The mutual fund industry's bitterest arguments have spread to the institutional trading world.
Soft dollars and directed brokerage are in the bullseye of trading and
Congressional critics. On Wall Street, the practices are the cause of repeated rows.
"It is a disgrace how soft dollars are used," said one buyside executive, who didn't want to be quoted by name. "Better tracking of the relationships is needed, mostly because the client just doesn't have an idea what is going on."
With comments like these frequently heard, could it mean soft dollars are headed for the dustbin of history?
Is it the end for these institutional trading arrangements, which were validated by the Securities and Exchange Commission's famous
section 28(e) rule of 1975. Soft dollars are now a vital part of the debate over reforming the mutual fund industry. This is the target of much criticism for its fee practices and its poor performance in the recent three-year bear market. The same kinds of arguments are present on the institutional trading side, says one industry professional. He says soft dollar abuses are rampant.
The lawmakers have heard these complaints before. Now several bills are pending on Capitol Hill that would do everything from ending soft dollars and directed brokerage to studying them and reducing permitted uses.
Universal Trouble
Ted Aronson, a portfolio manager and partner at institutional investment advisor Aronson+Johnson+Oritz, said his firm does not use soft dollars. He notes that the average institutional commission is 4.5 cents a share. However, Aronson says there is still a "lot of five and six cents a share transactions." Abuse is common, Aronson maintains, because the average broker "would have a tough time maintaining a straight face if he were to say that the costs of an average institutional trade exceed a penny a share."
Still, there's another reason besides the flow of commissions why regulators have a renewed interest in soft dollars. The SEC's Office of Compliance Inspections and Examinations (OCIE), some years ago, discovered a few abuses in a sweep of soft-dollar firms. But the regulators, many trading executives note, only found a handful of firms violating soft-dollar rules. And one ECN official said that the industry has been responding to complaints of soft-dollar violations.
"The heightened scrutiny is already having a positive effect," said William O'Brien, general counsel of Brut ECN. "The buyside is looking much more closely at how they spend their commission dollars. Before they were less sensitive to getting the lowest commission rate possible and the diversification of their commissions through multiple brokers."
Nevertheless, OCIE recommendations called for better record keeping by investment advisers and brokerages that use soft dollars, recommendations that have yet to be implemented.
So soft-dollar and directed brokerage relationships – along with 12b-1 and other mutual fund load charges – are now at the top of the to-do list of several lawmakers and trade group officials, who either want radical reform or termination.
Rep. Richard Baker (R-La), the chairman of the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, is pushing a bill that would require stronger soft- dollar disclosure standards, a bill that has been criticized by some in the trading industry.
"How much disclosure do they want? We already do a lot. All the information anyone would want is all there in what we disclose already," said Lee Pickard, a former SEC official and now a private attorney working with soft-dollar brokers. Pickard says there is little abuse in the soft-dollar business, a business, he says, that is vital for some clients who need research capabilities.
Although heavily criticized by some soft-dollar advocates, Baker's bill, HR 2420, seems tame compared to some of the other proposals that have been suggested or put into the form of legislation. For example, a leading securities group wants much more dramatic institutional trading changes.
Soft dollars as well as similar practices should be severely restricted, the Investment Company Institute (ICI) says. The problem with the current 28(e) safe harbor is that it gives "rise to the appearance of a conflict of interest," said Paul Schott Stevens, an ICI counsel, who recently testified before Congress.
Given the renewed concerns of best execution, given the recent stock and fund scandals, soft dollars are now viewed in a new light. Indeed, the fund industry, once a perceived paragon of clean practices, is among those calling for much tougher soft-dollar rules.
Exclude Products
To remedy soft dollar fears, the ICI wants more products and services excluded from the protections of 28(e). They would include computer software and hardware as well as other electronic communications facilities used for trading; publications, including books, periodicals, newspapers and electronic publications that generally are available to the public; and third-party research services, services that are not produced and provided by the broker dealer executing the transaction.
