WASHINGTON - The Securities and Exchange Commission's plan to ask mutual funds to disclose "soft-dollar" arrangements between their advisers and brokerage firms is sparking a fierce debate over whether it could jack up fund expenses.
Soft-dollar arrangements allow mutual fund investment advisers to receive everything from economic reports to software and consulting services in exchange for directing trades to brokerage firms. The research may be provided by the brokerage firm itself or by independent consulting firms.
Some industry officials say disclosure could result in higher expenses because mutual funds would have to break out - in their fee table - research their advisers now receive as freebies. Higher expenses, in turn, could affect a fund's performance adversely by reducing yields or net returns.
But lawmakers, regulators and some mutual fund officials who oppose soft-dollar arrangements have expressed concerns in recent years that such arrangements might let investment advisers shortchange mutual fund shareholders by paying inordinately high brokerage commissions in exchange for research services.
Current rules do not require mutual funds to show the cost of research obtained by their advisers in their financial statements to shareholders. They must, however, describe such practices in a "statement of additional information," filed with the SEC but not typically read by shareholders.
Nor do mutual fund advisers, who use the research to make investment decisions, have to report the cost anywhere. Instead, the cost is built into the price of securities the mutual fund advisers buy or sell through brokerage firms providing the research.
The soft-dollar issue has embroiled defined benefit and defined contribution pension plan sponsors for years.
The SEC's division of market regulation separately is drafting a rule requiring money managers to report such arrangements to their institutional clients. The agency could issue such a proposal within the next few months. The agency's market regulation division recommended the rule as part of its Market 2000 report released in January (Pensions & Investments, Feb. 7).
Money managers already must give their clients an annual written explanation of their choice of brokerage firms, including commenting on the rate of commissions they pay.
One reason for the popularity of soft-dollar arrangements between mutual fund advisers and brokerage firms could be the competitive pressure on advisers to keep their reported expenses low.
The belief that accounting for the soft-dollar arrangement will boost costs comes through in the funds' statements of additional information.
For example, T. Rowe Price Associates Inc., Baltimore, notes in its May 1 statement: "To the extent that research services of value are provided by brokers or dealers, T. Rowe Price may be relieved of expenses which it might otherwise bear."
The statement of additional information for Fidelity Investments' Magellan Fund, dated May 20, reported approximately 60% of its $72.5 million in brokerage commissions paid for the financial year ended March 31 were directed to firms that provided research services, although it noted "the provision of such services was not necessarily a factor" in doing business with those firms. About one-third of the fund's trades were executed by Fidelity Brokerage Services Inc., an affiliate.
Mutual fund expenses can vary depending on the type of fund, but on average, their expenses are around 1% of average net assets, said Anthony Evangelista, assistant chief accountant at the SEC's investment management division, which oversees mutual fund regulations. Mutual fund officials could not quantify just how much fund expenses might rise, because of the difficulties in pinpointing the cost of research they receive gratis from brokerage firms.
"As a pure economic theory, you can't get anything for free and if you are getting something with soft dollars, it has a value. But in the real world, that is not how it always works," noted Joel H. Goldberg, partner at the New York law firm of Shereff, Friedman, Hoffman & Goodman, which represents more than a dozen mutual fund firms, including T. Rowe Price.
Rather than pressing for cash discounts in commission rates, mutual funds may be better off accepting research from brokerage firms if the value of the research more than offsets the discounts they might receive, he explained.
Requiring mutual funds to disclose such costs, regulators and lawmakers say, would give shareholders and workers a clearer picture of expenses and allow them to better decide in which funds to invest.
"It would not be a negative because expenses that are now hidden would be brought to light," said Robert E. Plaze, assistant director of the agency's investment management division. Fund shareholders already pay for such research as part of the cost of securities investment managers buy and sell, he noted.
Moreover, disclosures of such expenses also could discourage the practice, Mr. Plaze and others suggest. "If they had to pay hard dollars, would they really buy this stuff?" he said.
He also acknowledged the difficulties in requiring mutual funds to tote up the costs of soft-dollar research in their financial statements. "The issue is if you get something you haven't negotiated, or haven't asked for, how much is it worth?" he said. If the adviser tosses out a research report received from a brokerage firm, does it still have value, he wondered.
The SEC's plans to study whether the cost of research services provided by brokers should be reflected as fund expenses follows its proposal last month requiring mutual funds to expense other services they receive from brokerage firms in exchange for directing trades there. Such services include custodian and transfer agent fees or printing costs funds otherwise would have to pay out of their own pockets.
The agency has asked the mutual fund industry for comments and suggestions on how best to require disclosures of research provided to mutual fund advisers, including how such research services should be valued, and how the value of such research should be allocated among various clients of an adviser that may benefit from the research.
The SEC also is looking into whether the difference between the lowest commissions paid by a fund, and commissions paid to brokerage firms that supply research, be considered as research expenses. Alternatively, the agency might require disclosures only of research services that have readily available values, such as newspaper subscriptions and price quotation services.
Some mutual fund officials are calling for the agency to re-examine its interpretation of a securities law that permits mutual fund advisers and money managers to pay higher brokerage commissions than they otherwise would, so long as they receive research services in exchange.
In 1986, the agency broadened its definition of research under Section 28(e), a 1975 amendment to the Securities Exchange Act of 1934, to include any product or service "that provides lawful and appropriate assistance to the money managers' investment decision-making process." The agency previously had defined research to comprise products and services not "readily and customarily available and offered to the general public on a commercial basis."
What's more, this amendment permits mutual fund advisers and other money managers to use one client's brokerage commissions to obtain research benefiting another, and does not require the investment advisers to allocate the cost of research among various clients.
"The question is of misuse and trust," noted Andrew M. Brooks, manager of the equity trading desk at T. Rowe Price, which manages $54 billion in assets primarily through mutual funds. A tighter SEC definition of research, detailing what types of services and products are acceptable, would shut down any abuses by mutual fund advisers, said Mr. Brooks, whose firm uses soft dollars "judiciously," he said.
"We would argue there is a deterioration in performance every time it is pre-determined where dollars go, vs. letting best execution determine where they go," said Harold S. Bradley, an outspoken critic of soft-dollar arrangements. "This money belongs to shareholders, not to us, and we are not afraid to disclose what we use," said Mr. Bradley, director of trading at Investors Research Corp., Kansas City, Mo., which manages the Twentieth Century family of mutual funds.
Investors Research, which generally shuns soft-dollar arrangements, paid a mere $110,000 or 0.2% of the $48 million it spent in brokerage commissions last year to purchase two reports requested by the funds' board of directors, Mr. Bradley said.
Mutual fund investment advisers and pension fund money managers earmarked more than $525 million of the $1.75 billion they spent on brokerage commissions last year to obtain soft-dollar research services from independent firms, Mr. Bradley has said.