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SKARBECK: Brokerage soft costs under tighter scrutiny

December 11, 2010

Ken Skarbeck InvestingThe U.S. Securities and Exchange Commission has expanded its attack on insider trading by shining the spotlight on a shadowy network of “consultants” who provide hedge funds and money managers valuable insights within a particular business or industry. This proprietary research would be illegal if it were deemed “material nonpublic information.”

Regulators are particularly interested in the apparent widespread use of “soft dollars” to compensate these consulting networks. Soft-dollar arrangements typically consist of a contract between an investment manager and the brokerage firm where security trades are placed.

The agreement is often based on higher-than-standard commission rates (paid by the investor/client) and the volume of trading placed with the brokerage firm. The brokers then reimburse the investment firm by paying for some of its business expenses like research services and computer hardware and software. Some firms even use soft dollars to help subsidize their office rent. Thus, soft dollars are essentially rebates on inflated trading commissions.

Many investment firms, hedge funds and mutual funds participate in this less-than-desirable industry practice. The SEC’s focus on soft dollars may indicate another push toward cleaning up some of the invisible costs borne by the investing public. The commission’s recent drive to reform mutual fund 12b-1 fees seems to demonstrate an effort to achieve full and upfront disclosure of costs to the investment client (of course, the mutual fund industry is fighting against 12b-1 reform).

In 1998, the SEC estimated that $1 billion worth of third-party research was paid for with soft dollars. With the explosion in the number of hedge funds since then, total industry soft dollars generated via trumped-up commissions amount to a several-billion-dollar slush fund today.

Naturally, fast-trading investment firms are highly coveted by brokerage firms seeking commission revenue and, in turn, the high-volume traders receive large soft-dollar rebates. One of the firms subpoenaed by the SEC was SAC, the giant, secretive hedge fund run by Steven A. Cohen. SAC trades securities like they are coins being pumped through a slot machine. The SEC has zeroed in on SAC and several of its former employees in an effort to learn whether soft dollars may have been concealed as payments to “consultants” for knowledge that may be deemed insider information.

The primary concern here is insider trading—the use of material non-public information for profit. However, if regulators wanted to change industry practices for the better, they would ban the use of soft dollars altogether. Unfortunately, that is unlikely to happen since there is a vast entrenched network of investment vendors that depend on the huge revenue paid with soft dollars. Investment firms would also lobby strongly against eliminating soft dollars.

While investment industry users of soft dollars have described them as akin to frequent-flier miles, non-users who abhor the practice call them kickbacks. If soft dollars are eliminated, investment firms would have to pay these administrative costs out of their own budgets, like any normal business, and effectively lower their client’s investment costs—thereby boosting their investment performance—compliments of significantly reduced commission rates.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
 

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