monies come over in cash, or in-kind, where the newly-appointed manager is likely to sell a certain portion of the portfolio to bring it in line with the portfolios of its other clients. These are newly found funds for the investment manager and, therefore, not required to pay previous commitments by the manager.
If the plan sponsor permits soft-dollar transactions or directs commissions, the sponsor should require the following information, at least annually, from the investment manager:
- A description of all soft-dollar services paid for; an explanation of how each service relates to the manager’s decision-making process.
- A note of what percentage of total commissions paid from the client’s trades or participation in blocks is attributed to research services, as opposed to execution, or the broker’s use of its own capital.
- The average commission rate paid for soft-dollar trades versus the average commission rate paid for non-soft-dollar trades
- If applicable, the “conversion ratio” that was negotiated by the consultant or investment manager to convert soft dollars to hard dollars.
Player 2: The investment manager
The investment manager has the fiduciary responsibility to seek best execution in all portfolio transactions, with the proviso that best execution is not necessarily defined as the lowest commission cost. Commissions generated must be in the best interest of the beneficiary of the assets.
The various regulatory authorities permit commissions to be allocated for two activities: trade execution and research. However, the vast majority of full-service brokerage firms still provide a bundled service. As a result, investment managers, generally, cannot be fully aware of the exact cost of the specific research reports and analysis they get. Therefore, they are not able to determine whether or not the overall cost is acceptable. Regulatory authorities have been trying for the past 30 years to get brokerage firms to unbundle – but, have not yet been successful. Reports estimate that the trade execution portion of commissions generated is less than 50%.
Investment management firms use soft dollars for three reasons:
- To reduce overall corporate costs
- To obtain research/services not readily available through traditional brokerage firms
- To appease clients who have set up directed commission programs.
Of these, only the second is unequivocally an appropriate use.
In addition to access to a broker’s proprietary research, investment managers allocate soft dollars for a variety of services that enhance the manager’s decision making process (e.g., performance measurement services, portfolio modeling and technical analysis software, political/economic / social/industry analysis, computers/terminals, fundamental databases, third-party research, stock quote systems, pricing services, custodial services, etc.).
Within an investment management firm, soft dollar transaction allocations are, generally, determined by portfolio managers, analysts, and traders. The allocations should be based on the ability of the brokerage firm to perform high-quality trade execution, the quality and value of the proprietary research provided, and the overall relationship – basically, trust in the people and firm to deliver valuable services.
Player 3: The broker/dealer
The majority of brokerage firms offer a full-service platform to investment managers that includes three main activities:
1) the efficient execution of trades;
2) proprietary research; and
3) other services (e.g., facilitating meetings and calls with corporate management).
Some full-service brokers will also permit the allocation of commissions to pay for third-party research and services for the money manager or plan sponsor.
A few brokerage firms provide an execution-only service – although, even here, a portion of the commission dollars might go towards third-party vendors for services outlined above under Investment Manager.
Pressures on broker profitability have become onerous in recent years, so the competition for commission dollars is significant. Commissions paid on a cents-per-share basis have been declining over the past decade, requiring brokerage firms to find other ways to increase volume in order to keep their bottom line healthy. At the same time, the percentage of block trades now represents approximately 50% of all trades on the Toronto Stock Exchange – trades that result in lower commissions on both sides.
Further, investment managers are also generating more and more of their research in-house and relying less heavily on street research. As a result, managers have been moving towards seeking execution-only transactions.
Player 3: The third-party vendor
In Canada, prior to April 1983, equity trading commissions were fixed – with no ability to negotiate. To be competitive, brokerage firms began to offer research and other services (e.g., trips/conferences, computer hardware or software, paying rents, etc. – mostly for the benefit of the investment manager). New regulations of the securities regulators in the early 1980s required all commission dollars to be used for the sole benefit of the beneficiary of the asset. This opened the door for third-party research offering a specific/niche products or services.
Player 5: The consultant
A few consulting firms have developed a service that captures some of the commission dollars generated to pay for pre-determined third-party services required by the plan sponsor. It also creates an additional income stream through a commission rebate program that places a portion of the commission dollars back into the account of the plan sponsor. In addition, the service may pay for the fees of the consultant.
The consultant, through their clout, may create a transactions allocation program directly with one or more brokerage firms. The investment manager is then told of the arrangement and asked to allocate a pre-determined portion of trading (either a specific commission dollars amount or a percentage of total commissions generated) to this recapture program – usually, on a best efforts basis. Whatever the source of the commissions available for recapture, the sponsor and investment manager(s) should consider this process, evaluate it against other means for achieving lower net commissions costs, the potential for unsatisfactory execution or the loss of relevant research to the investment managers, and decide whether to enter the arrangement.
