2. Abstract
Asset managers and broker-dealers are paying close attention to the current industry
debate on how investment research and related advisory services should be acquired and
paid for. At this point, regulators, industry associations, and some of the leading industry
players are all publicly discussing the issue and offering competing ideas about the
possibility and content of changes to the research consumption model. Asset managers
and mutual fund companies in particular, need to consider the impact of potential changes
to soft dollar/bundled commission regulation on their relationships with sell-side broker-
dealer firms, as well as the impact on their own management and disclosure processes.
Current Soft Dollar/Bundled Commission Arrangements
In the existing model, governed by Section 28(e) of the Securities and Exchange Act (see
sidebar), buy-side firms typically pay for research indirectly. To acquire broker-dealer
research and related services, many asset managers
negotiate a ‘bundled’ commission rate on trades. The
bundled commission includes access to a broker’s
research and research analysts, as well as access to the
broker’s trade execution services. In many cases,
broker-dealers also offer access to products and
services from third-parties, such as research reports,
market data information and other related products,
paid for through the bundled commission. Access to
these third-party products and services are managed by
accounting for ‘soft dollar’ credits.
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Bundled trade commissions provide benefits to both
sides of the buy/sell-side equation. Asset managers
benefit by having some of their advisory and data costs
paid for through trade commission flow as opposed to
charging those expenses against their management fees,
increasing their profit. Broker-dealer firms benefit
from the bundled commission structure as well. By
packaging their research offerings and linking these
offerings to trade commission flow, broker-dealers
avoid the need to separately price and sell individual
research products and services.
One source estimates that the portion of ‘per share’
trade cost allocated to proprietary and third-party
research and related services can be as high as 55% of
the total commission, depending on the individual asset
manager’s relationship with the broker-dealer.1
Other sources estimate that of the 5 cents
per share standard commission, 2 cents are actually used for execution purposes, while 3
cents go toward paying for proprietary research and soft dollar expenses.2
Investment Advisers and Research
• Prior to 1975, investment reports
were authored primarily by
independent boutiques. They would
be sent to clients, and if the clients
were satisfied, they would direct a
percentage of a trade commission to
them via the executing broker.
• This arrangement worked well until
fixed commissions were abolished
by the SEC in 1975. Standard
commission rates dropped and the
boutiques were priced out of the
business. Many were bought by
large broker dealers who realized
the research product was a good
offering for attracting clients.
• Shortly after abolishing fixed
commissions, the SEC also enacted
section 28(e) of the Securities and
Exchange act of 1934. This allowed
investment advisers to use broker
dealers charging more than the
lowest commission on offer,
provided that the commission was
“reasonable in relation to the value
of brokerage and research services
provided.”
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Regulatory Concerns with Soft Dollar/Bundled Trade Arrangements
Although the current model is legal and accepted in the industry, a number of concerns
have been voiced on its practice:
1. Market inefficiency – Under the current model there is no direct economic link
between the costs paid for investment research and the value that research provides
to the asset manager. In many cases, the negotiated commission provides access to
a far greater amount of research than the asset manager would ever hope, or want,
to use when making trading decisions. In fact, in surveys, buy-side institutional
investors routinely state that they see limited value in sifting through the reports
they get from the brokers. For example, in a Reuters survey of investment
managers, the value of research reports was rated as medium, and the value of the
rating or recommendation was ranked very low.3
Another survey, by Thomson
Financial, came up with similar results, finding that only approximately 30% of
managers agreed that external research played a “significant role” in their
investment decision making.4
This indicates that numerous proprietary research
reports are being created and distributed to customers who may or may not take an
interest in using them. One source states that there are now over a million equity
research reports produced annually.5
2. Limited disclosure to investors – Investors have little opportunity to view and
understand the investment research expenditures made by investment managers.
