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...

Traditional investment funds accrue dividends received from their underlying securities to the net asset value (NAV) of the fund. This accounting process inflates the value of the fund by the amount of income received. While this process is inefficient, it creates a way for a seller to earn their pro-rata income in the period in which they sell their security.

Remember, in a “last holder of record” payment system, only the last investors to hold a security on a specific day (the ex-dividend day), are paid the income from the security. If you sell before the ex-dividend day – you do not receive any income. However, you do receive a capital gain since the income generated by the fund has been incorporated in the value of the security

Consider the chart above, which shows how a $.835 dividend is accrued to the value of a security that has no price movement over 12 weeks. We are assuming that there is no price movement to make the model easier to understand. However, please note that price movement does not affect how income accrues to the value of a security. Let us assume that an investor bought this security for $100.00 at the beginning of week one. This investor sells their entire position in week 11 for $100.71.  

For comparison purposes, we will create an identical fund comprised of the same securities in equal amounts. The difference is that this fund will use FairShares’ intellectual property to account for and pay dividends. We will invest $1,000,000 in each fund and study the results.

Realized Return of Traditional Fund

  • Purchase Price = $100.00
  • Number of Shares Purchased = 10,000
  • Sell Price = $100.71
  • Profit = ($100.71 – $100.00) * 10,000 = $7,100.00
  • After Tax Profit = $7,100 * (1 – .4) = $4,260 (we are assuming a 40% tax rate here – short-term capital gain)

Realized Return of a FairShares Fund

  • Purchase Price = $100.00
  • Number of Shares Purchased = 10,000
  • Sell Price = $100.71
  • Profit = ($100.71 – $100.00) * 10,000 = $7,100.00
  • After Tax Profit = $7,100 * (1 – .8) = $5,680 (we are assuming a 20% tax rate here – Qualified Income)

Why Did the FairShares Investor Make More Money?

At first glance, you might be wondering how two investors who bought and sold these two investment funds for the same prices, could have different returns? 

The reason that the investor in the traditional fund underperformed the FairShare investor relates, once again, to the inferior structure of a traditional fund.  Investors who own an equity security for at least 60 days are entitled to receive qualified income treatment of their dividends. However, in a last holder of record system, you must own the security on the ex-dividend day to receive any dividend payment. Since this investor sold before the ex-dividend day, the seller won’t receive a dividend.

Wall Street understood that a seller would want their income, so they engineered an inefficient way of paying them. As stated above, as an investment fund earns income from its underlying securities, that income is added to the NAV – pushing it higher.  Therefore, in a traditional fund, a seller is paid their share of income via NAV appreciation. Said another way, sellers of traditional investment funds are paid their dividend payments by receiving a capital gain, instead of a dividend payment.

Our investor has met the holding period requirement to receive a qualified dividend that is taxed favorably at ~20%. Unfortunately, our traditional fund investor will receive a short-term capital gain instead of a dividend payment.  Short-term capital gains are taxed at ~40% – 100% more than qualified income.

Think about how crazy it is to take a dividend, which is taxed favorably, and then to transform this dividend income into a short-term capital gain, which is taxed twice as much……

The FairShares fund can pay sellers an actual qualified dividend – as opposed to a short-term capital gain. FairShares favorable security structure allows the FairShares investor to pay half the tax and keep more of what they earned!

Conclusion

This blog closes the loop. FairShares has demonstrated in numerous blogs how FairShares benefits buyers of securities. This blog shows how FairShares can increase returns by allowing investors to be paid they qualified income they earned and are entitled to receive.

FairShares makes investors more money when they buy and when they sell.

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

Author

Jeremy Roseberry

CEO

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