What are soft dollars?
A means of paying brokerage firms for their services through commission revenue, as opposed to through normal direct payments (hard dollar fees).
The investing public tends to have a negative perception of soft dollar arrangements because they believe that buy-side firms should pay expenses out of their profits, rather than from investors' pockets. As such, the use of hard dollar compensation is becoming more common.
For example, a mutual fund may offer to pay for research from a brokerage firm by executing trades at the brokerage.
Let's say that Large-Cap Value Fund (LCV) wants to buy some research from XYZ Brokerage Firm. LCV may agree to spend at least $10,000 in commissions for brokerage services in return for research from XYZ. This would represent a soft dollar payment. Alternatively, if LCV wanted to simply buy the research from XYZ and not agree to any kind of soft dollar fee, it might have to pay the brokerage firm $7,000 in "hard dollars" (cash) for the service.
The term soft dollars refers to the payments made by mutual funds (and other money managers) to their service providers. The difference between soft dollars and hard dollars is that instead of paying the service providers with cash (i.e. hard dollars), the mutual fund will pay in-kind (i.e. with soft dollars) by passing on business to the brokerage.
Let's take a look at an example: Wittenberg LLP provides MegaMutual Fund with computer equipment and software for transmitting investment information. Under an agreement or understanding between the two firms, MegaMutual will pay for these services by directing trades through to Feral Hitch, a large brokerage firm. Feral Hitch will charge an added fee onto the trades from MegaMutual. The money from these fees will then be sent to Wittenberg, which, in turn, gets its compensation for its services to MegaMutual. The added fee usually amounts to tenths of a cent, but because MegaMutual trades billions of shares a day, the amount adds up to real money - the fee it would've had to pay in hard dollars.
Soft dollars are a way for mutual funds to get services without having to pay for them directly. A hard dollar payment would require a check to be issued and recorded on MegaMutual's books, and the corresponding expense to be passed onto investors via the fund's annual fee. Under soft dollars, the expenses are hidden in the trading costs. While the practice is not illegal and the end result is the same (the investors pay), it does not help investors analyze the costs of using one mutual fund versus another.
Soft dollars became more of an issue as Wall Street activity came under greater scrutiny in the wake of the dotcom bust. However, soft dollars have been around a very long time and there are rules that govern their use. According to Harold Bradley (senior vice president of American Century Investments), fund companies do an estimated $10 billion annually in soft dollar business. And the Association for Investment Management and Research has established standards for the use of soft dollars to clarify and limit potential abuses. For more information, here is a link to their site: http://www.aimr.org/featuring/modules/softdollar/readings.html..
Fees or payments paid to brokerage firms in return for their services.
For example, let's say that Cory's Large Cap Value Fund wants to buy some research from XYZ brokerage. However, Cory’s doesn’t want to make any trades through the brokerage. In this case, the company could make a hard dollar payment (cash) and simply pay for the research outright. This is the opposite of making a soft dollar payment in which a brokerage firm is paid with the commission revenue from making trades.
A hard dollar payment can also refer to the fee that an individual investor pays to a brokerage firm for its services. For example, if an investor places a market order and pays the brokerage a $20 fee for that transaction, that is a hard dollar payment.