This set of radical reforms, the ICI's Stevens told Congress, would help investors understand the costs of various investment advisory products. Narrowing 28(e) would also be more consistent with the original purpose of the soft-dollar rule, Stevens said. The rule, he said, was designed to be "a narrowly tailored provision that allows a money manager to take into account the intellectual resources, as well as the execution capabilities, of a brokerage firm in determining how to allocate its trades."
One trading executive says the rule has many holes. "Soft dollars and directed brokerage have been a horribly abused part of the business," contended Harold Bradley, chief information officer and a former trading manager at American Century Investments. His comments sound like a page out of the book of John Bogle, the mutual fund industry critic.
"It [soft dollars] has been a hidden tax and fee on investors and people continue to build their business models around it," Bradley said. Nevertheless, Bradley – who disagrees with Bogle on some points – wants extensive reform of soft dollars, but says prohibiting all soft dollar arrangements would be "going too far."
But soft dollars have many defenders on the buyside. The feeling of some trading professionals is that they result in a better quality of research for clients. However, most buysiders contacted by Traders Magazine wouldn't speak for the record, fearing their comments would reflect on their firm.
Said one buysider, "just try to find someone in our business who favors getting rid of soft dollars." Another buysider would speak on the record. Mary Kable, a trader with Cleveland-based Shaker Investments, believes ending soft dollars would be a mistake.
"We are getting good value for a client through our executions at Merrill Lynch and Bloomberg," she said. An unintended consequence of abolishing soft dollars, O'Brien adds, is that low-cost ECNs would boom. "Price would become key and that would mean firms like ours would do very well."
Indeed, potential winners would include online brokerages operated by Instinet and Knight Trading Group. That's because funds, without the soft-dollar option, would be pressured to look for lower commissions when research tools are unbundled. Knight, nevertheless, recently bought Donaldson & Co., which provides soft-dollar services to institutions.
Kable has no objection to stricter soft-dollar accounting and disclosure rules. But, she adds, that soft-dollar prohibition – designed to help the institutional investor – would be counterproductive. "Why penalize us and our clients for the sins of a few people?" Kable asked.
Still, several members of Congress are arguing that soft dollars and directed brokerage must be ended. They believe the practice is rotten. Soft dollars are a kind of snake that bites investors. Snakes must be killed, not studied, according to U.S. Senator Peter Fitzgerald (R-Illinois), chairman of the Senate Government Affairs Subcommittee on Financial Management. His comment is an obvious reference to the Baker bill and its call for an SEC study of soft dollars. Fitzgerald contends the practice has no redeeming features.
Inflating Commissions
"Under soft-dollar arrangements, brokers inflate their commissions on portfolio trades and give credits to fund managers in return," Fitzgerald wrote in a booklet accompanying his bill, which is also known as the Mutual Fund Reform Act of 2004 (MFRA).
MFRA also calls for the elimination of revenue sharing and 12b-1 fees among other things. Fitzgerald said that all these practices are "riddled with conflicts of interest, serve no reasonable business purpose and drive up costs." [See Washington Watch.]
But officials in the trading industry disagree over the extent of soft dollar abuse.
"There is nothing fundamentally wrong about soft dollars, but there is also nothing fundamentally right about soft dollars," Aronson said. "That's because they muddy the water, leave room for abuse, and are very hard to audit."
Marc Lackritz, president of the Securities Industry Association, said that generally, "soft dollars are both pro-investor and pro-competitive, because they increase competition among money managers, encourage independent research, and give investors more choices."
The practice, embedded for years in listed trading, has even become more popular on Nasdaq, since the widespread introduction of a commission-oriented trading market. Some 60 percent of U.S. institutions are using Nasdaq commissions to fulfill soft-dollars commitments, according to a Greenwich Associates' study last year. That compares to 22 percent in 2002 and 13 percent in 2001. Greenwich Associates also found that Nasdaq trades now compose 23 percent of all soft-dollar commissions on Wall Street.
Part of the dispute over soft dollars is because the interested parties often can't figure out exactly what they are. Are soft dollar agreements – and its often confused close cousin directed brokerage – necessary reciprocal arrangements that keep many funds and independent research operations afloat, providing a better quality of services for their clients than if they didn't exist? Or is this controversial trading custom an exercise in fuzzy accounting and a license to steal, as some critics charge?
