Resistance to change on the part of mutual fund companies ETFs has cost them many assets over the years – especially when those changes benefit investors’ after-tax returns. ETFs tangibly improved after-tax-and-fee returns, transparency, efficiency, and accessibility...
The purpose of this whitepaper is to educate readers about a flaw in our market structure, that causes income-producing securities to trade “Dirty.” Dirty security pricing causes investors to pay inflated values for income-producing securities and then subjects investors to unjust taxation. Dirty security pricing is a systemic problem that results in investors buying fewer shares and incurring unnecessary losses each time they purchase a security or reinvest dividends. Dirty pricing, while mostly unknown to your average investor, is indeed disclosed as a risk in every investment fund prospectus. Investment fund accountants refer to this problem as “buying a dividend,” and it adversely impacts any investor who purchases securities that pay dividends, interest, or capital gains. Dividends, interest, and capital gains are otherwise known as realized income.
This paper uses simple examples to demonstrate how the system that we rely on for our financial well-being is quantifiably broken and does not serve us well. We also put forth a simple solution to fix the problems plaguing our markets. The solution, when implemented, increases the investment returns and buying power of any security that pays a dividend or capital gain. In addition to increasing the returns for the shareholders, asset managers are provided an opportunity to generate an additional stream of income from their investment funds by providing a value-added service.
There is a “Bug” in the System
“There is a bug in the system.” Those were the words of a prominent individual with a vast amount of experience in the securities industry with whom I had a conversation regarding the inefficiencies in our financial markets. The system this individual was referring to is the payment system that is used to account for and distribute income in the form of dividends, interest, and capital gains from a security issuer, to its owners. We will refer to this payment system as a “last holder of record system.” Under a last holder of record system, the last investor to own a security on a specific day (the ex-dividend day) is paid the entire monthly, quarterly or annual distribution, regardless of how long that investor owned their shares.
The last holder of record system creates a dilemma that, if not addressed, creates massive market structure problems. For the last holder of record system to function correctly, the market must disincentivize people attempting to “harvest dividends.” Harvesting dividends refers to the practice of buying a security the day before the ex-dividend day in an attempt to be paid the entire dividend or capital gain for the payment period, even though they only owned the security for one day. For the last holder of record system to work, the value of the security’s realized income must be reflected in the net asset value (NAV) or the price of the security. Therefore, when the dividend or capital gain is paid, the market and stock exchanges disincentivize people from harvesting dividends by dropping the price of the security by an amount equal to the dividend or capital gain payable. The word ex-dividend means “trading without a dividend.”
Dropping the value of a security by the amount of the dividend paid creates a zero-sum game. If an investor buys an investment fund today for $100.00 per share, that goes ex-dividend and pays a $.90 dividend tomorrow, they will be entitled to receive a $.90 per share dividend and the price of their shares will fall from $100.00 to $99.10. If you add up the gains and losses, the adjusted value of the shares, including the dividends owed, is still equal to $100.00. This investor was “paid” the entire dividend but has not earned any money.
But therein lies the problem. This investor will owe taxes on the $.90 per share dividend at their combined state and federal ordinary income tax rates. Assuming the investor resides in a high tax state, with an effective State and Federal tax rate of 50%, they will owe the IRS $.45 in taxes leaving the investor with a position that is now only worth $99.55 ($99.10 – current NAV plus a $.45 after-tax dividend). In less than 24 hours, this investor lost 45 basis points of their wealth.
Why did this Investor Lose Money?
The simple answer is that equities trade “Dirty.”
What Does Trading “Dirty” Mean?
A security is said to trade “Dirty” when the price an investor pays for the security includes the income that the security has generated since its last distribution. Typically, “Dirty” and “Clean” prices pertain to the bond markets. However, as we prove in this paper, income-producing securities, which include equities and registered investment funds, also have Dirty and Clean prices.
