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Seeking Hidden Costs : SEC Takes Hard Look at Brokers' Soft-Dollar Payments

November 19, 1996|BRETT D. FROMSON | WASHINGTON POST

One of the great hidden costs for mutual fund shareholders is the amount that funds pay for brokerage commissions, the fees they pay to buy and sell stocks and other securities.

And because brokerages are anxious to get trading business, there is the potential for abuse of so-called soft-dollar payments that brokers make to fund investment advisors in exchange for having trades steered to them.

Investors may be surprised to learn that commission costs are not included in their fund's expense ratio (expenses stated as a percentage of assets).

But the commissions, like other expenses, are paid from the net assets of the fund and thus are borne directly by shareholders.

The burden is far from incidental and can drag down fund performance, according to recent studies. Mutual funds will pay well over $1 billion in brokerage commissions to Wall Street firms, according to a study published earlier this year in the Journal of Financial Research.

Instead of being described in the prospectus, commission costs are included only in a fund's annual statement of additional information (SAI), which is not sent to shareholders unless they ask for it. Naturally, most investors don't bother to worry about the costs of investing during a bull market like today's, when they are making money.

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But mutual fund brokerage commissions are becoming a concern to the Securities and Exchange Commission.

The SEC is especially concerned about brokerages' soft-dollar payments.

The arrangement is called a soft-dollar transaction because the advisor receives these payments from the brokerages informally, essentially in exchange for the commission dollars.

Soft-dollar brokerage payments are supposed to be used for investment research that will benefit fund shareholders and other customers.

SEC Chairman Arthur Levitt said earlier this month that the commission will launch a targeted series of examinations of mutual funds, investment advisors and the brokerage houses with whom they do business.

Levitt and others at the SEC are concerned that investment advisors may be using soft-dollar payments to pay for expenses that should not come out of the mutual fund holdings of the fund customers.

Abusive shifting of advisor expenses to customers includes using soft-dollar brokerage payments to cover advisors' salaries, rent, vacations, heating and telephone bills, and car leases, for example, according to the SEC and investment managers. Any such expenses should come out of the fund expenses and be reflected in the expense ratio.

Another problem with soft-dollar brokerage services is that the commissions can be higher than those for trades in which there is no rebate, according to research by Greenwich Associates, a financial consulting company based in Connecticut.

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In addition, brokers may work less hard for funds that rely heavily on soft-dollar brokerage because they have to give some of the commission dollar to the investment advisor, according to Wall Street stock traders. That could mean that the fund does not get every opportunity to buy stock at the lowest available price and sell at the highest price.

Soft-dollar arrangements also complicate expense comparisons among funds. John Reckenthaler, editor of Morningstar Investor, notes in a forthcoming issue that the investment management company that picks stocks for the Twentieth Century funds eschews soft-dollar arrangements.

Brian Mattes, a spokesman for the Vanguard Group, which is well known for running low-cost funds, said transaction costs are a major reason why so many fund managers don't beat the market. Mattes and others advised mutual fund customers to avoid high-turnover funds unless they are convinced the manager is adding value to their investment return.

"The average stock mutual fund turns over about 85% of its holdings every year," Mattes said. "Unless the money manager is consistently picking winners, those transaction costs are a drag on fund performance."

Commission costs rise, of course, with the level of trading by a mutual fund. These costs also vary among types of funds. Small and overseas stock funds tend to have higher costs, whereas funds that invest in large-capitalization companies have lower commission expenses. This may reflect active trading or the difficulty of finding attractive small or foreign stocks.

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