Many investors are unaware that these costs are deducted as operating expenses
from the fund, reducing the return investors get on their investment. In fact, some
critics state that the “hidden fees” from soft dollars can add between 15 – 70 basis
points to the true cost of owning the fund.6
In 1998, the SEC conducted an
investigation into soft dollar practices and found that “virtually all of the advisers
that obtained non-research products and services had failed to provide meaningful
disclosure of such practices to their clients.”7
If there were more disclosure on the
use of soft dollars, managers would be more careful in how they were used, and,
theoretically, more money would be returned to fund investors.
3. Limited disclosure to the asset manager - One important issue of note is that while
most asset managers can and do break out the soft dollars spent on third-party
services, they themselves get no similar breakdown from broker-dealers on how
their bundled commissions are used internally at the broker-dealer firm. At an SIA
conference in June of 2004, a representative from Bear Stearns stated “Wall Street
firms currently don’t give big customers the option to break out the research and
trading components of a ’full service’ trading commission.”8
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4. Conflict of interest – Due to these arrangements with their broker-dealers, asset
managers are encouraged to route their execution through their soft dollar brokers,
as opposed to choosing the broker that will give them the best execution.
Industry Action on Softing
The issues described above, while currently stimulating debate, have actually been
known to industry players and regulators for some time. As the market’s tolerance for
these issues begins to wane, and as the demand for transparency increases, governmental
and industry agencies have begun to take action. Just note what we’ve seen over the past
nine months:
• In the U.S. Congress, The Mutual Fund Reform Act of 2004 was introduced on
the House Floor on February 10, 2004. This bill was passed by the House, but
was sent to Committee in the Senate.
• In May of this year, the Financial Services Authority (FSA) in the U.K. proposed
rule changes to explicitly limit the use of soft dollars for research and execution
purposes and asked the industry to develop initiatives for accomplishing this. The
matter will be reviewed in December, and if progress has not been made, the FSA
“will consider what further regulatory action is necessary.”9
• The Securities and Exchange Commission, prompted by Congress, has issued a
concept release on changes to reporting of transaction fees for mutual funds and is
continuing to review the matter through 2004.
• The Investment Company Institute (ICI), a U.S. association of mutual fund
companies, has come out in favor of ending the use of soft dollars for third-party
research.10
• The Investment Counsel Association of America (ICAA), a U.S. association of
investment advisers, on the other hand, thinks this will hurt small asset managers
as they do not have the resources to use hard dollars for all their research needs.11
• At the company level, some firms have taken matters in their own hands and will
stop using soft dollars for research and market data. Interestingly, Fidelity
Investments has also come out on its own and told its Wall Street trading partners
that it too will stop using soft dollars to pay for market data – a $50 million
decision on its part.
It should be noted here that there are asset management companies that have always
eschewed the use of soft dollars in their business. They range from small firms – Jensen
Investment Management (which has $2.1 billion in assets under management), to large
firms - American Century Investments (which has $90 billion in assets under
management). To these firms, the use of soft dollars did not fit with their investment and
business philosophies of putting investors first.
With the momentum building for change, it makes sense for buy-side and sell-side firms
to analyze the situation now and to understand the ramifications of any changes that
might occur.
5. 2. Limitation or elimination of soft dollars for third-party research and services –
Buy-side firms will limit the soft dollar portion of commission to third-party
research products only, excluding all other products and services such as market
data, periodicals, etc. Or, buy side firms will completely eliminate the use of soft
dollars for any third-party services.
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Potential Scenarios for Change
With all of the issues finally being aired, and regulatory and industry authorities fully
engaged, there are likely to be some changes in how bundled commissions and softing
will be handled in terms of consumption of research and related services. The issue has
also triggered debate on the fundamental value of the research product itself.
Three potential change scenarios include:
1. Increased disclosure of soft dollars for third-party research and services – Buy-
side firms will increase their disclosure of and breakdown of soft dollar fees paid
to third-party providers. Costs for proprietary research could also be disclosed,
but only if brokers were required to provide this information to asset managers.