Therefore, there are two separate components that, when added together, compromise a Dirty price:
- the value of the security’s underlying assets
- the total amount of income that the security has generated since the last distribution payment was made
Generally, bonds trade at their Dirty price. A buyer of bonds will pay the seller the current price of the bonds plus the accrued interest income that the bonds have generated since their last coupon payment. Let us assume that an investor wishes to purchase bonds that pay a $4,000 semi-annual coupon, and this investor buys the bonds halfway through the semi-annual payment period. In this instance, the buyer will pay the seller the price of the bonds, plus an additional $2,000 in accrued interest (exactly half of the $4,000 semi-annual coupon). The price of the bonds plus accrued interest is considered the Dirty price.
At the end of the semi-annual period, the bond buyer will receive the entire coupon payment of $4,000. What is this investor’s tax liability? Does this investor owe taxes on the entire $4,000 coupon payment, just like the equity investor in the example above was taxed on the whole dividend? The short answer is that our bond market investor will only owe taxes on the income they earned, which equals $2,000. The bond market has a mechanism in place to prevent unjust taxation of income received. When this bond investor bought these bonds, as part of the payment, he/she also prepaid $2,000 of accrued income that the bonds generated up until the day of sale. Paying this accrued interest amount compensates the seller for the income they earned. The bond market and the IRS recognize that the bond buyer has already spent $2,000 of their own money to purchase/prepay the interest income. Therefore, on the buyer’s 1099-INT tax form, the accrued interest that was paid is recorded such that it can be deducted against the total coupon/interest payment resulting in net taxable interest income of $2,000 ($4,000 total coupon – $2,000 in accrued interest = $2,000 in taxable income). This process prevents the bond buyer from paying taxes on the return of the prepaid accrued interest they paid to the seller. Therefore, this procedure prevents the buyer from paying taxes on the return of their own money. The IRS has deemed the reimbursement of prepaid interest a “return of capital” and is, therefore, not a taxable event.
Unlike the equity markets, bond markets move much slower, allowing the accrued interest to be calculated and separated from the actual price of the bonds. The accrued interest can then be reported on the investor’s 1099-INT to prevent unjust taxation. Equity markets move too quickly to perform a similar task, and the income that has been accrued to the NAV of an equity security is unknown by investors. Thus, making it impossible to replicate the mechanism in the bond markets that prevents an investor from being taxed on the return of their own capital.
Can You Verify That Equities Trade Dirty with Historical Data?
Absolutely, the fact that equities trade Dirty is not theoretical. You can discover Dirty pricing for yourself by comparing the NAV of an index investment fund to its benchmark index. Consider the chart below. What we have done is to calculate the percent change of VFINX, an S&P 500 index fund, from a fixed date of 12-14-2018 – the fund’s ex-dividend date. Next, we calculate the percent change of the S&P 500 benchmark index also from a fixed or anchored date of 12-14-2018. Once the percent changes of each data series have been calculated, you subtract the percent change of VFINX from the percent change of the S&P 500 Index. The result of this calculation is represented in the chart below. We have been taught that an index fund should track identically with its index. This is not true.
What you see in the chart below is the accumulation of accrued dividends (the dividend premium) that are added to the value of the security. This process inflates the value of the security beyond what the securities underlying assets are worth. The sharp drop you see every quarter is the investment fund declaring/paying its dividends. The declaration of the dividend declares the dividends received as a “liability payable” to shareholders. Journaling this liability resets the value of the fund such that it now trades Clean – albeit only momentarily. As soon as the fund receives another dividend from one of its underlying holdings, the dividend premium begins to grow again. As you can see from the chart, this fund is accruing dividends almost on a daily basis, starting on the ex-dividend day, and lasting through the end of each payment period making it nearly impossible to buy this security without “buying a dividend.”
Does the Equity Market Provide a Fix for its Dirty Pricing Problem?
Unfortunately, the current last holder of record payment system DOES NOT provide a fix for investors who purchase any type of income-producing regulated investment fund (ETF’s, mutual funds, REITS, MLP’s, etc.) or single securities, such as IBM.
Like the bond markets, investors who purchase income-producing investment funds and single securities are making two very different purchases that have been combined into one price or net asset value (NAV).
