Portfolio Management, Private Information, and Soft Dollar Brokerage: Agency Theory and Evidence


This paper empirically examines the agency problems associated with the use of soft dollars in delegated portfolio management. We assume that active portfolio managers are hired to identify private information about mispriced securities, but in the absence of careful monitoring by investors or compensating organizational arrangements they will have too little incentive to do the necessary research. To the extent they nevertheless succeed in identifying mispriced securities, much of the value of the information can be lost to market interlopers due to low-quality broker executions. We develop two agency cost hypotheses for the role soft dollars play in active portfolio management. One hypothesis views soft dollars as a symptom of agency costs that allows money managers to unjustly enrich themselves at portfolio investors' expense. The other hypothesis views soft dollars as a method of reducing agency costs by encouraging optimal research and enforcing property rights to private information by bonding the quality of broker executions. Using a database of institutional money managers, we find that soft dollar use is positively related to different measures of risk-adjusted performance, suggesting that soft dollars reduce agency costs when other controls are uneconomic. Moreover, soft dollar use is unrelated to management fees, suggesting that managers do not use soft dollars to unjustly enrich themselves.