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...

This article explains why achieving a benchmark return by investing in a traditional investment fund is nearly impossible – even before taxes, fees, and expenses. I know that may sound frustrating, but as I will explain later, there is hope and a better way to invest.

For many investors, including all investment managers who invest money on behalf of other investors, the ability to gain exposure to a particular asset class or index is essential. In fact, these managers are graded on their performance relative to these benchmarks and indexes. Achieving a benchmark return is especially important for institutional investment managers and consultants who manage significant sums of money.

What is a Benchmark?

According to Investopedia – “A benchmark is a standard against which the performance of a security, mutual fund or investment manager can be measured.” Essentially, a benchmark measures the performance you would receive if you bought all of the individual securities that comprise the index.  Investment funds are built to give an investor exposure to these benchmarks, but without having to buy all of the individual securities and to do so without needing large sums of capital. An investment fund is, therefore, a novel idea.

Unfortunately, the probability that an investor will achieve the same return as their benchmark is close to 0% – even before taxes, management fees, and all other expenses.

Why is Achieving a Benchmark Return Impossible

The simplistic answer is that it is not possible to achieve the benchmark return if investors are forced to pay more for the investment fund than its underlying assets are worth. When investors pay inflated prices, they get less of the underlying securities. When investors buy fewer securities, the fund produces less income when compared with the income that its benchmark will generate.

Equities Trade “DIRTY”

As discussed in our groundbreaking paper “Equities Trade Dirty – What that Means and Why it Matters,” we explained how investors are purchasing two separate interests when buying an investment fund.  Investors are purchasing an interest in the fund’s underlying assets and a second interest in the fund’s realized income (dividends, interest, and capital gains). Investment funds treat realized income, which is payable to investors by law, as an asset of the fund. This process inflates the fund’s value. There is no economic value realized by purchasing an interest in a fund’s realized income. As we discussed in “Equities Trade Dirty,” purchasing realized income leads to unjust taxation and lower returns. For this article, we will focus on the detrimental effects of the overvaluation of an investment fund’s NAV.

Modeling Traditional Fund Returns

To demonstrate how a traditional investment fund will always underperform its benchmark, we will create a simple model having the following characteristics.

  • A beginning NAV of $100.00 per share
  • 12 week period (one quarter)
  • We will use Excel’s random number generator to generate income earned by the fund in each of the 12 weeks
  • The income generated over the 12 week period is equivalent to a dividend of $.8358 per share
  • Therefore, the yield for this fund is .8358%
  • To keep things simple, we will assume that there is no movement in the fund’s underlying securities for the 12 weeks. Movement is irrelevant to a fund’s realized income. Therefore, the value of the securities for the period will be pegged to $100.00 per share. However, the fund will still earn income from its underlying holdings, as noted below.

The chart above (left) shows the income per share that will be earned by the fund’s underlying securities. The chart on the right shows how a traditional fund would accrue the fund’s realized weekly income to the fund’s NAV, which moves it from $100.00 to $100.83 over the 12 weeks. This process is identical to what happens in the markets.

Let’s assume that 12 different investors will purchase $1,000,000 of the fund each week at the current NAV for each week.  The graph “Total Shares Purchased” on the left above shows how many shares can be bought with $1M, which is based on the NAV at the time of purchase. You can see that the number of shares purchased is inversely correlated with the NAV appreciation. As the shares get more expensive, because realized income is being added to the NAV, the total number of shares that can be purchased shrinks.

The graph on the right “Realized vs. Benchmark Yield” shows the benchmark yield compared with the yield that each investor will realize based on the number of shares that each investor was able to buy.  Fewer shares purchased means that investors will receive fewer dividends, and this leads to underperformance. Therefore, you can now understand how the accumulation of realized income to the NAV impairs an investor’s buying power and yield – even before tax. As we know from previous blogs, investment outcomes grow worse when investors purchase traditional funds in taxable accounts because they will be subjected to paying taxes on income that they did not earn.

In addition to depressed yields, the money that went towards buying the dividends and capital gains will eventually leave the fund when distributed and no longer appreciate in value. Money that leaves a fund can no longer appreciate, and managers can no longer bill on it.

What Happens When Capital Gains are Factored In?

The situation gets worse when we model in a small capital gain. Like dividends, realized capital gains cause the NAV to become inflated relative to the actual value of the fund’s holdings.  In the chart below, we model out what happens to the benchmark yield vs. realized yield (actual investor yield) when we assume a fund has realized a small $1.50 per share capital gain.

As you can see in the chart above, when a fund has realized any amount of capital gain, you begin substantially underperforming the benchmark yield right out of the gate.

The only way an investor can achieve their benchmark return in a traditional investment fund is if they are so lucky that they buy the fund on a day when the fund has not received a dividend or realized a capital gain. From what I have seen, this is a very rare event. Since investment funds do not publish their real-time realized income, there is no way for an investor to know the actual value of the fund for which they are buying. This lack of transparency is problematic because an investor can unknowingly buy an index fund with a large amount of realized income included in its NAV, which will subsequently lead to dramatic underperformance on a pre-tax and after-tax basis.


The purchase price of a benchmark has neither a capital gain nor a dividend included in its price. However, traditional investment funds gross up the fund’s value by the amount of the fund’s realized income. This inflationary accounting treatment causes investors to pay more for the fund than its underlying assets are worth.  When investors overpay for the assets they buy, they generate a yield/return that is inferior to the yield and return of the investment fund’s benchmark.

When an investor buys an investment fund that tracks a particular benchmark, they expect to achieve that benchmark return, less a management fee. As we have shown here, an investor has no shot at achieving a benchmark return if they buy a traditional investment fund. Investors who buy these traditional benchmark related funds are destined to underperform – even before a management fee is assessed.

If an investment fund desires to achieve its benchmark return, then it must remove the realized income from the NAV, and that can only be done by leveraging FairShares intellectual property. FairShares can create investment funds that are priced appropriately and lead to higher investment returns and more accurate benchmarking. If you aren’t buying a fund using FairShares – you are paying too much.

Follow us on Twitter @BuyFairShares as well as on LinkedIn.


Jeremy Roseberry


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