Investors who purchase income-producing securities are buying two substantially different interests in a security:
- The value of the security’s underlying assets.
- The realized income (dividends, interest, and capital gains) that the investment fund has generated since its last distribution.
Investment funds are generally not permitted to earn a profit, and all, or substantially all, of an investment fund’s realized income must be distributed to investors periodically, or by year-end.
The act of purchasing an investment fund that has realized income included in its price is known in the industry as “buying a dividend.” There is absolutely ZERO economic value in buying a dividend.
If Equity Markets Do Not Have a Fix – Then What Happens When Investors Buy Equities?
When investors buy income-producing equity funds, two material events occur:
- The investor will be forced to pay more for the fund than it is worth because they had to purchase the realized income that was included in the fund’s NAV.
- Taxable investors will lose money because they will be subjected to paying taxes on the return of their own capital when the realized income that was purchased/prepaid when the security was bought is returned via a taxable dividend or capital gain distribution.
The act of overpaying for an asset, and then paying taxes on income that was not earned, causes a myriad of other performance problems, which include, but are not limited to, the following:
- Lower compound annual returns.
- Lower yields – fewer shares were purchased because of the premium paid.
- Inability to meet a benchmark return when an investor purchases an index fund. Investors who buy index funds believe 100% of their invested capital goes towards buying the securities that comprise the index. However, as we have proven here, the investor is also forced to purchase the accrued dividends and capital gains, in addition to the underlying securities. Hence, for an index fund that has accrued a capital gain and dividend representing 1% of the security’s value, only 99% of the investor’s capital is used to purchase the security’s underlying assets. This 1% deficit makes it nearly impossible for an investor to achieve a benchmark return because the benchmark return assumes that 100% of an investor’s capital is used to purchase the indexed securities.
- Higher volatility and tracking error – a result of inflating the NAV or price by an amount equal to the total value of the security’s realized income and then subsequently dropping the value of the security when the distributions are declared; creating tracking error and unnecessary volatility.
How Much More in Taxes are Investors Paying as a Result of Equities Trading Dirty?
To answer this question, let’s reexamine our previous example of the equity investor who bought a share of an investment fund for $100.00 and who earned a $.90 per share dividend the following day (the ex-dividend day). We will assume the $.90 per share dividend was accrued at a rate of $.01 per day for 90 days. Therefore, when the investor bought this investment fund, the fund had ~ $.89 of dividends that had been received from its underlying securities that are now included in the security’s price. This investor bought/prepaid $.89 per share worth of dividends and then earned an additional one day’s worth of dividend equal to $.01 per share for the one day the investor owned the fund. Calculating the taxes owed on the accrued dividend:
- $.89 * 50% tax rate = $.445 in taxes paid on the purchased dividend
- $.01 * 50% tax rate = $.005 in taxes paid on the earned dividend
- Total taxes owed on accrued dividends is $.45
Since the equity markets have a “bug,” and the investor does not get to deduct the purchased/prepaid dividend from the total dividend, this equity investor will pay taxes of $.45 instead of paying taxes on the income the investor earned. The taxes on the income earned by the investor is $.005.
This example demonstrates how this equity investor paid 89X more in taxes than they owed.
What About Capital Gains?
Let’s take our equity investor example one step further by adding in a capital gain. Purchasing an investment fund with an embedded capital gain can be even more punitive than buying accrued dividends. In 2018, it was estimated that 86% of mutual funds paid a capital gain. The average capital gain distribution in 2018 was 11% of a mutual fund’s total assets. For our equity example, we will assume that in addition to a $.90 per share accrued dividend, the fund also has an embedded capital gain equal to 8% of the NAV, or $8.00 per share, which will remain unchanged until distributed. Assuming this level of capital gain remains constant, when the capital gain is distributed, our equity investor will owe taxes on the capital gain, as well as the dividend. Capital gains distributions can be classified as either long-term or short-term and are taxed at different rates. We will assume that 50% of the total capital gain is taxed at an ordinary income tax rate of 50%. The remaining 50% of the capital gain is taxed at long-term capital gains rates equal to 30% (both tax rates represent combined state and federal taxes).