3. Unbundled Commissions – Buy-side firms will pay for all products and services
from broker-dealers and third parties separately, using “hard dollars”.
These scenarios may be realized through some combination of market-driven interest and
regulatory action. As we have seen above, some large firms are moving down these
paths independent of regulatory action.
Under all these scenarios, it would behoove asset managers to assess how changes in the
environment would affect their business models and investment processes. When
analyzing the impact of these changes, forward thinking asset managers should take the
opportunity to wring what benefit they can out of the situation.
Costs and Benefits of Change Scenarios
Scenario 1: Increased Disclosure
The impact of increased disclosure would vary by firm, but there would obviously be
increased costs in the form of development of the required reporting and ongoing
monitoring of the soft dollar costs. As mutual fund managers are currently required to
report figures on portfolio turnover and total commissions paid to investors,12
as well as
to track payments for third-party services, the costs of additional reporting would seem to
be limited. Depending on the asset manager, however, this cost could be higher if there
is little technology currently in place to manage this function.
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Some firms could reduce these reporting and monitoring costs by reducing the overall use
of soft dollars – in essence, using a reduction in soft dollars to pay for the increased
disclosure requirements on those expenditures.
In terms of how disclosure would impact customer relationships and new business, much
would depend on how the firm’s costs compare to those of their peers, in combination
with the firm’s investment performance. Increased investor awareness on the issue
would negatively impact those firms with high costs and low returns as they would be
viewed as bad investments. Conversely, those asset managers with low costs and high
returns could use those facts to draw in more business.
The impact of increased disclosure on other stakeholders would be mixed. Certainly it
would be a plus for investors, who would get a better sense of what their money was
being spent on, and whether it was being spent wisely. The effect on independent
research firms would be neutral or potentially negative – increased disclosure would
generate awareness about the amounts spent on third-party research, and, depending on
how the asset management firm thought the numbers looked, it could continue the
practice or cut some of its third-party research. Broker-dealers would also be impacted
negatively, as comparisons could be easily drawn on the costs of third-party versus a
broker’s proprietary research. The population that would be impacted the most severely
would be those providers of non-research services that are currently paid through soft
dollars – market data, newspapers, conference sponsors, etc. Those asset management
firms looking for a marketing and public relations advantage would likely cut into those
suppliers as a way of decreasing soft dollar costs and improving their image with their
customers.
Scenario 2: Limit or Eliminate Soft Dollars
In this scenario, soft dollars are limited and/or eliminated. In essence, asset managers
would be required to pick up the costs that are now paid out of investor funds.
If soft dollars were limited to only execution and research purposes (as in the FSA
proposal) then costs would increase for the average asset manager that relied on soft
dollars to pay for market data terminals, subscriptions and the sundry other items that soft
dollars are now commonly used to pay for. In addition to the hard costs of services
provided, internal operations and technology changes would be needed to manage the
new vendor relationships and the related accounting and audit tasks that would be
required.
If third-party soft dollars were eliminated, costs would increase still more as managers
would need to pay directly for research from third-parties. More time and money would
need to be spent on finding and selecting the appropriate research providers. Firms may
also have to hire analysts internally to add coverage to areas that external research
covered. Small asset managers in particular could suffer as they would not have the
resources on hand to fill the gaps, either financially or with staff.
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MFS, a large mutual fund company with $142 billion in assets under management, has
stated that it will no longer use soft dollars for third-party research or market data
services. The firm estimated this will cost them about $10 - $15 million annually.
The flip side of these increased costs, however, is that if soft dollars were eliminated,
asset managers would not have to send as many executions to their soft dollar brokers at
5 cents a share, but could place more orders with more ECNs and other venues at 1 or 2
cents a share. This in turn would drive down average commission costs. MFS estimates
that if they can bring down the average commission from 5 cents to 4 cents a share, they
will save $80 - $90 million annually. These lower commissions would mean reductions
in the operating expenses for the typical fund, thereby increasing, by a small amount, the
fund’s performance figures and so increasing its attractiveness as an investment for
customers.
