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...

What would you do if someone who you did not know asked you to pay taxes on the income that they earned?  I think most people would be outraged or appalled at the thought of someone, even asking that question.

However, if you are a taxable investor, you are paying someone else’s taxes every time you make a trade, as well as every time you reinvest your dividends and income.

Before you stop reading because you think I am completely insane – bear with me as I explain, in detail, exactly how this happens.

Global financial markets operate using an antiquated system where only the last holders of record of a security receive the income (dividend and interest) that a security earns over a payment period.

Does this mean that if you own an income-producing security and sell the security before the ex-dividend day, you receive no compensation for the income that the security earned while you owned it?  Well, not quite.  The seller gets their pro-rata share of income earned in the form of a capital gain, not a dividend.  This is the way the last holder of record system compensates sellers for the income earned by the fund during the time it was owned.

Here is how a seller gets paid a capital gain instead of a dividend:

  • During a payment period, an investment fund will receive regular dividend and interest payments (realized income) from its underlying holdings.
  • When the investment fund receives those dividend and interest payments, they are treated as assets, even though, by law, realized income is a liability of the fund.
  • By treating the realized income as assets, they are accumulated in the price or the net asset value (NAV) of the security, which pushes the price of the security higher. The security is now trading at a premium to what the underlying holdings are worth.
  • When you have this appreciation in the price of a security, you begin to earn the income generated by the fund, but you do so in the form of a capital gain.

This process is inefficient and potentially subjects the seller, who is earning this income, to very high capital gains tax rates, instead of receiving the much more favorable “qualified income” tax rates – more on that in a future blog.  However, the last holder of record system is not efficient and harms anyone who uses it.

Since income received by the fund is incorrectly accounted for as an asset when it is actually a liability, the buyer of this fund purchases the seller’s taxable liability.  The buyer now becomes responsible for paying the taxes on the income that the seller earned through the price appreciation of the security.  Let me say that again, just so it is clear. When an investor buys an income-producing security, they are now responsible for paying the taxes on the income earned by the seller, in addition to whatever the buyer will collect from the date of purchase.  This utter madness happens because the buyer “bought a dividend,” and they are now responsible for paying taxes on the dividend they just purchased.  That dividend will be returned to the new buyer when it is paid, and the buyer will owe tax on the dividend they bought.  Again, the dividend that was purchased represents the income earned by someone else and not by you.  You are, therefore, paying someone else’s taxes!

Do you believe me now?  Let’s look at a simple example.

On day zero, an investor purchases 1,000 shares of a fixed income fund that trades at $100 per share.  For simplicity, we will assume that the values of the underlying bonds do not move.  Therefore, the security prices are constant.  But in a last holder of record system, even though the securities will not fluctuate in value, the NAV gradually rises over the period as the fund receives income for the reasons mentioned above.  For this example, we will assume that income flows in evenly for the next 90 days at a rate equal to $.01 per share per day.  At the end of the period, the investment fund will be worth $100.90 because it received cumulative income worth $.90 per share.  On the last day of the period, this investor will sell their shares to “you” who buys the shares for their full value – $100.90.  The sellers, therefore, upon selling their shares to you, earned $900 in income through the appreciation of their shares.  You have consequently bought a dividend, which was the income that the seller earned, equal to $.90 per share.  The day after you purchased these shares, the investment fund went ex-dividend.  The fund will drop from $100.90 to $100.00 because a $.90 per share liability is finally booked to recognize the realized income the fund earned as a liability payable.  The process of booking this liability reduces the NAV accordingly and is the reason security values fall on the ex-dividend day.

Let’s look at what just happened here….

The $.90 per share dividend that you purchased has been returned to you but has been returned in a manner that creates a taxable event.  Here is how the math breaks down to calculate your after-tax return, in less than 24 hours.

  • You purchased 1000 shares for $100.90 per share, which is equal to a $100,900 investment.
  • The price of the shares on the ex-dividend day is $100.00. Therefore, you have lost $.90 per share in value or $900.
  • You will receive a $900 dividend payable, but this dividend is taxable at your marginal state and federal rate of 50%. Therefore, you will owe $450 in taxes ($900*50%).
  • Your after-tax investment in now only worth $100,450 (($100*1000) + $450)).
  • You lost $450 of your money, or a loss equal to 44 basis points, in less than 24 hours.

What just happened here?  How did you lose $450 overnight?  Well, you bought a dividend which represented the income earned by the person from whom you purchased your shares.  As soon as you buy “their” dividend, you are now responsible for paying “their” tax!  Just like that, your net worth is immediately reduced because you paid taxes on the income a stranger earned.

But FairShares is Here to Help!

An investor who purchases an investment fund using FairShares technology DOES NOT pay anyone else’s taxes, except for their own.  In the example above, a FairShare investor would owe $0 in taxes.  Furthermore, the FairShare buyer would have purchased this fund for $100.00 per share instead of $100.90 per share, allowing them to buy more shares for the same amount of money invested.

If anyone reading this “is not” outraged, please reach out to me before April 15th of this year.  I would be happy to arrange for you to pay for my taxes.

If you are upset that you have been paying other people’s taxes your whole life, a result of the last holder of record system, call your investment managers and tell them to #BuyFairShares so you can keep more of what you earn.  By doing so, you will improve the way global markets work so that you and your family can enjoy a better quality of life.  Join the FairShares movement!


Jeremy Roseberry


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