Calculating the taxes owed on the accrued capital gain:
- $4.00 * 50% = $2.00 (ordinary income rate)
- $4.00 * 30% = $1.20 (long-term capital gains rate)
- Total taxed owed on capital gains is = $3.20 ($2.00 + $1.20)
How Much Did Our Equity Investor Overpay in Taxes?
Finally, let us calculate the actual income this investor earned, the total amount of taxes the investor is required to pay on the capital gain and dividend distribution in a last holder of record system and lastly, the taxes the investor should owe if they were not subjected to paying taxes on the return of their own capital.
- $.005 – taxes paid on actual income earned by the investor
- $.445 – taxes paid based on the return of the dividend that was purchased
- $3.20 – taxes paid on the capital gain that was bought and then distributed
- $3.65 – total taxes paid
Of the total taxes paid of $3.65, the investor should have only paid $.005. That means that 99.86% of the taxes paid by this investor should not be owed. This investor, unfortunately, paid 729X (seven hundred twenty-nine times) more in taxes than they should have paid.
Question – is it acceptable for a hardworking and responsible investor to pay 729X more in taxes than they should owe? This is the unfortunate reality of the system we rely on for our financial well-being.
How is it Possible that our Equity Investor Overpaid by This Much?
The regrettable answer is that this equity investor was forced to pay taxes on all the income and capital gains the investment fund earned BEFORE the equity investor bought their shares. Even though the equity investor did not earn this income or capital gain, they are now responsible for paying taxes on it anyway.
In essence, buying a dividend or a capital gain is equivalent to buying someone else’s taxable liability.
Are you OK with paying taxes on the income that someone else earned?
Does this Mean the Seller Pays No Tax? – Double Taxation of the Same Dollar
Unfortunately, this is not a zero-sum game. The seller of the equity securities will also pay tax in the form of a capital gain. Remember, the income that a security generates is accumulated to the price of the security – pushing the security value higher than what the security is worth. That appreciation increases the value of the security by the amount of the income collected. Therefore, a security whose underlying assets are worth $100.00 per share, and that has generated $1.00 per share of income, will be priced at $101.00. The seller who sells this security to a buyer will realize the income that the security generates in the form of a $1.00 per share capital gain – instead of being paid a $1.00 per share dividend.
We now have a situation where the same dollar of realized income is being taxed twice. Once as a capital gain realized and paid by the seller, and then again, as dividend income when the realized income is paid to the buyer as a dividend distribution.
How Does Dirty Pricing Affect Purchasing Power?
Unfortunately, the harm caused by the last holder of record system extends beyond unjust taxation. Dirty pricing also negatively impacts the number of shares an investor can purchase, as well as the annualized yields that will continue into perpetuity.
Let us consider what the impact of Dirty pricing has on our equity investor. We know that there was a $.89 dividend and an $8.00 per share capital gain that was included in the price of the $100.00 per share investment fund when it was purchased.
- Dirty Price = $100.00 per share
- Clean Price = $91.11 per share ($100.00 less $8.89 per share in dividends and capital gains)
Assuming this investor wishes to purchase $1,000,000 worth of this investment fund, they will end up with the following share amounts based on Clean and Dirty pricing.
- Dirty Price # of Shares Purchased = 10,000 ($1,000,000 / $100.00)
- Clean Price # of Shares Purchased = 10,975 ($1,000,000 / $91.11)
The Dirty pricing results in our equity investor buying 975 fewer shares with an identical amount of capital for a fund made up of the same securities in equal amounts. Furthermore, since our investment fund pays a $3.60 per share annual dividend, the investor who purchased the Dirty priced investment fund will realize an annual yield that is $3,510 less than the yield that an investor would achieve by buying an investment fund utilizing Clean pricing.
