Amidst the wreckage brought on by the bust among technology stocks in 2000 and 2001, regulators and elected officials pointed to Wall Street research analysts as the culprits. These people, it was argued, were too close to the companies they were analyzing, and as positive research reports allegedly won investment-banking business for the blue chip Wall Street firms they worked for, analysts supposedly did the bidding for banking houses by writing glowing research reports about the companies they were covering.

Ever eager to be seen solving problems, regulators and legislators demanded that money managers of all stripes seek out independent research to use as a counterbalance in making investment decisions. Wall Street firms were supposedly too conflicted to offer unbiased opinions on companies, so independent research not connected in any way to investment banking fees would right the ship among money managers supposedly blinded by glowing research from the Street.

Wall Street firms were supposedly too conflicted to offer unbiased opinions on companies.

That story needs to be remembered, in light of SEC Chairman Christopher Cox’s push to get Congress to repeal legal protection of “soft-dollar” arrangements between money managers and traders. It is through the latter that many money managers are able to purchase outside research once deemed necessary by the powers-that-be.

Simply put, soft dollars are money that a broker takes in as a commission, but then spends as an institutional client (often a mutual fund) dictates—often on things like real-time news service subscription fees. These are effectively overhead costs, but they go on the books as a commission for stock trading and therefore do not count toward the mutual funds’ expense ratio.

Whenever a money manager trades with a big Wall Street firm like Goldman Sachs, he receives many “free” services such as GS research and invitations to Goldman-sponsored seminars and outings. Of course these services are not really free: the money manager pays for them in the form of commissions which, theoretically, could be lower if these extras were not provided. While services retained due to soft-dollar trading are certainly hidden in a money-manager’s trading costs, the perks offered by bulge-bracket firms are similarly obscured. Soft-dollar trading is a vehicle for a money manager to capture the same economics when he wishes to trade with a full-service Wall Street firm, but prefers independent to broker-sponsored research.

As the Wall Street Journal’s Judith Burns noted recently, “Congress gave the green light to so-called ’soft-dollar’ deals in 1975, on condition that such deals provide items that money managers can use to benefit investors, such as stock research.” Ignoring for a moment the desire of Congress to nose its way into private financial activities, money managers generate soft dollars when they run trades through certain brokers that specialize in the activity. Rather than the one-to-two cent per share charged by Wall Street firms possessing research analysts, they pay as much as five cents per share to soft-dollar brokers.

The latter then return a portion of commissions generated through the more expensive trades to the manager in the form of everything from office equipment to Bloomberg machines to independent research. For asset managers not yet established, soft dollars enable them to acquire technology and information necessary to compete with more established money-management firms who can pay for all manner of goods and services out of pocket.

Cox says the “fog that surrounds soft dollars makes investing harder, not easier for ordinary investors.” If that’s true, he needn’t worry about abolishing soft-dollar activities for the certainty that investors will seek managers who don’t confuse them with same. The same applies to his fear that soft-dollar trading isn’t always transparent. If so, the discerning investor concerned by this legal form of trading might look elsewhere.

Cox argues that there’s a conflict of interest when it comes to soft dollars in that they “may cause money managers to engage in excessive trading of client portfolios to obtain soft-dollar benefits.” The latter theory doesn’t hold up for the simple truth that investors, for good or bad, judge money managers based on past and existing returns. If managers trade for any reason other than to generate the greatest returns for clients, clients can switch to any of more than 8,000 mutual funds.

The abolition of soft dollars would tilt the playing field dramatically in favor of a handful of Wall Street giants... How soon Washington forgets.

Importantly, a ban on soft dollars would make it hard for the marginally profitable money manager to stay in business. For an SEC Chairman so concerned about the investor class, this is what should concern Cox the most. The existence of thousands of mutual funds insures a high level of competition that continues to compress fees, all the while driving managers to do best by their clients. Banning a process by which nascent funds are able to compete with larger entities is all to the good, and accrues to the small investor.

If the present bull market ends in tears, that managers are able to pay for outside research with soft dollars will hopefully cushion the money-management industry from more intrusive legislation; the kind that a free-marketeer such as Cox would certainly decry. Remember, it was the dearth of independent research that supposedly blinded money managers just seven years ago. The abolition of soft dollars would tilt the playing field dramatically in favor of a handful of Wall Street giants, and away from independent providers of investment advice. How soon Washington forgets.

Ultimately, Cox should see to it that that when people allocate their assets, they do so freely. Rather than outlaw the use of soft dollars, he should embrace the competition they engender. And if investors are not pleased with soft-dollar activity, a ban will be superfluous.

John Tamny is editor of RealClearMarkets. He can be reached at: jtamny@realclearmarkets.com  

Image credit: Photo by Flickr user Terrapin Flyer