So, depending on how the firm manages the change, there could actually be a net benefit
for asset managers in limiting or eliminating soft dollars.
For investors, limiting or eliminating soft dollar expenditures would be advantageous as
long as the asset management firm took those expenses onto its books and did not raise
management fees to compensate. Investors would, hopefully, enjoy lower costs and
higher returns if the use of soft dollars was curtailed. Independent research houses and
non-research soft dollar service providers would likely see a drop in business as the
notion of paying hard dollars for their products would cause most asset managers to re-
evaluate the use and the value they receive from them. Non value-added suppliers would
wind up being dropped from vendor lists. For broker-dealers, this scenario would cause a
major shift in how and what they provide to their asset management clients. Without a
soft dollar reason to execute with their brokers, most asset managers, as described above,
would send more business to ECNs and other venues and rely on full-service brokers
only for the trades that needed special handling. Proprietary research would also be
affected, as once asset managers started pricing out the cost of research in hard dollars for
third-party providers, they would then demand the same pricing from proprietary
brokerage providers.
Scenario 3: Unbundled Commissions
The last scenario is the most wide-ranging, and would cause significant change for all
stakeholders involved. For this scenario to unfold, broker-dealers would need to
voluntarily or be compelled by regulation to unbundle their commission fees. Fidelity
Investments, for one, is asking the SEC to require brokers to assign a value to proprietary
research and disclose that value to its customers.13
In the long term, this scenario may offer the most opportunity for a free market to
develop in research products. Unbundling could potentially open up a new world of
customized products and services to asset managers. Broker-dealers, free from the
shackles of cookie cutter ‘maintenance research’, could create highly differentiated and
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focused institutional research that hard dollar payments could allow. The research
product could itself be unbundled, or componentized, into more value-added sub-
products such as advisory only, reports and models, and other spin-off products. These
products would be better tailored to the needs of the asset managers, rather than the “one-
size-fits-all” model that is prevalent today.
For asset managers, unbundling would open the door to only paying for the research they
really need, so there is a likely chance they could reduce spending on research products.
Unbundling commissions could also result in the price of execution services going down
as these would also be opened up to competition from independent third parties.
However, depending on the choices made, these savings could be slightly offset by the
increased costs of procuring and managing higher numbers of suppliers.
This scenario could also benefit investors, as free markets in research and execution
products would result in lower investing costs for asset managers and, consequently,
better returns for their customers. Third-party research and non-research providers would
be exposed to full market competition for their products and, as a result, would be
compelled to adjust their business models accordingly to see success. Large broker-
dealers would be affected the most, as the oligopolistic business environment they are
used to would slowly transform into free market competition for their products and
services.
Some research producers have seen the changes ahead and are already adjusting their
business models accordingly. S.G. Cowen, for one, has stated that it will stop issuing
ratings and quarterly earnings reports and instead focus on publishing research “only
when it had some unique value and could not easily be duplicated by competitors.”14
Other firms have developed networks of “experts” to call on demand. In these instances,
investors call the firms with specific questions and the research firm finds the appropriate
resource that can address the issues and answer the questions.
One last interesting angle to consider is the impact unbundling would have on research
distribution. To avoid public perception of favoritism, and to comply with disclosure
regulation, most broker-dealers today distribute their research to all institutional and retail
clients simultaneously. If asset managers were to begin paying for broker research in
hard dollars, would they be able to pay extra to get more timely information from the
broker than their competitors or individual investors? Or alternatively, how valuable in
hard dollars would the research be to asset managers if everyone were still to get the
information at the same time that they do? Asset managers owe it to themselves to
consider that, if a free market allows once again for them to get that potential ‘first call’
from an analyst, that hard dollar research might indeed be worth paying for. This could
be a thorny issue for regulators to address, as a truly free market for research may tilt the
playing field towards those who are willing to pay more, which is a direct reversal from
the outcomes of recent regulatory action.
