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Soft Dollar Arrangements

Instructor: Lori Forrest

Lori has taught college Finance, Operations and Business courses for over five years. She has a master's degree in both Accounting and Project Management.

Payments for brokerage services provided to clients are tightly controlled and monitored by many different agencies. These dollars, soft dollars, are retained on a trade to be used for research services that provide a primary benefit to the client.

Soft Dollar Arrangements

During a trip to the grocery store in most states, the cost of your items is totaled for you, and tax is added to the bill. Most of us simply pay the total and do not think twice about the taxes paid. Some individuals understand the tax structures and perhaps even how the tax dollars are allocated and spent. For states with sales tax, individuals do not have a choice as to whether they pay sales tax or not.

Now think about an investor who is trying to understand the cost of an investment as well as the expected return they will earn. Investors play a big part in their own financial plan, however, there is nothing wrong with looking to an expert for help with such an important decision.

Being rich is a common investment goal, but what that really means in dollars and cents differs from one investor to the other.
Suitcase full of money

Many individuals have a fairy tale vision of becoming rich by investing. While the associated goods and services paid for are seemingly straight-forward (like our groceries), payments for commissions and fees (similar to the taxes on our grocery bill) are not always fully understood by investors. Investors can manage their own financial planning or hire a brokerage firm to provide services. Brokerage firms understand how the market structure works, the fees and cost of different services and what factors will have an impact on overall financial planning. A broker's expertise, access to research, and market data makes them a valuable resource to their clients.

Soft Dollars

Soft dollars, also known as brokerage, include any dollars retained on a trade to be used for services for the client's benefit. When brokerage firms pay for research services through commission revenue rather than a direct payment, this arrangement is termed soft dollar payments. In contrast, payments made by advisers for products or services with their own money, not commissions, are called hard dollars. The Security and Exchange Commission (SEC) reports show that more than 40 percent of commissions are used to obtain research and other services that will benefit the investment adviser, and around 90 percent of advisers engage in soft dollar arrangements. The costs of research or bundled services is not always fully disclosed by the fund but rather included in the cost of each trade, having an impact on the long-term performance of an individual's financial plan.

Why are Soft Dollars Important?

Some investors would argue that the end result is the same; whether using soft dollars or hard dollars, the investor still bears the cost. The structure of soft dollars and the difficulty associating a direct cost with these payments highlights the challenge of managing such hidden costs. Unlike taxes, which are imposed on individuals at a set rate, soft dollars must be allocated based on the product used or the percent of a service specific to a client's benefit. While the use of soft dollars provides a positive impact on investor flows, the bottom line impact is lower fund performance.

That is all the more reason that soft dollars are outlined in Section 28(e) of the Securities Exchange Commission Act of 1934. This section provides clarification around the use of account transaction commission dollars to pay for research services. The use of these dollars can have a major impact on an investor's ability to analyze trading cost. Soft dollars can be hidden in these costs, and while the use of soft dollars is not illegal, the use of soft dollars has many rules that govern their use. Many different organizations help maintain standards around the use of soft dollars and the associated risks.

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