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Soft dollars are a means of paying brokerage firms for their services through commission revenue, as opposed to through hard-dollar direct payments.
The investing public tends to have a negative perception of soft-dollar arrangements. Many investors believe that buy-side firms should pay expenses out of their own profits. As a result, the use of hard-dollar compensation is becoming more common.
KEY TAKEAWAYS
Soft dollars are commission payments to a brokerage firm that are used, in part, to pay for other services such as research.
Soft-dollar transactions are frequently criticized for lacking transparency and hiding abuses.
Soft dollars are sometimes defended as providing access to a greater variety of research.
How a Soft-Dollar Transaction Works
Suppose that an institutional investor pays a brokerage firm six cents per share in commissions. However, it might only cost three cents per share to perform the trade. The other three cents are soft dollars used to pay for additional services provided by the brokerage. In exchange for paying these higher fees, the institutional investor might receive access to research. https://stockstrategy.net/
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Under the right conditions, none of the above presents a problem for the Securities and Exchange Commission (SEC). The regulator is willing to permit soft-dollar transactions, provided that the investor gets good execution, and the commissions are reasonable.
Criticism of Soft Dollars
Mutual fund investors pay the costs of research and other bundled services provided in the soft-dollar transaction. Yet these costs are not disclosed by the fund. They are simply part of the costs of trades, and they impact the long-term performance of the fund.
Technically, the mutual fund would disclose the hard cost of research in its management fee. However, that charge is not paid from the management fee when it is paid for with soft dollars. The fund managers argue that institutional investors ultimately bear all of the costs. However, using soft dollars to pay for research doesn't allow investors to conduct an accurate cost analysis when selecting the fund.
Soft dollar values are not determinable, nor are they equal. What one investment manager receives in the form of services may differ from what another manager gets. That opens the door for conflicts and abuses. The mutual fund investors never know what portion of their transaction costs are applied to the soft services or their actual investment.
Although soft-dollar transactions are still widely used, there is a growing movement to eliminate them. That is especially true as financial reform and issues of transparency become more important in the industry.
Benefits of Soft Dollars
Soft dollars can provide some benefits to investors. One of the main arguments is that they offer access to a greater variety of research.
For instance, investment advisors can use all the research material obtained through soft dollars to benefit all of their clients. According to defenders of soft dollars, eliminating this practice could hinder research efforts by investment advisors and lower returns for their clients. https://stockstrategy.net/
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Example of Soft Dollars
A mutual fund may offer to pay for research from a brokerage firm by executing trades at the brokerage.
Assume that a large-cap value fund wants to buy some research from XYZ Brokerage Firm. The fund may agree to spend at least $10,000 in commissions for brokerage services in return for the research, which would be a soft-dollar payment. If the fund simply wanted to buy the research, it might have to pay the brokerage firm $7,000 in hard dollars (cash) instead.
Real-World Example of Soft Dollars
In 2013, the SEC levied sanctions against New York brokerage firm Instinet, LLC. Instinet did not flag payments of more than $400,000 in soft dollars to San Diego-based advisor J.S. Oliver Capital Management. However, there were clear signs that the money was used for dubious purposes and not properly disclosed to clients.
The SEC found that associates at J.S. Oliver Capital had misused the soft-dollar payments. Ultimately, the SEC ruled that Instinet overlooked the misuse of the soft dollars and settled with the company for about $800,000.
Traders or investors may choose to use a stop-loss order to limit their losses and protect their profits. By placing a stop-loss order, they can manage risk by exiting a position if the price for their security starts moving in the direction opposite to the position that they've taken.
A stop-loss order to sell is a customer order that instructs a broker to sell a security if the market price for it drops to or below a specified stop price. A stop-loss order to buy sets the stop price above the current market price.
Advantage Over a Stop-Limit Order
A stop-loss order becomes a market order to be executed at the best available price if the price of a security reaches the stop price. A stop-limit order also triggers at the stop price. However, the limit order might not be executed because it is an order to execute at a specific (limit) price. Thus, the stop-loss order removes the risk that a position won't be closed out as the stock price continues to fall.
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Potential Disadvantages
One disadvantage of the stop-loss order concerns price gaps. If a stock price suddenly gaps below (or above) the stop price, the order would trigger. The stock would be sold (or bought) at the next available price even if the stock is trading sharply away from your stop loss level.
Another disadvantage concerns getting stopped out in a choppy market that quickly reverses itself and resumes in the direction that was beneficial to your position.
Investors can create a more flexible stop-loss order by combining it with a trailing stop. A trailing stop is an order whose stop price, rather than being a fixed price, is instead set at a certain percentage or dollar amount below (or above) the current market price. So, for instance, as the price of a security that you own moves up, the stop price moves up with it, allowing you to lock in some profit as you continue to be protected from downside risk.
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Benefits of Stop-Loss Orders
Stop-loss orders are a smart and easy way to manage the risk of loss on a trade.
They can help traders lock in profit.
Every investor can make them a part of their investment strategy.
They add discipline to an investor's short-term trading efforts.
They take emotions out of trading.
They eliminate the need to monitor investments on a daily (or hourly) basis.
Examples of Stop-Loss Orders
A trader buys 100 shares of XYZ Company for $100 and sets a stop-loss order at $90. The stock declines over the next few weeks and falls below $90. The trader's stop-loss order gets triggered and the position is sold at $89.95 for a minor loss. The market continues trending downward.
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A trader buys 500 shares of ABC Corporation for $100 and sets a stop-loss order for $90. After the market closes, the business reports unfavorable earnings results. When the market opens the next day, ABC's stock price gaps down. The trader's stop-loss order is triggered. The order gets executed at a price of $70.00 for a substantial loss. However, the market continues dropping and closes at 49.50. While the stop-loss order couldn't protect the trader as originally intended, it still limited the loss to much less than it could have been.
What's a Stop-Loss Order?
It's an order placed once you've taken a position in a security (on the buy side or sell side) with instructions to close out your position by selling (or buying) the security at the market if the price of the security reaches a specific level.
How Does a Stop-Loss Order Limit Loss?
A stop-loss order limits your exposure to less of a loss than you might otherwise experience by automatically closing out your position if your stock trades to an unfavorable market price level that you designate. If you use a trailing stop with your stop-loss order, that protection can move with your position even as it increases in value. So, a loss could translate to less profit rather than a complete loss.
Do Long-Term Investors Need Stop-Loss Orders?
Probably not. Long-term investors shouldn't be overly concerned with market fluctuations because they're in the market for the long haul and can wait for it to recover from downturns. However, they can and should evaluate market drops to determine if some action is called for. For example, a downturn could provide the opportunity to add to their positions, rather than to exit them.