More on hidden fees- soft dollars anyone?

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As you know by now, mutual funds have hidden fees in the form of institutional brokerage commissions, that are passed on to fund investors.

In the previous post, I detailed how mutual funds pays their brokerage firm(s) a certain amount per share (i.e. 4 cents a share), to buy or sell stocks or bonds, in bulk.

These trading commissions are looked upon as ‘hidden costs’ because most investors are unaware of their existence and mutual funds are not required to tell you about them. And getting published information about the whereabouts of these fees is not easy.

A new component

Well, lets add something new to the mix. Another shady component of these trading costs are something called ’soft dollars’. Now this is a little tricky so I want you to stay with me here.

Soft dollars are a way for mutual funds to defray some of their costs, by accepting larger than normal commissions from their broker, in exchange for various services provided by said broker.

In essence, instead of paying hard (real) dollars for things like trade research, new computer equipment, trading software, etc., mutual funds allow themselves to be charged inflated commissions. In return, the broker provides all the above items, and is made whole by adding the cost of said items on to the top of brokerage commissions they charge the mutual fund.

Its a sneaky way for mutual funds to hide these capital costs; by commingling them with trading costs, rarely viewed by investors. This way it never ends up inside the prospectus (and the living rooms of fund investors) but instead in the Statement of Additional Information.

A typical soft dollar arrangement works something like this…

Brokerage firm ABC Co. buys and sells stocks for BigWigFund. BigWig and ABC have been doing business for quite sometime. Normally, they charge BigWigFund 3 cents a share to buy or sell XYZ stock. But ABC Co. just bought brand new computer equipment for BigWigFund’s offices.

Instead of paying ABC Co. (in real dollars) for the new computers, BigWig agrees to allow ABC Co. to charge them 3 1/2 cents a share to make up for the cost of the new computers. This way BigWigFund doesn’t have to show the computers as a ‘publishable’ expense and can wrap the cost of the new computers into trading commissions.

Therefore artificially suppressing the perceived costs associated with the fund. (Man o man, I had to stop 3x while writing that sentence. It’s damn confusing to me and I wrote it)

In conclusion

That’s how the soft dollar payment scenario works, more or less. Like I like to say, “out of sight, out of mind.” After the last 2 posts, I might have to change the expression I use to describe mutual funds to: “it’s all smoke and mirrors baby…”

• Here’s a good article I came across (from July 2007) that reiterates a lot of the points I’ve made in the last two posts.
• Another article that touches on the soft dollar issue, but goes into scary detail about some of the inherent conflicts of not having fee transparency in the mutual fund business.

Tags: Hidden fees, Mutual Funds, soft dollars