Money Management Executive
Despite the request by Securities and Exchange Commission Chairman Christopher Cox that Congress eliminate soft-dollar safe harbors, industry insiders argue that such a change would produce nothing but toil and trouble for investors.
The real antidote to what Mr. Cox called "a witch's brew of hidden fees" is simple disclosure, according to a survey of 43 institutional investment managers and 37 plan sponsors conducted in April by the Dallas broker-dealer Capital Institutional Services Inc. and the Connecticut consulting firm Greenwich Associates.
But when it comes to what that disclosure might look like, investment managers and plan sponsors alike are looking back to regulators for the magic ingredients.
"There is a general feeling among market participants that current 28(e) regulations regarding research and brokerage provides value, but current disclosure practices are ambiguous and inconsistent," Kristi Wetherington, chief executive of Capital Institutional, said in a white paper her firm and Greenwich Associates published.
Passed in 1975, Section 28(e) of the Securities Exchange Act of 1934 frees money managers from the fiduciary responsibility of always choosing the lowest-cost brokers, provided that the higher commissions buy research that helps managers make higher-quality decisions for their investors.
Soft-dollar spending, which accounts for about $11 billion of commissions a year, has been the subject of scrutiny for several years. In the past some commissions had been directed to purchases not in the best interest of investors — things ranging from vacations to college tuitions for managers' children.
Last year the SEC passed guidelines that delineated how that money could be used. Spending for research was in, but using commission fees for office space, or telecommunications lines used to access research, was out.
And even though everyone understands the rules, not everyone knows how commission dollars really are spent, since there is no uniform method of reporting the totals. Only 35% of the managers who participated in the survey said they report to clients the total commissions paid, and only half of plan sponsors ever ask.
"Ultimately, the reason plan sponsors aren't pushing this is that they really don't understand," said Michael Mayhew, the chairman and CEO of Integrity Research Associates LLC in New York.
In theory, the chief investment officers of plan sponsors would agree that understanding those plans' expenses is part of their function as fiduciaries, but in practice, commissions remain an opaque, and relatively minor, part of their jobs, Mr. Mayhew said. "While it is an important issue, when you look at all the other jobs they have running these large plans, on the list of 20 things to do, it's probably 21st."
In fact, 7% of the investment managers surveyed said that they feel intense pressure from their internal management and fund directors to disclose fees, while 45% said they feel no pressure at all from sponsors, and as of April, 44% said they felt no pressure from regulators. John Feng, a consultant with Greenwich Associates, said the internal pressure may come from a desire to use transparency as a competitive advantage when marketing funds' services, or to stay ahead of regulators.
Even when commissions are reported, it seems everyone does it differently. Of the 35% of investment managers who report commissions, only about 25% report how much goes to research.
In a May 31 speech, Mr. Cox called such murkiness "at odds with investors' best interests," resulting in conflicts, complexity, and inflated costs. He warned that soft dollars may spur managers to trade more than necessary to raise revenue, or to use one client's commission to cover research for another.
In some cases, soft dollars have been used to cover referral fees paid to clients who recommend others, Mr. Cox said. He urged Congress to eliminate or significantly revise the safe harbor legislation, and he called the harbors as "out-of-date as the Betamax, leisure suits, and 'Welcome Back, Kotter.' "
However, Ms. Wetherington said eliminating the soft money is not the answer. "Today's call for transparency would address the concerns of the SEC," she said, and unlike eliminating soft dollars, simply reporting the amount allocated to trading versus execution would let small and midsize broker-dealers, like Capital Institutional, stay in business.
The question is what the disclosure should look like. In the survey, 60% of managers and 67% of sponsors said they would like the SEC to define how commissions and should be reported.
Where they differ is in how involved they want regulators to be. Plan sponsors want the SEC to play a prominent role in prescribing how those fees are broken out. The need for those services and research will not go away because soft dollars do, Mr. Feng said.
James Morrow, chief operating officer at Capital Institutional, said the alternative is for investment managers to skimp on research to keep expenses down, or even to rely on brokers' in-house research. Only the largest broker-dealers would be in a position to compete, and small research companies and broker-dealers alike, both known as fonts of industry innovation, would likely close shop or be acquired, he said.
Even companies like Fidelity Investments, which announced last year that it had "unbundled" commissions through an agreement with Lehman Brothers, still directs a vast majority of commissions to research, he said.
Mr. Mayhew said that eliminating the soft dollars "would be a $6 billion problem," and that the people picking up the tab, ostensibly, would be the investors.
"Don't let anyone bamboozle you by telling you it's an independent research problem," he said. "It's a problem for every single brokerage firm, from the largest on down."