The two charts below demonstrate the difference in Clean and Dirty pricing for a security that pays a .90% quarterly dividend, has 8% appreciation, and generated an 8% capital gain. It is assumed that dividends, security appreciation, and capital gains accrue evenly over the year. This demonstrates why many investors do not buy mutual funds in the 4th quarter of the year – because of the embedded capital gains.
How Can I Determine my Tax Liability Before I Purchase a Security?
As a general rule of thumb, one must determine an estimate of both the accrued dividends and embedded capital gains that exist in a security as a percentage of the price. You then multiply this realized income percentage by the total amount of money you intend on investing. This product gives you the total amount of your money that will go towards buying dividends and capital gains. Finally, you multiply the amount of money that was used to purchase dividends and capital gains by your personal income tax rate. Keep in mind that some distributions are taxed differently depending on their income classification. Staying with our equity investor example, if this investor bought $1,000,000 worth of an investment fund described above, they would be subjected to paying the following taxes that this investor should not owe.
- Tax on Dividend Purchased = (($.89 / $100.00) * $1,000,000) * 50%) = $4,450.00
- Tax on short-term capital gain = (($4.00 / $100.00) * $1,000,000) *50%) = $20,000
- Tax on long-term capital gain = (($4.00 / $100.00) * $1,000,000) * 30%) = $12,000
- Total unnecessary taxes paid = $36,450
This investor suffers a $36,450 avoidable and unnecessary loss equal to 3.64% of their invested capital. This loss quantifies how inadequate the last holder of record system is and proves why it must be replaced.
What Do Investment Funds Say About Equities Trading Dirty?
Consider what BlackRock says about “buying a dividend” in the underlined text below:
“Buying a dividend” refers to purchasing a mutual fund just prior to a distribution by that fund. If the fund is held in a taxable account, this generates an unnecessary tax bill. In essence, a portion of the investment is returned to the investor as a taxable distribution.
Investment funds disclose this risk to investors. The underlined text above proves the arguments made in this paper. Investors are subjected to an unnecessary tax bill each time they buy income-producing assets because they are taxed on the return of their own capital.
Who is to Blame?
We live in a society that, instead of focusing on a solution, we resort to blaming someone else. There is no one to blame for the way our current last holder of record system works. The last holder of record distribution system most likely began in the 1400s when bonds became an investable asset. Before fast computers and databases existed, the last holder of record system operated as a means to compensate sellers for the income they earned if they sold their security before a distribution. In a last holder of record system, only the last holder of record is paid. Sellers who sell their securities before the distribution receive no income. The last holder of record system, while archaic and inefficient, provides sellers the income they earned in the form of a capital gain, instead of an income distribution.
Can the Last Holder of Record System be Fixed?
Yes, the last holder of record system can be fixed. My partner and I have dedicated a substantial amount of research and development time and money to provide the market with a simple fix. This fix can be implemented quickly and can be used on any existing or new investment fund, or on single securities. We have filed four PCT Utility patents covering the systems and methods needed to fix this issue for every investor in 153 different countries where we have patent protection under the Patent Cooperation Treaty (PCT).
The simple solution needed to solve this problem is to improve the security’s accounting and accrue dividends and capital gains in real time for what they are – liabilities. Unfortunately, this solution is not possible as long as we continue operating under a last holder of record payment system. If a security trades at its Clean price, it is not possible to drop the price of the security by the amount of the distribution. Remember, for a last holder of record system to function correctly, there must be a mandatory drop in the price of the security on the ex-dividend day. This drop in price prevents people from “gaming the system” and harvesting the distribution. If dropping the security price by the amount of the distribution is not possible because the security is priced Clean, then structural chaos will ensue because investors will rush in to buy a security the day before the ex-dividend day to harvest the distribution.
To improve the accounting, we must engineer new payment systems and methods. FairShares has built, and filed patents, on a new system that allows income-producing securities to price Clean. Clean security pricing all but guarantees that 1) a security will be priced fairly, and 2) that investors will only pay taxes on the income they earned, and not on the return of their capital. With FairShares, securities trade Clean, so there is no need to drop the price of the security on the ex-dividend day, and a security will track almost identically to its benchmark or index.
