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New York—A recent survey of compliance officers at SEC-registered investment advisors shows continuing confusion about the topic of soft dollars.   Two years have passed since the SEC clarified that the use of bundled commissions to purchase broker/dealer research is a form of soft dollars, yet distinctions are still being drawn between ‘soft dollars’ and ‘proprietary research’.  As one example, only 33% of respondents said they rely on 28(e) for soft dollar purchases, yet 82% of the respondents pay bundled commissions for full-service brokerage research.  And these were compliance officers…

Soft dollars or sticky dollars?

The headline finding of the study was that 63% of the firms “avoid soft dollars,” up from 59% the previous year.  Avoiding soft dollars means:

“Our firm does not actively seek out soft dollar products and services; to the extent we can, we avoid soft dollar usage.  While full service brokerage firms provide us with their own research materials (proprietary research) and other products, we do not request such materials and often discard them unread.”

We are meant to believe that the brokers are forcing their research on the reluctant asset managers.  This is misleading at best.  First of all, asset managers are demanding a variety of research services from full service brokers, ranging from access to management to bespoke research, all of which are paid through commissions.  Secondly, brokers are cutting off the research supplied to their clients unless they commit to certain thresholds of commission spending.  If the firms are getting sell-side research, you can be sure that they are paying for it.

Remedial reading of Section 28(e) required…

Another bizarre aspect of the study is the apparent distinction between the safe harbor provided by Section 28(e) of the Securities Act of 1934, which permits the use of commissions to pay for research, and ‘proprietary’ research from full service broker dealers.  Only 33% of compliance officers surveyed said they rely on 28(e), while 82% of the compliance officers surveyed use proprietary research paid for through bundled commissions.  Hello?  What do you think allows you to use bundled commissions to purchase proprietary research?

The minority of compliance officers that ‘fessed up’ to using 28(e) chose this option:

“We do rely on soft dollars to purchase certain products and services within the 28(e) safe harbor.  In addition to proprietary research, we also receive outside research and other products and services from third party providers, paid for by our broker-dealers.”

At the same time, for the 82% that use proprietary research, most (93%) do not ‘unbundle’ proprietary commissions.  The remaining 7% attempt to place a dollar value on proprietary research through a variety of techniques, such as broker votes or comparison to third party research. 

The survey

The online survey, conducted in March 2008, received responses from 409 compliance professionals at SEC-registered investment advisors.  Most of the respondents were from small firms (79% of the firms had less than 50 employees and 45% had assets under $500 million.)  Since most hedge funds are unregistered, the majority of the respondents were long-only managers.  The survey was organized by ACA Compliance Group, the Investment Advisor Association, IM Insight and Old Mutual Asset Management.

What about hedge funds?

The survey highlights the continuing befuddlement surrounding soft dollars, despite attempts by the SEC to provide guidance and clarification.  The biggest irony in the situation is that hedge funds, which are largely unregulated by the SEC, are generally far more transparent in their use of soft dollars.  The majority of hedge funds disclose in their prospectuses their use of soft dollars, and they make no apologies to their investors.   

We have seen in our own surveys significant differences between the way hedge funds and long only use research.  Hedge funds are more proactive in seeking out innovative, alpha-generating research, and they are more rigorous in reviewing and culling under-performing sources of research. 

Perhaps long-only managers can learn from the experience of hedge funds.  They can come clean on the use of soft dollars without dire consequences, as long as clients understand that commissions are being used for good research that generates returns.  Less time and energy can be spent obfuscating, and redirected to better managing the research they receive.

The full survey can be found at http://www.acacompliancegroup.com/documents/2008%20IM%20Survey%206-30-08.pdf