Soft-dollar advocates are going to have a harder time pleading their case.
That's because tainted fund manager MFS Investments announced last week it would put an end to soft-dollar commission payments, representing a major turn of the tide in the battle over hidden trading costs.
The move came on the heels of the firm's $350 million settlement of trading violations and months of withering criticism of the inherent lack of transparency in fees imposed on shareholders.
Currently, MFS and other major players spend about 5 cents a share for equity trades in bundled soft-dollar arrangements including stock research and execution costs. MFS will now pay for third-party research with cash out of its own pocket, unlike past instances where the expenses were passed on to fund shareholders. While there are a number of mutual fund companies that do not use soft dollars, MFS is the first big-time fund shop to do away with the practice.
The ramifications of MFS' ban on soft dollars will be felt throughout the industry, given that they make up a significant portion of broker compensation. Wall Street firms have long opposed unbundling their cumulative trading price, arguing that the services rendered are not easily quantified. However, the problem for investors is that these arrangements mask the true cost of owning shares in the fund. In some instances, commissions can tack on 500 basis points to a fund's expense ratio, as in the case of the $273 million Van Eck International Gold Fund
"The crazy thing about soft dollars is that [a fund] will pay 5 cents a share for a full-service broker and they'll give you allocations of 20% of the commission for fund sales or research, for example. If you don't take it, they're still going to charge you 5 cents a share," said Robert Pozen, the new non-executive chairman at MFS. "The only way to change that is to bring some real pressure on the system by [switching] to an unbundled system." At present, there is no good accounting on soft dollars, he noted.
The Securities and Exchange Commission is mulling a proposal that would restrict the use of soft dollars, while a bill drafted by the Senate would eliminate them altogether. Meanwhile, the Investment Company Institute supports narrowing the uses for soft dollars but maintains that it is vital in acquiring quality research.
Pozen said the ban on soft dollars would not cause MFS to raise advisory fees, but rather, would simply reduce the company's bottom line. He estimated the company would pay anywhere from $10 million to $15 million annually for research and market data. Independent research firms are worried that this will cut them off because a lot of them get paid heavily in soft dollars. Pozen thinks this will have a positive effect because it will sort out which firms provide the most valuable research.
He went on to say that quantifying the monetary benefit for the individual investor depends on how much Wall Street firms are going to bring down the cost of execution.
"If we can bring down the norm from 5 cents a share to 4 cents a share at MFS, it would be worth $80 million to $90 million." Pozen said. "We're only going to be successful in bringing down the price for fund shareholders if other mutual funds, pension funds and the SEC get behind us to put the pressure on."
Clearly, a hefty settlement with state and federal regulators for trading violations forced the company's hand on this issue, but other firms not tainted by the scandal are mulling a similar move. Fidelity Investments, the nation's largest mutual fund firm, wrote a letter earlier this month, albeit after the comment period had ended, urging the SEC to require mutual funds to quantify and separately report soft dollar research expenses.
"Industry-wide disclosure of soft-dollar expenses will not only enhance individual investors' understanding of their mutual funds' expense structures and performance, it will also help the Commission, Congress, the industry and others in their extensive efforts to identify and analyze trends in fund expenses," wrote David Jones, Fidelity's senior vice president of product strategy, and Eric Roiter, general counsel.
Additionally, Fidelity suggested the SEC mandate brokers to assign a value to proprietary soft-dollar research they provide to advisors related to trade executions. Fidelity also suggested that these expenses should be included in funds' expense ratios. Fidelity, for its part, says it is able to estimate the dollar value of soft-dollar research, including proprietary research. The firm relies on a small core group of brokers to execute its fund trades and while it is not an exact science, Fidelity is confident it can deliver a solid estimate of the aggregate value of research.
Bob Millen, principal at Jensen Investment Management, believes that fund managers should earn their fee and not pawn off the cost of research on to shareholders. His $2.1 billion fund has had a written policy in place since its inception that it does not use soft dollars, a measure Millen believes will become the norm in the aftermath of the MFS announcement.
MFS also instituted other reforms that it considers to be best practices, including customizing shareholder reporting. The company plans to issue quarterly statements that spell out in dollar terms the expenses associated with that individual's portfolio holdings. Pozen said that the firm will estimate the cost to shareholders on the assumption that the shareholder has held the fund for the entire quarter and that this represents 80% to 90% of its customers. Anything more than that would be too costly, he said. The cost to upgrade technology to support this enhanced fee disclosure will be in the neighborhood of a few million dollars.
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