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Can third-party payments benefit the principal?: The case of soft dollar brokerage

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  • Horan, Stephen M.
  • Johnsen, D. Bruce

Abstract

In a typical soft dollar arrangement, a security broker provides an institutional portfolio manager with credits to buy research from independent vendors in consideration for the manager's promise to send the broker premium commission business when trading his portfolio securities. Because portfolio investors implicitly pay for brokerage, critics argue soft dollars reflect a breach of loyalty in which the manager unjustly enriches himself by shifting to investors the research bill he should pay out of his own pocket. We hypothesize, to the contrary, that by paying the manager's research bill up-front the broker posts a quality-assuring performance bond that efficiently subsidizes the manager's investment research. Our database of private money managers shows premium commissions are positively related to risk-adjusted performance, suggesting soft dollars benefit investors. Premium commissions are also positively related to management fees, suggesting soft dollars are not a pure wealth transfer from investors that is competed away in the managerial labor market.

Suggested Citation

  • Horan, Stephen M. & Johnsen, D. Bruce, 2008. "Can third-party payments benefit the principal?: The case of soft dollar brokerage," International Review of Law and Economics, Elsevier, vol. 28(1), pages 56-77, March.
    • Handle: RePEc:eee:irlaec:v:28:y:2008:i:1:p:56-77
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    4. Jeremy Burke & Angela A. Hung & Jack Clift & Steven Garber & Joanne K. Yoong, 2015. "Impacts of Conflicts of Interest in the Financial Services Industry," Working Papers WR-1076, RAND Corporation.
    5. Habib, Michel & Johnsen, D. Bruce, 2015. "The quality-assuring role of mutual fund advisory fees," CEPR Discussion Papers 10438, C.E.P.R. Discussion Papers.

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