The term soft dollars refers to payment mutual funds and other money managers to their service providers. The difference between soft and hard dollars is that instead of having to pay the providers of funds (i.e. dollars), the mutual Fund will pay in-kind (i.e., soft dollars) by transferring business of the brokerage.
Let’s look at an example: LLP Wittenberg Fund provides MegaMutual with computer hardware and software for the transmission of information about investments. In accordance with the agreement or arrangement between two firms, MegaMutual will pay for these services by directing trades to Feral hitch, a large brokerage firm. Feral hitch will charge extra for transactions with MegaMutual. The money from these fees will be directed to Wittenberg, which, in turn, receives compensation for their services MegaMutual. The added fee usually amounts to tenths of a percent, but MegaMutual billions of stock trades per day, the amount adds up to real money – the fees would have to pay in hard dollars.
Soft dollars is a way for mutual funds to get services without having to pay for them directly. A hard dollar payment would require a check issued and registered in the books MegaMutual, and the expenses must be transferred to the investors through an annual contribution to the Fund. With soft dollars, the expenses are hidden in the trading costs. Although the practice is not illegal, and the end result is the same (the investors pay), does not help investors analyze the costs of using one mutual Fund versus another.
Soft dollars became an increasingly important issue, as wall Street activity, more attention was given after the fall of the Internet companies. Still the practice has been around for a very long time, and the rules governing its use. According to Harold Bradley (senior Vice President American century investments), the Fund company is estimated at $10 billion annually in soft dollars. Association for investment management and research has set standards for the use of soft dollars in order to delineate and limit possible abuse. For more information, please visit their website: http://www.aimr.org/featuring/modules/softdollar/readings.html.