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Soft Money - Revisited
Soft dollars are basically the cost of the trade above the actual transaction cost. Brokerages who trade for fund managers bundle their services when they contract with a money manager. Currently you are paying for this service. Soft money is not easily understood. So be patient as we take a look at something might be both as necessary to a successful return on your investment and at the same time, something you might find loathsome as well. A good deal of time is spent these days looking at the topic of fees. Who pays for what and why has been at the heart of many of the scandals that have racked the mutual fund industry. And as unpleasant as they may seem, they are, in their most simplified form, the cost of doing business. Once an investor determines what type of risk tolerance they can stomach, the search for funds that match that criteria begins. The most conservative among us will choose an index fund, a passively managed mutual fund whose holdings usually mimic some index. The manager of this fund has little in the way of trading to do apart from rebalancing or following changes in the index they are following. Investors who can tolerate greater risk will need to have an actively managed fund. This type of fund requires the manager to make investment decisions in order to keep fully invested and increase the returns of their portfolios. Portfolios with higher returns are often compared to indexes so performance better than your peers is important. That performance costs money not only in timely trades but for the research that accompanies that trades. Now the questions begs to be asked: should you pay or should the fund company? Whether this research is good is another matter that we will get to in a minute. Shareholders generally have no problem with the cost of an executed trade. We understand that stocks need to be bought and sold and that comes with a certain handling fee. But the core of the soft money problem has fallen under "safe harbor" rules. Safe harbor rules were first brought into focus with the amendment of the Security and Exchange Act of 1934. These so-called bundled services have become safe harbors for such costs passed on to shareholders, making us pay for not only research but computers and software. Bloomberg terminals do not come cheap by the way. But problems and more questions start rising when these safe harbors are abused. Should shareholders pay to send their managers back to school for such things as professional development? Or pay for the phones? No we shouldn't. More problems are found with the bundled services themselves. Often these services use other small indenpendent firms to execute trades with the brokerage acting as a middle man or reseller. This means, that had the mutual fund manager done a little shopping, they could have saved a little money with the less expensive service.
If soft money were going for research then everyone should know how much. Outlawing the use of third party research is not a good step either. Much of the good quality research comes from these small independent firms and the cost of that research might well translate into excellent returns. Is it worth the costs? The biggest fear that the industry has would be from drive for the fund company to make a profit for their shareholders. Many fund companies are publicly held and owners of stocks in fund companies have been awash in profits. Estimates of the loss of profits if soft money were halted are somewhere in the 6-8% range. Faced with having to suddenly pay for these costs with cash, many managers might find the service not worth the cost. That might turn a good deal of active managers into passive "closet" indexers. For now, a little self tightening and a little more transparency would be good for all parties concerned. The belief that you have to spend money to make money may be worth holding onto when it comes to active management. Order your copy of Building Wealth in a Paycheck-to-Paycheck World by Paul Petillo. It is packed with safe, proven wealth-building strategies that cover all the major components of a balanced financial plan, including:
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