A soft-dollar trade costs institutions 23 basis points more than a cash trade, a new analysis shows.
Moreover, the study shows soft-dollar costs can vary widely, depending on the type of investor making the trade, and the type of broker executing the trade.
Those findings are based on a recent analysis of the trades of 33 institutional investors.
The findings have important implications for investors and regulators concerned about the costs and benefits of soft dollars, the authors contend.
(A soft-dollar trade directs a portion of the trading commission toward the payment for services not related to the trade, such as research.)
The study, "Institutional Trading and Soft Dollars," was a joint effort of two academics and a money manager.
The authors are: Sunil Wahal, assistant professor of finance at Emory University's Roberto C. Goizueta Business School in Atlanta; Jennifer S. Conrad, the Mary Farley Ames Lee Distinguished Professor of Finance at the Kenan-Flagler Business School at the University of North Carolina at Chapel Hill; and Kevin Johnson, partner and director of research for Aronson + Partners, Philadelphia.
But the study addresses only one side of the soft-dollar equation -- costs. More information is needed on the benefits of soft dollars to properly evaluate them, Mr. Wahal said.
"We're not saying soft dollars are good or bad because we don't know what the benefits are," Mr. Wahal said.
The value of services received from soft dollars will vary widely from investor to investor, so it's tougher to generalize about the benefits, he said.
"You can get lots of things for soft-dollar payments. You need to sort of tally all that up."
With a recent focus on soft dollars coming from regulators and other industry groups, the authors hoped to make the process of evaluating soft-dollar programs easier with what they believe is the first study of its kind.
"Nobody has a stock-by-stock analysis . . . that tells you how much soft-dollar trades cost," Mr. Wahal said.
Mr. Johnson of Aronson said the study results show investors using soft dollars "don't get something for nothing."
He said pension executives authorizing soft-dollar expenditures might ask: "Is the stuff that I'm getting worth the extra cost?"
Pension execs respond
Some executives are a step ahead of that: They believe paying for research with soft dollars muddies the waters whether the benefits are worth the cost.
"There's a philosophical and/or accounting issue: Is this good business practice?" said Garth Dickey, executive director for the Indiana Public Employees' Retirement Fund, Indianapolis.
Payments for research services should be directly linked, and managers should pay for research with their own money, he said.
The study itself points out there is "a paucity of data" regarding soft-dollar costs, he said.
William Quinn, president of AMR Investment Services Inc., which manages the pension fund for American Airlines, Dallas-Fort Worth Airport, Texas, said investment managers are "already getting paid" for the services they provide.
There's no reason a pension fund should have to chip in -- through soft-dollar expenditures -- to cover more of a money manager's expenses, Mr. Quinn said, particularly if the trades are costing more.
He said AMR tries to limit its soft-dollar payments as much as possible. Still, in situations such as block trades, not using soft dollars could result in getting a worse price, he noted.
He said there are situations where AMR essentially is forced into trading through directed brokerage, such as when an external manager is making a block trade on behalf of multiple clients.
Not all pension fund executives agree. R. Charles Tschampion, managing director for General Motors Investment Management Corp., New York, chaired a recent panel that created soft-dollar standards for the Association for Investment Management & Research, Charlottesville, Va.
Mr. Tschampion disagreed with the view that eliminating all soft-dollar payments for research would be a good thing. He said there are plan sponsors that also are internal money managers that pay for research with soft dollars, and those that want their money managers to get needed research via soft-dollar payments.
Putting a value on Wall Street research is a difficult thing, and eliminating soft-dollar execution would "basically grind the system to a halt," he said.
Frequent flier miles
Despite the study's findings, he said: "I don't believe that you're necessarily paying up (more) for the research.
He likened it to airline frequent flier miles. Are airline tickets necessarily more expensive because of frequent flier miles that are accumulated?, Mr. Tschampion asked. Smart consumers can get the miles and pay low fares, if they are diligent. The same is true for investors, who can get the research and get low-cost executions, he said.
Wayne H. Wagner, president of trading consulting firm Plexus Group, Los Angeles, said he wasn't surprised by the study's results. "The numbers were, in general, consistent with what we have found," he said. A smaller-scale study by Plexus showed the cost difference to be about 29 basis points.
A spokesman for the Securities and Exchange Commission, Washington, which is scrutinizing soft dollars, declined to comment.
The study's authors note the 23-basis-point difference in cost between a soft-dollar trade and a cash trade varies by the type of investment institution.
For momentum-style investors, the cost difference between a soft-dollar trade and what they call a best-execution broker is 28 basis points, while for index fund traders, the difference is only six basis points.
After controlling for differences between investment managers, estimated costs for all managers falls to 11 basis points, still a significant amount, the authors said.
The authors attempted to identify both the explicit costs and the implicit costs of directing a trade for soft-dollar execution.
