CHICAGO - Soft dollars can add 50% to the cost of investment management, while providing little incentive for money managers to restrain the cost of obtaining research, most of which is wasted, Ennis Knupp + Associates Inc. contends.
The common practice of money managers "paying up" for investment research with excess brokerage commissions reduces pension funds' investment performance, according to a study by Ennis Knupp, Chicago.
Each additional penny paid per share in brokerage commissions lowers a typical equity portfolio's annual rate of return by about six basis points, estimates the study written by Neeraj Baxi, consultant, who seeks to quantify some of the excess costs.
Investment managers "have little incentive to hold costs down" for investment research and other services paid in "soft dollars," the practice of paying brokerage commissions in excess of the cost for just trading execution. Because money managers "incur no direct cost for these services," much of the research they obtain goes unread.
"Portfolio managers read only approximately 30% of the research they receive through soft dollars," Mr. Baxi states in the study, "pointing to inefficiencies in the use of soft dollar arrangements."
"We think investment managers should pay for research out of the investment management fees," Mr. Baxi said in an interview.
"While this arrangement could conceivably result in higher management fees, it should not have a negative effect on the net wealth of investors," the study contends. "Research expenses would be explicitly paid as part of the overall management fee, rather than reflected implicitly in poorer performance results."
"If an investment manager pays for research himself, he will make sure he spends it wisely," Mr. Baxi said. "But when a manager is using pension assets to pay those costs, there is a tendency not to monitor and control these costs."
The study likewise criticizes commission recapture, the practice of rebating part of the commission back to the fund sponsor, and questions stepout trades.
"Commission recapture makes no economic sense," the study states. "It seems ridiculous: you pay 6 cents and get back 4 cents - you might as well just pay 2 cents," Mr. Baxi said in the interview, suggesting a commission recapture scenario.
The study also found "a universal desire (among investment managers) to minimize stepouts," the practice of a money manager asking a broker to give up part of a trade to a commission recapture broker. "Managers believe that excessive stepouts may diminish their bargaining powers with brokers."
The Ennis Knupp study advocates unbundling research and execution costs, easing concern about how the practice of paying up incurs hidden fees and excessive costs and can lead to potential abuses, such as excess trading to generate more commissions.
"We aren't saying investment managers are abusing soft dollars," he said. "But why leave the door open for possible abuse? Just make it really clean and really simple" by unbundling the cost of research.
Mr. Baxi sees little chance of such unbundling in the near future.
Use of soft dollars has been criticized for years, but appears to continue unabated.
The Department of Labor and the Securities and Exchange Commission both studied the issue without making any significant change to the legal safe harbor.
"Clients don't focus on commissions and research costs because they don't see it," Mr. Baxi said. "Can institutional investors demand investment managers not do this? It is a difficult question. Unless all investment managers do it for all clients and all investment managers unbundle, there is no incentive for an investment manager to do it for one client."
"It might take legislation to do something," he added. "Big pension funds could pressure for change."
He said a declining stock market also could bring that pressure.
"In the 1990s, when the market was rising, you didn't care if you lost 20 basis points in commissions," he said. "You didn't even look at it. In a declining market, commission cost is a bigger share of returns.
"The current state of the market (is) a motivator for institutional investors to focus on this issue," he added.
For pension executives, "monitoring (of soft dollars) is difficult, if not impossible," he said. "I don't think institutional investors can monitor the cost of soft dollars and determine their utility for the managers."
Mr. Baxi said the vast majority of managers use soft dollars. The study cites an estimate that the total value of research purchased with soft dollars exceeds $1 billion.
R. Charles Tschampion, managing director, General Motors Asset Management Corp., New York, said, "This is like a never-ending story. This issue will never go away."
He supports the use of soft dollars for research under standards promulgated in 1997 by the Association for Investment Management and Research, Charlottesville, Va. Mr. Tschampion chaired the AIMR task force on the issue.
He said it would be very difficult to try to unbundle research costs from execution costs.
"You aren't paying up (in commissions) anymore at (brokerage) houses that provide research than at houses that provide execution only," he said. "We don't view it (soft dollars) as a problem." he added. "It's of such small consequence in the area of the funds." In terms of abuses, he said that fund officials should be monitoring trading activity, regardless of soft dollars, to look for potential churning, measure best execution and evaluate how managers are allocating commissions to brokers.
Yet the study notes, "a large percentage of soft-dollar arrangements is entirely undocumented."
James M. Hacking, executive director, State Universities Retirement System of Illinois, Champaign, said of the $10.2 billion fund: "We scrupulously stay away from soft dollars. It causes more trouble than it is worth."
Although he hasn't seen Mr. Baxi's study, Todd Burns, chief executive officer, Lynch Jones & Ryan Inc., New York, agreed with many of its assertions.
"I think he (Mr. Baxi) will find agreement in the pension plan community," including on the inefficiencies of the cost, Mr. Burns said.
"Once an investment manager stopped using its clients' money (soft dollars) and had to use its own money for research, it would pay a lot more attention to what it is spending the money on," Mr. Burns said.
He disagreed with Mr. Baxi's arguments on commission recapture. "Commission recapture helps pension sponsors unbundle so they don't have to pay for research," he said. Lynch Jones & Ryan is a major commission recapture broker.
Mr. Burns thinks pension funds need to measure their commission costs better. "At a minimum, they should ask for more clarity on where their commissions are going."
If changes are to come to soft-dollar practices, Mr. Burns said, "it is the pension sponsors that have to stand up and demand change. Not me, I'm a commission recapture broker. This is my business.
"It would be hard for any individual pension sponsor to change the world of soft dollars," he added. "It would have to be a concerted effort by many pension sponsors. But lots of people and pension sponsors think soft dollars are great," he said. "I don't think there is any groundswell to change soft dollars.
"I'm not saying anything is wrong with soft dollars," he added. "Managers are responsible for getting best execution. There are lots of definitions of best execution."