When a Soft Touch Is Anything But

A ‘soft touch’ conjures up thoughts of someone who is easy prey, gullible and vulnerable to theft. In the context of financial services, a light touch regulation speaks of a more flexible and relaxed approach to regulatory oversight. For many years in the US and Europe, the world’s largest trading bloc, the rule of law has given birth to financial services legislation and banking supervision aimed at protecting the consumer. However, the reality is that in spite of a raft of regulations and edicts, for too long and in too many instances, the mutual fund industry has taken advantage of the consumer, in many cases causing permanent loss of capital. Sadly, when ethics meet profitability, profitability wins.

I mention this by way of introduction to ‘soft dollars’, a term used in the industry to describe the benefits received by a financial intermediary or broker dealer as a result of commissions earned on a transaction: in essence a kickback from broker to trader, funding both investment-related and non-investment-related goods and services. Investors pay an inflated commission to trade securities, reducing overall investment returns. The benefit, in the form of goods and services, accrues directly to the fund manager. The cost of the ‘soft dollar’ goods and services would otherwise have come from the fund’s management fee. Soft dollars represent a well-disguised increase in fees.

Commission may also result when a manager or intermediary allocates money to a fund. Today, many financial institutions are owned by multinational corporations that may also own life assurance and pension companies, which are themselves producers of financial products. This is a clear conflict of interest between principal and agent.

Whatever the currency, the practice of taking ‘soft dollars’ is now subject to legislation in the US and Europe, but legislation is only as effective as robust policing and penalties. In reality, neither is aggressively pursued, with the result that in some instances financial intermediaries are still inflating prices that are not disclosed. Recent cases successfully investigated and prosecuted by legal counsel acting for account holders is proof that, in spite of regulation, this practice continues. Commissions are inflated and swallowed up in trading. Over time, this ‘market impact cost’ will reduce the performance of a portfolio. Deliberate lack of transparency makes it difficult for the investor to accurately obtain true costs. The investors must dig for the information because it will not show up in the portfolio valuation.

When fiduciary responsibility to investors competes with corporate desire for profits, profits win. As investors, we must be vigilant. Since its birth in 1924, the mutual fund industry has not ceased its creative efforts to find visible and less visible means to take advantage of individual investors.

Jeremy Blatch TEP
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