The reason a mutual fund exists is so small investors can pool their money, hire professional management, and attain diversity that would be nearly impossible for the small investor by himself or herself. It would stand to reason then that funds with hundreds of millions, or even billions, would have economies of scale to demand from the street the most competitive rates for trading their shares. Yet, as you will see, not only are fund firms NOT getting the most competitive rates, they are paying well more than any individual can get through their discount broker.

What are Soft Dollar Expenses?

Hard dollars are expenses that come out of a fund manager's management fee. These expenses include salaries for the fund managers, analysts, and customer service people (yep, you get dinged when you call that 800 line), the costs of printing all those statements and other required literature, and all other office expenses associated with running a fund. Oddly, very real expenses such as spreads and trading commissions are not included in the hard dollar tally, and show up only as a slightly decreased, barely perceptible decrease in annual performance. High friction in these areas can amount to substantial costs over the course of a year when you consider that a multi-billion dollar mutual fund trades billions and billions of shares.

Recognizing that decreasing a dollar of hard expenses for a fund manager increases profit to their bottom line by a dollar, sell side firms make arrangents with the fund managers to provide everyday items in exchange for order flow at above-market costs. For example, a sell side brokerage firm provides investment research (the value of which is itself in doubt), Bloomberg terminals, office space, even a junior analyst or two, in exchange for the fund's order flow at, say, 5 cents a share versus the normal 2 cents a share. The sell-side brokers get fat commissions, the fund manager gets "stuff" that would otherwise be paid out of his management fee. Everybody is happy...except for the shareholders who are footing the bill, and for the most part, have no idea, that this is going on unless they read deep into the prospectus' fine print.

Why You Should Care

The Wall Street Journal investigated this practice and determined that, in 2002, $12 billion dollars were spent in soft dollar arrangements, where $6.7 billion of this was an unnecessary mark-up from the sell side. Further, WSJ spotlighted several firms that were paying 5 cents per share traded. That's $50 per 1,000 shares. Now, consider that any individual can open an account with a discount broker and pay less than $10 for a comparable execution. The wholesale rate for clearing these trades is probably $1 for diligently-shopped execution services performed on an agency basis for a multi-billion dollar fund.

The Investment Company Institute (the apologist association of Mutual Fund Management Firms) brushes off this practice by stating that all of the items received have value that the shareholders would have to pay anyway. Maybe. But, these expenses should be coming out of the management fee. This practice masks hidden expenses that can be used by individuals and their advisers when comparing one fund versus another. The only reason to mask the true expenses is to hide the fact that the managers are siphoning off more money from investors than their fiduciary duty allows. In less savory professions, this arrangement is called a kickback.