While the systems and methods needed to affect Clean pricing are not obvious and have eluded the stock market since its infancy, fixing our broken system is simple, eloquent, and above all, fair to all investors.
How Does FairShares Work?
FairShares partners with investment managers to solve their two biggest problems:
- fee compression
FairShares is a value-added service that an investment manager can offer their shareholders for a fee. FairShares allows investment managers to equitably distribute realized income to ALL of a fund’s shareholders based on their pro-rata ownership for the payment period. This process differs substantially from the last holder of record system, which only distributes income to the last shareholders of record. FairShares creates tangible value. Therefore, managers can charge a premium management fee for a fund that uses FairShares technology. The premium fee boosts the revenue the fund generates, all while providing additional value to its shareholders.
Providing Clean pricing is a win-win for the entire industry. Investment funds that utilize FairShares technology will enjoy a competitive advantage over a traditional investment fund structure and, as a result, will gather more assets under management as fiduciaries reallocate assets away from Dirty assets and into Clean assets.
FairShares is an intellectual property company and licenses its systems and methods to investment managers and other service providers for a nominal fee.
Can FairShares Enable Fixed Income to Trade Clean?
Yes, our intellectual property portfolio covers the systems and methods needed to allow investors to buy and sell bonds at their “Clean” prices. This means that buyers of bonds no longer need to pay accrued interest when purchasing bonds, allowing them to buy more bonds and earn higher returns.
The act of prepaying accrued interest when purchasing bonds is equivalent to providing a 0% interest bridge loan to the seller. Because of the prepaid interest, the buyer was forced to pay more for the bonds than they were worth and will now realize a lower total return. This is yet another example of the inefficiencies present in the antiquated last holder of record system.
FairShares technology will revolutionize global fixed income markets, making them more efficient.
Can FairShares Make Single Equity Securities, Like IBM, Price Clean?
Yes, the only requirement of FairShares to make a security trade Clean is a complete record of shareholder ownership.
Do Asset Managers Generate Less Revenue as a Result of Clean NAV Pricing?
Absolutely not. Asset managers who offer FairShares proprietary equitable distribution service to their shareholders will make more money. Asset managers will bill on a value equal to the Clean NAV plus the investment fund’s realized income. Billing in this manner ensures that they are billing on the actual value of assets the fund manages. Therefore, market participants will transact at the Clean NAV. However, asset managers will still earn an equivalent amount of income when compared with Dirty NAV pricing.
Furthermore, providing investors with FairShares, “Clean pricing” means that they will earn higher returns and have more money to invest. When investors make more money, so do their asset managers. Finally, asset managers can earn an additional fee from each of their investment funds, bolstering the revenue generated, and belaying fee compression.
Because fixing the broken last holder of record system is the right thing to do for the investment community.
Investment managers owe a fiduciary duty to their shareholders to reduce the total cost of ownership of the securities they offer. Until now, there was no viable alternative to the last holder of record system. This whitepaper clearly shows there is a better way and a brighter path forward for investors and investment fund managers alike. It does not make sense that the system society relies on, causes irreparable harm, each time they make a responsible decision to save for their retirement.
It is with 100% certainty that FairShares can improve the investment returns of any security that pays a dividend or capital gain. Markets cannot be efficient without FairShares.
The purpose of this paper is to inform the reader that “Clean” security pricing is a reality. Market participants, including security issuers and stock exchanges, should embrace Clean pricing and encourage others to learn more about the advantages of Clean vs. Dirty pricing. This paper quantifies the improvements in security performance when applying Clean pricing to mutual funds, ETF’s, and single securities. The whitepaper continues by showing how even fixed income markets can be made more efficient by adopting Clean pricing fundamentals.
At FairShares, we look forward to working with investment managers, stock exchanges, transfer agents, and custodians to create a genuinely efficient market resulting in better financial outcomes for investors and asset managers worldwide.