Soft Dollars: Hidden Fund Costs Exposed at Last

Finally, the Investment Company Institute is getting out ahead of some reform issues. Although the reform bill in Congress would only mandate studying soft dollars, the ICI has called for a ban on most components of soft dollars.

Soft dollars are payments from fund companies to brokerages that are tacked on to the commissions they pay when they trade stocks. In return for overpaying, brokerages give the fund companies services in return. These services can include third-party research, access to IPOs, or pretty much anything the fund company wants--even goods like computers or office furniture.

Here's the catch: When fund companies buy services this way, they aren't included in the fund's expense ratio, so the actual costs can be hidden from fund investors. And there's another catch: Fund companies generally get less than $1 back for $1 in soft dollars. Thus, the true costs to fund shareholders are raised.

The ICI says soft dollars should not be used to buy third-party research or other goods readily available, such as computers. The ICI did say, though, that soft dollars should still be allowed for the purposes of buying sell-side research that is proprietary to the brokerage.

I say ban it all, and I'm not the only one. Some fund companies have avoided this unsavory practice altogether. American Century and Bridgeway have avoided soft dollar deals and have no doubt saved their fundholders a good bit of money in the process.

In addition, the ICI called for an end to directed brokerage commissions. "Directed brokerage" is really a euphemism for kickback. The way it works is that when fund companies trade stock, they will make a point of sending some of those trades through the brokerages that in turn sell their funds. Morgan Stanley's settlement with the SEC showed that this was often done at a price above the standard commission.

Putnam recently said it would stop paying directed brokerage commissions.

Both of the above are the sort of practices that have allowed fund middlemen and fund companies to nickel and dime fund investors in a more or less legal way. It's encouraging to see the SEC and ICI working to put an end to these bad practices. The SEC and Congress ought to follow through and ban soft dollars and directed brokerage. There may never be a better chance to push these reforms through than now. It's conceivable that 20 years from now, the two things that most directly shape the landscape of mutual fund investing could be the Investment Company Act of 1940 and the reforms enacted in 2004.

These aren't the only steps needed to return fund investors to the top of the pyramid, however. Manager incentive disclosure, anticompetitive sales practices, and fee disclosure are all problem areas that need to be addresssed quickly.