My view
Over many years in the industry, I have had experience with soft dollars from within a captive plan sponsor, within a consulting firm that provided a third-party/commission recapture program, and within a couple of investment management firms that use soft dollars to pay for research/services.
Working as a plan sponsor, I entered a commission recapture program in the early 1980s perceiving that the pension fund would receive the exact same research/execution/service from the brokerage community at a 20% discount from the posted rates. We took advantage of this to create an income stream to the fund that it could not equivalently achieve by just reducing its own commission costs. With a much tighter system today, I do not believe this opportunity exists to the same degree.
In my next reincarnation as a consultant, I increasingly came to believe that recapture arrangements are detrimental to best execution for three reasons. First, managers might be inclined to pay a slightly higher commission rate to pay for soft dollar obligations just to satisfy the consultant and make the plan sponsor happy. Second, not all brokerage firms permit these programs and, therefore, investment managers might miss out on research/services And third, if the broker knows that a trade will result in commissions leaving the desk, the investment manager may not get first call on the block.
As an investment manager, I tried being a purist and attempted to eliminate all soft-dollar arrangements with third-party vendors. The ultimate test for me was that if we needed the product or service to benefit the client, then we should be willing to pay for it out of our general operating expenses. I always felt that the client was paying twice for money management expertise: first, in management fees and, second, with their commissions covering some research, data, or software costs – and paying for these directly introduced greater discipline to our spending. However, as much as I tried to get to a zero allocation to third-party research, I found that there were some services that we just could not purchase with hard dollars. If we wanted those services, we would have to enter a soft-dollar arrangement.
Conclusion
Despite popular belief, and efforts to change, the use of soft dollars has actually been on the rise over the past couple of decades. In the U.S., Greenwich Associates has estimated that soft-dollar transactions now account for about 40% of total commissions generated and, for Canada, it is estimated to be close to one-third. The largest users in the U.S. are public funds.
Soft dollars and directed commissions by themselves are not evil. There are some benefits: they can enhance competition for non-traditional research and services by letting independent research providers compete; they give managers more choices; and they can help smaller firms by lowering the barriers to entry. However, the concerns raised against soft dollars are also clear. These arrangements may raise overall transaction costs. They may also result in inefficient trading where fulfilling a commitment might trump best execution. And there could be a misallocation of resources by managers purchasing marginal research/services.
As well, soft dollar usage by investment managers results in a hidden cost of active management, hindering the efforts of the plan sponsor to evaluate the true cost of obtaining portfolio management services. Finally, for investors who prohibit the use of soft dollars, are they getting a free ride from the research/services paid for by the soft dollars of other investors?
This raises key questions for plan sponsors. Should you permit your manager to use soft dollars? If so, what are the guidelines? Should you utilize directed commissions to pay for research or services that you believe are for the sole benefit of the plan beneficiaries? if so, what are these services? Or should you set up a commission recapture program to create an additional income stream to the fund?
For the investment manager, the question is how far to go in paying directly in hard dollars for external research. The criteria must be to maximize the dollar value received by the client for the total absolute dollars paid. Soft-dollar arrangements, essentially, give managers a rebate on the commissions they generate.
There are only two uses for commissions: to pay for execution and to pay for research. Execution is easily defined: the cost to trade a security. As a best guess, the cost to execute a typical large-cap equity trade in institutional volume would be between 1 and 1½ cents per share. If the total commission cost was 4 cents, the percentage allocated to research and dealer profits is, thus, between two-thirds and three-fourths of total commission costs. Research cost and value are much harder to define. The regulatory bodies have tried over the years but the onus remains on investment managers to justify all the research goods and services that are not directly paid for as necessary and valuable aids in their decision-making process and to allocate trades accordingly (subject always to meeting best execution standards).
The appropriate use of every commission dollar starts with a well thought out and clearly expressed trade and commission allocation policy by the plan sponsor. From there, the plan sponsor should maintain a full understanding of how the sponsor’s agents, primarily investment managers, do, in fact, manage the commissions under their control. Finally, an effective reporting and monitoring structure should be in place to ensure commissions continue to be used by the sponsor, investor and agents in the most cost-effective way for the fund and the benefit of all plan beneficiaries.
There is no free lunch.