What are soft dollar standards, and when do they create an ethical problem?

Soft dollars are a frequently tested ethics topic because they sit at the intersection of client duty and potential conflicts of interest.

What are soft dollars?

When a portfolio manager executes trades through a broker-dealer, the client pays commissions. Some broker-dealers offer "soft dollar" arrangements where a portion of those commissions pays for research services, trading systems, or other products that benefit the manager.

The CFA Institute Soft Dollar Standards:

The key principle: Soft dollar arrangements are permissible ONLY if the research or services received directly benefit the client, not just the manager.

Permissible uses of soft dollars (benefit clients):

• Research reports and databases (Bloomberg, FactSet subscriptions)
• Quantitative analysis tools and models
• Market data services
• Performance analytics software used for client portfolios

Impermissible uses (benefit the manager, not clients):

• Office rent and utilities
• Travel expenses
• Personal electronics (laptops, phones for personal use)
• General administrative overhead
• Marketing materials

The Three-Part Test:

Mixed-use items:

Some services benefit both the manager and clients (e.g., a computer used for both personal email and client research). In these cases, the manager should make a reasonable allocation — paying for the personal portion with hard dollars and only using soft dollars for the client-benefit portion.

Disclosure requirements:

• Managers must disclose soft dollar arrangements to clients
• Clients should understand how their commissions are being used
• Firms must maintain records of all soft dollar transactions

Example:

Kiran uses client commissions to subscribe to a proprietary equity research platform (permissible — directly aids investment decisions). She also uses soft dollars to pay for her Bloomberg terminal at home, which she uses 60% for client work and 40% for personal trading. She should pay 40% with hard dollars and only use soft dollars for the 60% client portion.

Exam tip: The exam tests whether you can distinguish between soft dollar uses that benefit clients (permissible) and those that only benefit the manager (violation). If the product/service doesn't directly help investment decisions for clients, it shouldn't be paid with soft dollars.

Master soft dollar concepts in our CFA Level I Ethics course.