In June, Fidelity Investments announced that it will no longer pay for market data with soft dollars - even if it means forking out $40 to $50 million a year in hard cash - as previously reported in the Wall Street Journal. But, according to the Journal, Fidelity, which declined to comment for this story, will continue to to pay for research with soft dollars. Separately, Massachusetts Financial Services (MFS), which settled charges in February 2004 with the New York State Attorney General's Office and the SEC stemming from last year's mutual-fund trading scandal, has said it, too, will cease purchasing market data with soft dollars.
Regulators have been examining the fees that mutual funds charge investors and the trading commissions they direct to brokers. This has intensified the scrutiny on soft-dollar arrangements, and any change in soft-dollar policy will impact the entire asset-management industry. The increased focus on mutual funds' expenses and disclosure of brokerage commissions to investors is causing the industry to re-evaluate the way it does business and how it uses technology to track third-party services purchased with soft dollars.
Since last year, the Securities and Exchange Commission (SEC) has been looking into whether mutual-fund companies should reveal more information about the brokerage commissions and other transaction costs they pay brokerage houses for services, including trading technologies and research, out of retail investors' assets. As a result, asset managers may be required to increase disclosure; brokerage firms may face ongoing pressure to unbundle their commissions and price their research separately from executions;, and independent research providers that market their services through third-party brokers may need to find new distribution mechanisms. Several major mutual-fund companies, including Fidelity and MFS, have taken a stance against soft dollars ahead of any regulatory action.
What's fueling the soft-dollars controversy - which are used by institutional investors to cover the cost of obtaining market data, research and other technology goods and services, such as hardware and software - is that they are hidden from investors. The commissions are deducted from investors' assets, but they are not part of a fund's expense ratio. While investors see the brokerage commissions on their trade confirmation, the amount in soft dollars that was used to pay for market data or independent research is hidden from investors.
Though money managers know what they pay for support technologies and independent research - because they are tracking expenses internally - these costs are not disclosed to investors. The soft-dollar debate is "a question of making something transparent, something that historically has been opaque but has certainly been documented and tracked over the years," says Lisa Shalett, CEO and chairman of Sanford C. Bernstein, a broker-dealer that provides independent research.
But, because full-service brokerage houses provide their proprietary research services through a commission that is bundled with trade execution, money managers often cannot break out the costs of each service. The cost of data products such as Bloomberg terminals or investment analytics such as FactSet, however, are documented. "The cost of market data and independent research products is known to the asset manager. What they don't have transparency into is what they're paying for the brokers' research," says Allan Rosenstein, a partner at Capco, a global provider of consulting and services to the financial-services industry.
Meanwhile, electronic trading "has set the stage" for unbundling, says David Quinlan, president of Boston-based Eze Castle Software. The sell side has unbundled its commissions for electronic executions, which cost 1 or 2 cents per share. "If the sell side is telling the buy side that they can do electronic trading for a penny, and the buy side is paying 4 or 5 cents a share for bundled commissions, they want to know where that other 4 cents is going," Quinlan says.
Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio