MUTUAL FUND SHARES STILL TRADE DIRTY – 80 YEARS LATER

When I say “dirty”, I mean unfairly. In this case, the unfairness in question was never purposeful. It’s simply an example of how antiquated technologies and accounting principles are still the standard methods used in the investment industry. It is still the case that capital gains and dividend distributions are determined based upon the “last holder of record” at a designated date. It has always been done this way and still is. 

The problem is that this method results in different tax and wealth implications for different investors based on the dates that they buy or sell shares. In everything else they do, US businesses use GAAP accounting which specifies daily accruals, assuring evenly spread profits, losses and costs to assets and liabilities. The discontinuous and uneven manner of recording these distributions and payments in a last holder of record payment system periodically allows investment managers for certain classes of investors, especially high net worth individuals and family offices, to implement tax arbitrage and dividend arbitrage strategies in attempts to minimize tax bills while fully realizing income. This means that certain classes of individuals benefit at the expense of others. One of the stated missions of the US Securities and Exchange Commission is precisely to prevent this from happening.

Challenges of Addressing Current Inefficiencies with Technological Innovations

With technology comes the ability to improve upon age-old inefficiencies. FairShares, a FinTech company based in Delray Beach, FL, has engaged me as a Senior Advisor to confirm the fact that their technology can allow fund companies to seamlessly install their systems and methods cheaply and efficiently into any investment fund to transform “last holder of record” accounting to GAAP-prescribed accrual accounting. Applying GAAP accrual accounting to a fund’s realized income improves the investment returns and buying power of all investors.

This isn’t the first time that the status quo kept the industry more costly and inefficient than it has needed to be. The Securities Act of 1940 (“40 Act”) created the traditional mutual fund structure still in use today. During the past 20 years I have written and spoken about the antiquated inefficiencies inherent in the structure. Making the structural shift to the ETF structure, as we are finally seeing an increasing number of active managers do, addresses many of these inefficiencies including:

• ·      The need to make trades in cash on an exchange;
• ·      too many capital gains tax events;
• ·      the need to manage to daily cash flows;
• ·      Forward pricing at Net Asset Value, an unknown price when buy/sell order placed;
• ·      No ability to get in and out until the end of day; and
• ·      Cash drag.

In general, technology has made incredibly rapid and impactful changes to transform what the investment and trading industries were in 2000 into what they are today. Trading, in particular, has become light-years more efficient in many ways. There are so few trading inefficiencies that statistical arbitrage, once a dominant hedge fund strategy doesn’t seem to exist anymore. Retail fees have gone from quite significant to zero at most major brokerage firms.  Many of those same brokers now allow their clients to buy fractional shares on many major stocks and ETFs. All of these changes produced significant positive impacts on investing and trading worldwide. Yet, all of these changes were once resisted and even vilified by those who believed they were vested in the status quo.

As with ETFs, I’ve experienced quite a bit of initial resistance in imploring mutual fund companies simply to take a look at the technology; let alone the benefits of making the processes fairer to fund shareholders. But this time, the FairShares team has taken several mutual fund, accounting and market regulatory experts through the deep dive and corresponding math. Almost universally, the reaction was surprise that capital gain and dividend distributions weren’t already being handled by mutual funds this way as the FairShares methods are far more equitable and consistent with GAAP and in the best interest of their shareholders.

Once the fact that accruing dividends and capital gains as payable liabilities was fairer to investors and the marketplace, something certain to resonate with the US Securities and Exchange Commission and FINRA, the next question is whether the differences for fund shareholders are significant. The answer is a resounding yes. We estimate that FairShares can help fund companies and their shareholders in the aggregate save tens of billion dollars in wasteful frictional costs every year.

FairShares Inventor and co-Founder Jeremy Roseberry takes his readers through the process and how badly fund investors can overpay in this article where he proves that investors can be paying “hidden costs” that amount to more than 51X the fund’s management fees: https://buyfairshares.com/why-your-low-cost-investment-fund-is-costing-you-51x-more-than-you-think/ 

Much of the differences surrounds two issues:.

1)   Investors are forced to overpay for investment funds they buy because they are buying two separate interests upon each purchase. They are buying an interest in the fund’s realized income (dividends and capital gains) plus an additional interest in the fund’s underlying investments. There is no economic value in buying dividends and capital gains. “Buying a dividend” is a risk that is disclosed in each fund’s prospectus. Therefore, investors are paying more for an investment fund than it is worth. This means they are buyer fewer shares than they would otherwise buy if dividends and capital gains were not included in a security’s price.

2)   When the dividends and capital gains an investor purchased are ultimately returned to the investor via a distribution, they are considered taxable income. Therefore, investors are being taxed on a return of their own capital. In essence, taxable investors are trading $1.00 for $.60 by exchanging an after-tax dollar for a pre-tax dollar.

For years, mutual fund investors have been persuaded to dollar cost average their contribution. This na?ve approach makes them fair game to be picked off by tax arbitrageurs and dividend arbitrageurs who time when they buy and sell fund shares in an effort to maximize after-tax returns. 

The implications of the benefits of the FairShares patent-pending processes in equitable shareholder treatment and increased wealth capture for most investors go well beyond equity mutual funds. In fact, the benefits are probably greater in most fixed income funds. Even though most Exchange-Traded Funds are somewhat tax-efficient, these same benefits apply to them as well. After all, they also use the “last payer of record” accounting method for dividends and capital gains. 

(Sidebar: the same FairShares process can also eventually be used by corporations for fairer payments of their dividends. See https://buyfairshares.com/equities-trade-dirty-what-that-means-and-why-it-matters/}

As many of you are well aware, I’ve been working in the Responsible Investing and ESG areas for many years including being on the Board of Skytop Strategies. With mutual funds and ETFs so key to many of our retirements and our future, this issue should not continue to be ignored.

If mutual fund complexes are made aware that a simple cost-effective change can make their fund-shares fairer and generally more profitable, they have a fiduciary obligation to do so and need to be transparent about that. Responsible financial organizations should lead by example.