Equities Trade “DIRTY” – What that Means and Why it Matters

Overview: 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...

The purpose of this article is to outline some of the many competitive advantages that investment managers will realize as a result of using FairShares’ technology.  We will explain how the use of FairShares technology will increase the revenue earned by investment managers and improve the compound annual returns of their shareholders, making FairShares a win/win for all market participants.

It is also essential to understand the industry’s competitive landscape. The competitive strategy being used by the largest asset management firms to gain market share centers around cutting asset management fees and commissions. Investment managers hope that by reducing fees, the revenue lost from the fee cut will be offset by new investors buying their funds. This strategy, which is creating fee compression, is not a viable long-term solution for the investment management industry.

Instead of cutting fees to compete, how about creating a better product, one that investors would be more than willing to pay a premium? Now that is a much better solution.

Below we will outline some of the many competitive advantages available to investment managers if they implement FairShares’ proprietary technology.

Structural Alpha    

FairShares’ technology gives an investment manager the ability to clone any existing income-producing investment fund in the world and outperform it. Guaranteed outperformance is possible because of the superior fund structure that FairShares offers investment managers. Not only does FairShares offer its shareholders tax advantages, but FairShare funds are priced at their fair value, allowing investors to buy more shares with the same amount of capital and benefit from the higher annualized yields associated with owning additional shares.

Best Performing Index Funds    

Index funds that use FairShares technology will trade at a discount and outperform their peers. For example, an S&P 500 index fund that uses FairShares technology will price Clean and will trade at a discount to all other traditional S&P 500 funds. Not only will FairShare index funds trade at a discount, but there are no adverse tax consequences associated with purchasing the fund, and the fund’s tracking error and volatility will improve. For more on how FairShares can create the best performing index funds see THIS blog.

Increased Investment Management Fees    

An investor who buys a fund that has a 2% annual yield, and that pays income quarterly, can pay up to 25 basis points in taxes that they do not owe. Unneeded taxes significantly increase the total cost of ownership of the investment fund.  Consider an index fund with a low annual management fee of 1.5 basis points. The actual total cost of ownership of this fund, when you include the unneeded taxes, is 16+ times higher than the management fees. Therefore, any rational investor would be willing to pay a higher management fee to avoid unnecessary taxation and decreased buying power. If investors are willing to pay an extra 1.5 basis points in management fees, to avoid paying 25 basis points in unneeded taxes (which is a rational economic decision), the revenue the investment manager earns doubles!

Increased AUM Revenue Generated from Higher Compound Annual Returns

It goes without saying, when investors earn higher returns, so do their investment managers. The current last holder of record dividend payment system, under which investors pay taxes they do not owe and buy fewer shares, acts like a “drag” on an investment manager’s revenue. Furthermore, we are dealing with returns that compound, so a certain amount of money saved today, grows/compounds into a much more significant number in the future.

Attract New Assets

There is simply no comparison between a FairShare fund and a traditional investment fund. Investment Advisors, who owe a fiduciary duty to seek “best execution” for their clients, will be compelled to allocate to a FairShare fund, over an equivalent traditional fund. A FairShare fund offers investment managers a verifiable competitive advantage when compared with their competition. If there are two identical S&P 500 funds and the traditional fund is priced at $300 and the FairShare fund, which holds the same securities in the equal amounts, is priced at $298.50, $1.50 less than the traditional fund, which fund will investment managers buy? The answer is obvious and does not need an explanation. This concept is especially relevant when you consider index funds, which, to a certain extent, are commodities and offer no differentiation. Consequently, FairShares can give index managers a definite competitive advantage over their competition for the purpose of gathering new assets.

An Asset Manager’s Revenue is Unaffected by the Discounted Transactional Net Asset Value (NAV)   

Some investment managers may think that discounting their NAV will reduce the revenue generated from asset management fees. This assumption is incorrect.  Managers will be compensated based on the investment fund’s total assets under management, not the NAV, which has been appropriately adjusted to recognize dividends correctly – as liabilities. After all, even though dividends are declared and treated as a liability of the fund, which takes the dividends out of the NAV, investment managers are still managing the realized income that the fund has received and should be paid for their work accordingly. Therefore, the NAV that managers will use to bill their investors is equal to the transactional NAV that investors buy/sell at, plus the realized income the fund has accrued to date. This process ensures that investment managers are compensated fairly.

Decreased Volatility Improves a Portfolio’s Risk-Adjusted Return Metrics

Since a FairShare fund will always trade at its fair value, there is no need to drop the price of the fund on the ex-dividend day. These market mandated drops in the value of the security unnecessarily increase the volatility of a security, as well as confuse investors (why is my investment fund down, when the market closed higher?). Since volatility is used as a measure of risk in many risk-adjusted return metrics like the Sharpe Ratio, reducing volatility increases the risk-adjusted return. Therefore, investment advisors can enhance their portfolio’s risk-adjusted returns by using FairShare funds in the construction of their portfolios.


Jeremy Roseberry


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