"Clearly, a huge amount of money has been sucked out of investors pockets through funds using investor funds to take care of their business purposes but do not care about investors in terms of this research," Bradley said. "Commissions are too high and are not meeting the test of research."
Bradley described how one firm recently tried to bill investors for a $12 million computer system it used to manage its information flows. "They called that research because investors will benefit from it. So they take a $12 million expense off the line because they have fees from soft dollars to help them pay their bills," Bradley said. "It's not right."
He got more hot under the collar again when he said the firm tried to persuade American Century to buy the system, assuring it that "American could soft it." American Century, he added, rejects that kind of practice.
Soft-dollar advocates concede that better disclosure practices are needed. But they warn that the draconian steps called for by critics would hurt the trading and research industries. While Bradley favors a large cutback in soft dollars, he doesn't support the Fitzgerald approach.
"I don't think the senators understand how ending soft dollars could hurt capital formation," Bradley said. So soft dollars, Bradley concedes, if they are properly regulated and reformed, have a role in the marketplace, provided buyside traders abide by best execution standards. But will the trading industry reach this point?
"They [soft dollars] are very important to our clients. They help institutional clients pay their bills," said a spokesman for Instinet.
Soft dollars, like taxes, is a subject that always generates discord and sometimes raised voices. "If they were eliminated, investment management firms would only have two choices. They would have to get rid of the technology or find hard dollars to pay for it," maintains Robert Hegarty, vice president, securities and investments for the TowerGroup. "And we know that they have already cut to the bone on technology budgets and the hard dollars just aren't there."
The Survivor
One vendor said he doesn't fear the end of soft dollars. Firms would find hard dollars to pay for "mission critical applications," according to Eric Soderberg, a vice president with Macgregor. "We clearly see ourselves among those who offer mission critical systems." He is against radical solutions. "The good use of soft dollars – to pay for order management systems – gives the buyside a good option payment. I can see no reason to get rid of it."
TowerGroup estimates that the investment management industry spends about $6.6 billion a year on technology. About two billion dollars of that is spent on market data. And about $600 million of that is paid for with soft dollars, Hegarty said. He estimates that total soft-dollars credits come to about $1 billion a year for independent research firms, which doesn't include proprietary research. A Greenwich Associates report estimates that 90 percent of investment advisers use soft dollar arrangements.
Still, this debate begs a simple question – can someone exactly define soft dollars? And, since the proper use of soft dollars is a direct result of obtaining best execution, another subject of great debate, maybe, some traders say, defining best execution is also a futile exercise. Nevertheless, the SEC has certainly tried with best execution regulations going back to the 1970s.
Paul Roye, SEC Director of the Division of Investment Management, in a memorandum last year to incoming SEC Chairman William Donaldson, wrote that best execution is the ability to "execute securities transactions in such a manner that the client's total cost or proceeds in each transaction is the most favorable under the circumstances."
Last year, in a hearing before Baker's House subcommittee, SEC officials said proposals calling for better soft-dollar disclosure were not adopted "because of intractable problems in valuing the research and services that advisers receive for soft dollars." Regulators conceded that it can be quite a task to quantify the "effect of the benefits on the accounts' performance."
Still, making the issue even dicier, soft dollars are only a part of best execution. Commission costs, Aronson maintains, are "the tip of the iceberg." He said that his firm believes that commissions comprise maybe 10 percent of the total execution costs, which includes spreads, opportunity and implementation costs. Nevertheless, rising volumes have made that iceberg bigger. Given the billion plus share trading of recent days, even that ten percent is a large amount, Aronson adds.
Aronson dislikes soft-dollar arrangements and would love to see them terminated. Still, he concedes that soft dollars couldn't be ended without causing huge problems for many firms that are dependent on the practice. Therefore, Aronson is calling for extensive reform of soft dollars.
