Structural Alpha
What is it and when does it exist?
Legacy bias and inertia on the part of mutual fund companies are always to the detriment of investors.
ETFs brought structural alpha to fruition that has tangibly improved after-tax-and-fee returns, transparency, efficiency and accessibility to end investors. The same is true of trading and fund accounting technologies over the years. Mutual fund companies have been slow in making changes even though they benefit fund efficiency and by extension, the investors.
FairShares, protected by four filed patents, is the latest example of a FinTech development that can provide structural alpha to mutual funds and their investors. FairShares addresses a legacy work-around that was necessary in 1933 and 1940. The "last holder of record at ex-date" system is at odds with GAAP-prescribed accrual accounting. Trying to use accrual accounting for dividends and capital gains for price mutual fund shares would have been a technology nightmare for fund companies when the system was adopted.
FairShares Technology provides for accrual accounting of mutual fund shares. The results are fairer pricing, more accumulated shares for dividend re-investors and no lump-sum capital gains distributions. This change benefits everyone but arbitrage traders.
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.
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 and Ambassador for US Transparency for the Transparency Task Force. 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.