Who actually pays for your advisor’s research?
Somebody buys the research reports, the market data, and the analytics software. It is almost never the firm that uses them. It is usually the trading commission that came out of your account.
Consumer education, not investment advice. Paul Powell is not currently a licensed financial advisor.
Soft dollars are what happens when the firm managing your money sends its trades to a particular broker, pays that broker more commission than the trade required, and gets research, data, or software back in return. The research is free to the firm. The commission is not free to you. Congress wrote a law in 1975 that says this is allowed.
The commission is doing two jobs
Start with the decision nobody tells you is being made. When a manager has discretion over your account, they don’t just decide what to buy. They decide who executes the trade. And the broker on the other end of that decision is selling more than execution.
Brokers hand managers research reports, market data feeds, trade analytics, order-management tools, and access to their analysts. The manager could write a check for all of it. Instead, the manager routes the trades and pays a commission above the lowest rate available — and the difference buys the research. No invoice. No line on anybody’s expense budget.
The industry calls that arrangement soft dollars. Hard dollars are what you pay for something out of your own pocket. Soft dollars are what you pay for it with somebody else’s.
And that “somebody else” is the client. The safe harbor covers client commissions on agency trades, which is a polite way of saying the money leaves your account, not the manager’s. Your advisory fee is a number you agreed to. Your trading costs are a number nobody quoted you.
You don’t have to take my word for how the conflict works, because the SEC makes advisers write it down themselves. Form ADV Part 2A, Item 12, instructs the adviser to explain that when they use client commissions to obtain research, “you receive a benefit because you do not have to produce or pay for the research,” and to disclose that “you may have an incentive to select or recommend a broker-dealer based on your interest in receiving the research or other products or services, rather than on your clients’ interest in receiving most favorable execution.” That is the regulator dictating the confession and the firm signing it.
There are limits on what the commission can buy. The SEC’s 2006 guidance says company research, market data, trade analytics, market color and advice on execution strategy are eligible. Mass-marketed publications are not. Neither are overhead, computer hardware, office rent, salaries, or travel.
Those limits exist because the practice drifted badly. When the SEC’s examiners swept the industry in 1998, they found that 28% of the money managers and 35% of the broker-dealers examined had entered into at least one arrangement outside the safe harbor. Things clients’ commissions had paid for included office rent, utilities, carpeting, professional dues, CFA exam review courses, entertainment, meals, travel, and salaries. The examiners’ sharpest finding was not the spending. It was that virtually all of the advisers buying non-research items had failed to give clients meaningful disclosure of it.
That report is from 1998, and it is the reason the 2006 guidance exists. The rules are tighter now. The structure is identical.
Completely. Congress wrote it down.
Section 28(e) of the Securities Exchange Act says a manager with investment discretion has not breached their fiduciary duty “solely by reason of” paying a commission larger than another broker would have charged, so long as the manager “determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage and research services provided.” It is a safe harbor, added in 1975, and it is doing exactly what it says.
Ask yourself why a safe harbor was necessary in the first place. You only need a law saying “this is not a breach of fiduciary duty” for conduct that otherwise looks like one. Spending a client’s money above what the job required, to buy something you would otherwise have to buy yourself, is the textbook shape of a conflict. Congress didn’t decide it wasn’t a conflict. Congress decided the conflict was worth allowing — if the manager acts in good faith and tells you. The good faith is theirs to determine. The telling is buried in a document most clients never open.
Item 12 is already written. Go read it.
This one is unusually easy to check, because the disclosure is mandatory and it lives in a predictable place. Pull your advisory firm’s Form ADV Part 2A brochure — the same free public file you’d pull for a background check — and turn to Item 12, “Brokerage Practices.”
Three things to look for. Whether the firm says it may pay commissions higher than other brokers charge in return for those benefits — the form calls that “paying-up.” Whether the benefits are used for all client accounts or only the accounts that generated the credits, because those are not the same deal. And the list of what they actually acquired with client commissions in the last fiscal year, which the SEC requires to be specific enough for you to evaluate the conflict.
Then apply the ordinary standard from the Method: anything that affects what you pay gets answered in writing, before you hire. Soft dollars belong in the same written round as fees and conflicts — the round covered by the 12 questions.
“Do you or any related person receive research, data, software, or any other product or service from a broker-dealer in connection with my trades? If so: list what you received last fiscal year, state whether you pay commission rates higher than the lowest available in order to receive it, and tell me whether those benefits are used for all client accounts or only the accounts that generated the credits.”
An honest answer to that costs a good firm ten minutes, because Item 12 already says it. A firm that can’t produce it in writing has told you something too.
You’ve read your fee schedule. Have you ever read your trading costs?
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