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Summary and Recommendations
Regardless of the changes ultimately made to soft dollar regulation, it seems almost
certain that external analysis and research will remain in one form or another because
asset managers do value these products. In surveys, asset managers say the most
important piece of the research pie is the industry knowledge that sell-side analysts
possess, and the timely access to that knowledge. These are followed by the integrity and
professionalism of the analysts themselves.15
Asset managers should be concerned about any changes to the soft dollar regulations, as
they will impact their business and profitability. However, if they do occur, and
especially if there is appropriate time given for the industry to adjust, forward-thinking
asset managers will treat it as an opportunity to better manage costs, and to foster and
develop closer relationships with those suppliers that are better aligned with their own
business and investment strategies. They can then move toward a research model that is
more value-added and at a lower cost than the one currently in use.
In closing, we suggest asset managers focus on the following actions, regardless of the
eventual regulatory outcome:
1) Further your understanding of how you use proprietary and third-party research,
and determine what providers and what information from those providers you feel
to be most important.
2) Develop alternate plans for the acquisition of research and related services in the
event that regulatory changes come to pass.
3) Prepare for the business, administrative and operational impacts of regulatory
change, and calculate the financial costs and benefits to determine the suitable
research model for your company under the various change scenarios described.
1
Carol Curtis, “Hard Questions for Soft Dollars,” Securities Industry News, April 5, 2004
2
U.S. Senate Committee on Banking, Housing and Urban Affairs, “Review of Current Investigations and
Regulatory Actions Regarding the Mutual Fund Industry: Examining Soft Dollar Practices,” Statement of
Dr. Howard M. Schilit (from Senate website:
http://banking.senate.gov/index.cfm?Fuseaction=Hearings.Detail&HearingID=102)
3
Reuters and Institutional Investor Research Group, “The U.S. Equities Investment Report,” Volume 1
(November 2002): p. 15
4
Scott Rosen, “The Independent Research Report,” Thomson Financial, Summer 2004, p. 13
5
Ibid, p. 8
6
Kevin Burke, “Soft Dollar Dilemma Incites Fierce Battle on the Hill,” Money Management Executive,
April 5 2004.
7
U.S. Securities and Exchange Commission, “Inspection Report on the Soft Dollar Practices of Broker-
Dealers, Investment Advisers and Mutual Funds,” September 22, 1998, (from SEC website:
http://www.sec.gov/news/studies/softdolr.htm)
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8
John Hechinger and Ann Davis, “Fidelity Toughens Up Against Soft Dollars for Market Data,” Wall
Street Journal, June 28, 2004
9
Financial Services Authority, “FSA Confirms Proposals to Tackle Softing and Unbundling,” May 7,
2004, (from FSA website: http://www.fsa.gov.uk/pubs/press/2004/039.html)
10
Investment Company Institute, “Comment Letter to SEC,” December 16th
, 2003, (from ICI website:
http://www.ici.org/statements/cmltr/03_sec_soft_com.html#TopOfPage)
11
ICAA Statement re: Soft Dollars, March 3, 2004, (from ICAA website:
http://www.icaa.org/public/letters/comment030304.pdf)
12
U.S. Securities and Exchange Commission, “Concept Release: Request for Comments on Measures to
Improve Disclosure of Mutual Fund Transaction Costs, Release No 33-8349,” December 19, 2003, (from
SEC website: http://www.sec.gov/rules/concept/33-8349.htm)
13
U.S. Securities and Exchange Commission, “Comments of David Jones, Senior Vice President of
Product Strategy & Communications, Fidelity Management and Research Company,” March 2, 2004,
(from SEC website: http://www.sec.gov/rules/concept/s72903/fidelity03022004.htm)
14
Joseph Nocera , “Wall Street on the Run,” Fortune, June 1 2004,
15
Reuters and Institutional Investor Research Group, “The U.S. Equities Investment Report,” Volume 1
(November 2002): p. 15
