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...

Overview:

This paper will quantify the additional income and investment returns that are created when an investment fund uses FairShares systems and methods to improve the way that dividends, interest, and capital gains are accounted for and paid. The reason this additional income can be generated is that FairShares technology properly values income-producing assets and prevents investors from incurring the systematic daily losses that investors are subjected to in our current market structure – a result of “buying a dividend” a risk that is disclosed in every investment fund prospectus.

Income-producing assets accrue the realized income generated by the fund to the net asset value (NAV) of the fund. Therefore, realized income is treated as an asset of the fund, even though it represents a payable liability. The process of accruing realized income to the NAV of a security artificially inflates the value of the asset.

Investors are unknowingly buying two separate and very different interests when they purchase an investment fund. They are buying an interest in the fund’s assets, as well as a separate interest in the fund’s realized income (dividends, interest, and capital gains).

When an investor buys a security that has realized income included in its NAV, there is a minimum of two adverse outcomes.

  1. The investor will pay more for the asset than it is worth resulting in impaired buying power (i.e., buying fewer shares).
  2. The investor will lose money with the realized income they purchased is returned to them via a dividend or capital gain distribution, both of which are taxable events. Investors are therefore taxed on a return of their capital.

This risk of loss is disclosed in every investment fund prospectus.  Consider what a multi-trillion-dollar investment manager says on their website:

“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.

Investors are subjected to these losses at any point that the fund has generated any amount of realized income. 

How can we calculate the losses that investors realize when buying an investment fund?

By making some basic and reasonable assumptions, we can calculate the estimated losses that investors are subjected to in an investment fund over one year.  Since FairShares allows investors to avoid these losses, they will not be subjected to these losses and will, therefore, generate additional income when compared with the income generated by investing in a traditional security. By having an estimate of the daily realized income of the investment fund, that is built into the NAV, and by estimating an average amount of daily volume, we can calculate the losses that investors incur in a traditional fund. FairShares protects investors from these unneeded losses.

For our model, we will evaluate a fund with the following characteristics*:

  • A beginning NAV of $100.00
  • Quarterly yield of .90% representing ordinary income (i.e., bond interest)
  • A yearly capital gain of 6% of the NAV
  • The security will appreciate by 8% (market moves do not impact these losses or this analysis)
  • Maximum state and federal tax rate on ordinary income of 50%
  • Maximum state and federal tax rate on long term capital gains of 30%
  • Capital gain distributions are allocated 50% long-term gains and 50% short-term gains for tax purposes
  • We will straight-line dividends and capital gains so that they are accrued evenly over the year
  • Average daily volume of 750,000 shares per day representing taxable investors who will buy and hold this security through the end of the year when the capital gain distribution is made. This is a large investment fund with an adequate number of shares outstanding to handle the volume and turnover.

* Actual losses will depend on an individual’s specific tax rate and the number of shares traded by taxable investors who will hold the security through the end of the year. We do not have access to this data and must, therefore, make reasonable assumptions. Furthermore, many funds have a much higher volume than 750,000 shares a day. Higher volume leads to increased transaction value, which leads to greater losses.

Results

The analysis suggests that the unnecessary losses realized by this fund’s investors are equal to $421,698,744 for the year. That is a staggering sum of money. Let’s break this down. To calculate the losses, one must calculate the total amount of capital that was used to purchase the dividends and capital gains. Next, we multiply the total dollars that were used to buy the realized income by the appropriate tax rates to calculate the amount of unnecessary taxes paid by investors (i.e., losses). Remember, when investors buy dividends and capital gains, they will then be responsible for paying taxes on those purchases, even though no income was earned. The IRS is very clear that a “return of capital” is not taxable. However, the current market structure is set up so that being taxed on a return of capital is regrettably unavoidable.

Here is the math needed to calculate the losses on dividends:

On the 89th day of the year, there was a .89% dividend accrued to the NAV of $104.35. On this day, there was also an embedded capital gain equal to 1.48% of the NAV.  The aggregate transaction value for the 89th day was $78,262,500 ($104.35 NAV * 750,000 shares traded).

To calculate the taxes owed on the dividends purchased multiply the aggregate transaction value of $78,262,500 by the accrued dividend of .89% = $696,536.25. This calculation tells us the amount of the total transaction value that was used to purchase dividends. Therefore, $696,536 worth of dividends were purchased. We know that investors will need to pay taxes on the purchased dividends when they are distributed. To calculate the tax liability, multiply the dividends purchased by a 50% tax rate. The total losses, for this one day, on the dividends that were purchased is equal to $348,268.

