How the Use of Soft Dollars Affect Your Retirement Funds

The concept of soft dollars has been around for quite some time. Soft dollars are commonly used by mutual funds (and other fund management firms) to make payments to their service providers.

last updated Friday, November 1, 2024
#Soft Dollars #Resultant Costs

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by John Burson

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The fundamental difference between soft and hard dollar (cash) payments is that the mutual fund will pass some of the business to a brokerage instead of directly paying the providers.

What Are Soft Dollars?

Payments made to brokerage firms via commission revenue instead of direct payments are known as soft dollars. However, the investing public generally views such arrangements negatively. Investors believe that buy-side firms should use their profits to pay expenses, making hard-dollar compensation more common.

How Does It Work?

X LLP provides Y Mutual with software that transmits investment information. Both companies have mutually agreed that Y Mutual will pay for these services by directing trades to a specific brokerage firm. The brokerage firm will charge an extra fee on Y Mutual’s transactions. Money from the additional fee will be sent to X LLP as payment for the services provided. Usually, the added fees amount to a fraction of a cent, but Y Mutual trades shares amounting to billions daily, so it sums up to a large amount of money pretty quickly.

Why Soft Dollars?

In the example above, Y Mutual would have had to make the payment directly, which would require the writing of a cheque. The cheque would have to go into the company’s books, and the resultant costs would have to be passed on to the investors. Soft dollars provide a way for mutual funds to receive services and not have to pay for them directly. The point is to hide expenses in trading costs and have investors pay for them without their knowledge. The overall cost of running the company will seem low, which appeals to many investors.

What It Means For Investors

Soft dollars make it extremely difficult for investors to compare the cost of using one mutual company over the other. This is because smooth dollar payments will appear as the cost of the transaction. In the long run, using soft dollars means more business for the mutual company. However, there is a growing negative perception vis-à-vis the use of soft dollars. The investing public argues that mutual funds should pay for the expenses using their profits instead of investor money. You are the investor if you save for your retirement using a mutual fund. Each soft dollar transaction takes a toll on your returns.

 
 
 

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