But what would happen if these involved relationships were to be abolished by the lawmakers? Who would be the winners and losers in any massive cutbacks of soft dollars? First, it is the big brokerage firms that earn "90 percent of the soft-dollar commissions. That is why the SIA is taking such a strong stand against abolishing soft dollars," according to John Meserve, president of Bank of New York's commission research payment services group. "There's not a full-service firm out there that doesn't provide soft dollars," added Meserve. "Hundreds, maybe thousands of analysts would be laid off," predicted Pickard, if soft dollars were abolished.
More Disclosure
"We believe the current system works well," Meserve said, "although we support enhanced disclosure of quantitative information regarding investment advisers' use of client commissions and advisers' brokerage allocation practices."
Buyside firms, independent research firms and hedge funds would also likely take big hits if soft dollars went away, say industry observers. Unlike a traditional fund, which only bets on the market rising, hedge funds, since they can profit going down as well as up, tend to execute much more than a traditional equity fund. Therefore, they tend to earn soft dollars at a much faster pace than the garden variety mutual fund. Buyside firms would be scrambling to find hard dollars for research, Meserve said.
Still, critics maintain that these are extra charges that are being palmed off on the unknowing institutional client. These charges are often disguised, according to Aronson. He proposes a much higher level of disclosure, arguing that today there is just too much disclosure that is written in obscure language.
"The information is now there," Aronson said. "But it is so well hidden, it is so well obfuscated, so inundated with marketing; that the typical investor can't figure whether they're coming or going."
Blind Package
Aronson gives an example of soft-dollars arrangements that are subtle. He points to blind package trading, which has been around for over two decades. A firm submits tons of volume to brokerages at guaranteed prices and asks them to bid on the entire package, which could, say, generate business valued at half-a-billion dollars. The adviser gets a dirt cheap price – say two cents a share – plus a few cents more on top of that for the capital guarantee with no soft dollars allowed.
"Someone might say to their traders that we really have to pay off those analysts at the big wirehouse we do business with and who helped us with this package. And it may not just be a few cents a share they get, it can be a lot more than that," Aronson claimed. By helping the wirehouse, the market impact costs can ultimately be 20 cents a share. "The costs can be gargantuan," he said. "It's insidious. Nobody sees it."
Nevertheless, several trading executives say that doesn't justify killing soft dollars or even going as far as the ICI's suggested reforms. "That's throwing out the baby with the bathwater," said Wayne Wagner, the chairman of the Plexus Group, a transaction cost analysis firm. "A lot of legitimate, competitive research services, under what the ICI is recommending, would not be available."
Nevertheless, Wagner concedes the need for better disclosure of soft-dollar arrangements and some narrowing of 28(e). Wagner said that "stuff you can buy on a newsstand" shouldn't be covered. However, any new regs should do nothing to hurt the growth of independent research firms that use soft dollars, he says.
Indeed, one trading executive, who emphasized that he is on neither side in the soft dollar controversies, added that it is critical that the independent research firms not be hurt. "I am not passing judgment as to whether soft dollar payments should be banned," wrote Joe Gawronski, COO for agency broker Rosenblatt Securities, in a letter to Traders Magazine. "However, I am certain that adopting a rule that favors the large Wall Street broker dealers over the independents is not only unfair and illogical, but risks further damaging the credibility of our industry." If the independents are allowed to compete, he added, "on a level playing field," this would likely improve the integrity of the markets.
Wagner says that soft-dollar abuses should be penalized but the regulators already have most of the powers necessary to prevent the abuses. Wagner said he might go one step further – require that each fund firm adopt the recent Association for Investment Management & Research best execution standards. That would require each firm to have a trade management oversight committee.
Aronson, a client of Wagner's Plexus Group, says it is up to the institutional client to monitor the money manager. "I would want to know not only what they did with soft dollars but what they got and what they did with them," Aronson said. "An honorable and reasonable firm can now justify and measure how they use soft dollars." The march of technology, he asserts, means that brokers and managers have no more excuses for not producing exactitude in how and why soft dollars have been spent.
Best Execution
Ultimately for SIA's Lackritz and many trading pros, the issue may simply be one of obtaining best execution. "If fund investors received mediocre executions because of soft dollars or directed brokerage arrangements, the relationships are indefensible. Poor executions in the absence of soft dollar or directed brokerage arrangements are also indefensible," Lackritz said.