To calculate the capital gain, we go through the same process, but we will split the capital gain distribution into equal parts – 50% short-term and 50% long-term gains for tax purposes.

Here is the math to calculate losses on capital gains:

  • Total capital gain purchased = $78,262,500 (transaction value) * 1.48% (capital gain % of NAV) = $1,158,258
  • Tax on long-term gains = ($1,158,258 * .5) * 30% tax = $173,742
  • Tax on short-term gains = ($1,158,258 * .5) * 50% tax = $289,564
  • Total losses due to unnecessary taxes on capital gains = $463,306

Total losses on dividends and capital gains = $348,268 + $463,306 = $811,574

On the 89th day of the year, the investors who purchased this fund will lose $811,574. If you were baffled by how a fund could cost investors $421 Million in unnecessary losses over one year, now you can understand that this is absolutely possible by quantifying the losses for just one trading day. Keep in mind that this is only the 89th day of the year. The embedded capital gain in the fund’s NAV will continue to get larger, which will increase the losses experienced by investors who buy this fund later in the year as the capital gains approach their peak value.

Quantifying the Value of FairShares

When FairShares is used, investors are not subjected to these losses. Additionally, the impact of buying capital gains can be completely eliminated depending on how aggressive the manager wants to be in accruing them.  Therefore, investor losses in a traditional investment fund become additional investor gains in a FairShares fund. Investors who can avoid losses end up with more money in their pockets.  For example, if we take our example above, investors who bought a FairShares fund on the 89th day of the year would have generated $811,574 in additional income on this one day vs. what they would have made in a traditional fund. The chart below shows the aggregate value that FairShares creates for shareholders. This incremental value is not only good for the shareholders, but it is good for investment managers, too, as they will have more money to manage.

 

Examining the Mispricing of the NAV

The two charts above show the difference between Clean and Dirty pricing. The chart titled “Dirty vs. Clean NAV” demonstrates how a fund that accrues dividends and capital gains to its NAV will trade at a substantial premium vs. the value of the underlying portfolio of securities.  The green line represents the Clean FairShares price. The Clean price represents the actual value of the underlying holdings of the fund, which is gradually appreciating at an 8% annual rate. The grey line represents the Dirty NAV, which is equal to the value of the underlying securities plus the fund’s realized income (dividends and capital gains). The grey line shows the prices that investors must pay in our current market structure. The green line shows the prices that investors pay for an identical fund that uses FairShares systems and methods. The three small drops of the grey line represent quarterly dividend payments.  The large drop of the grey line near the end of the data series is the day that the fund pays out its yearly capital gain distribution and its end of year dividend distribution. You can clearly see at the end of the year when the fund pays out its capital gains and dividends; the fund’s NAV is reset to equal its Clean price.

The second chart, titled “Per Share Premium Paid for Dirty NAV Pricing,” calculates the premium that investors are forced to pay on every day of the calendar year. This premium is the difference between the Dirty and Clean price. At the end of the calendar year, investors must pay $114.85 for a fund that is only worth $107.98 – an overvaluation of $6.87 per share.

Conclusion

This brief paper demonstrates, using reasonable assumptions, that the aggregate losses in just one investment fund, for one year, can total over $400,000,000. Our research suggests that there are over 10,000 investment funds in the US. Therefore, one must extrapolate these losses over all of the 10,000 investment funds. One must also factor in the losses that are generated from individual equities like IBM, who do not generate capital gains but pay dividends in the same manner as an investment fund.

These substantial losses can be easily avoided by using FairShares proprietary systems and methods which allow realized income to be accounted for properly – as a liability payable to shareholders. Accounting for realized income as a liability removes the realized income from the price of a security and makes it nearly impossible for investors to “buy dividends.” The result is that investors buy more shares with the same amount of capital because they are purchasing securities for their actual value, instead of an inflated value. They also avoid the losses associated with “buying dividend and capital gains,” which can meaningfully increase an investor’s total return.

FairShares helps investors keep more of what they earn. If the investment fund in the example above used FairShares, the shareholders would have generated an extra $400,000,000 in wealth.

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Author

Jeremy Roseberry

CEO

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