How the Current Accounting Treatment of Dividends Adversely Impacts Investor Returns and Buying Power

In this article, we will give you a preview of the Abstract and Introduction of a detailed research paper that our firm wrote.  We used actual data to compare the returns and buying power of a traditional investment fund with an equivalent investment fund which does not accrue dividends to its net asset value.  While the conclusions of the paper are dire, there is hope.  FairShares corrects all of the shortcomings of the current payment system which is detailed below.  The investment community must address the flaws inherent in the last holder of record payment system so that investors are rewarded for investing, not penalized.

If you have an interest in reading the entire research paper, please reach out to us.  We would be happy to provide it to you.

How the Current Accounting Treatment of Dividends Used by Investment Funds Adversely Impacts Investor Returns and Buying Power

Abstract

This quantitative research study was performed to show how the current accounting treatment of dividends in a last holder of record payment system impacts investment returns.  The results of the study were conclusive and disconcerting.  The study was performed using historical data from an S&P 500 mutual fund – FXAIX (the use of index funds is an ideal type of fund to use in this research as the holdings are controlled and easily duplicated for comparison purposes. We are not singling out FXAIX for any reason other than it is a popular index fund.  Our research found that the current accounting treatment of dividends used in a last holder of record system, at a minimum:

• Subjects investors to taxes that they do not owe.
• Diminishes an investor’s buying power and yield because of artificially inflated net asset values (NAV).
• Introduces unnecessary volatility that lowers risk-adjusted return metrics.
• Demonstrates how the total cost of ownership of an investment fund can be 17 times higher than the fund’s management fee.
• Burdens the sellers of investment funds to unfavorable capital gain tax treatment when they are eligible for qualified income tax rates.
• Creates a scenario where investors have a 50% chance of underperforming their benchmark on a pre-tax basis because income from the investment fund’s underlying investments does not accumulate to the NAV evenly, causing distortions in the NAV, which impacts an investors pre-tax total return.

The conclusions reached above are a result of an investor “buying a dividend” which is a required accounting process needed to operate under a last holder of record distribution system.  A screenshot of the FXAIX prospectus can be found below, which gives a warning to investors regarding the tax consequences associated with purchasing income-producing investment funds in a last holder of record system.  Buying a dividend, which is unavoidable in a fund like FXAIX, guarantees that a taxable investor’s net worth is lowered immediately upon the purchase of an investment fund.  Consequently, this results in hundreds of billions of dollars in losses for investors in global financial markets, which, in turn, lowers an investment manager’s revenue generated from their assets under management.

This analysis was conducted by comparing the returns of an investment fund, FXAIX, that includes realized income in the investment fund’s net asset value with an identical investment fund, which does not include realized income in the fund’s value.  The authors also introduce methods to fix all of the issues mentioned above by simply enabling a favorable accounting change and distributing income equitably to all investors, not just the last holders of record, creating a more fair outcome which improves investment returns.

Introduction

The purpose of this paper is to analyze the effect that a “last holder of record” financial distribution payment system has on an investor’s investment returns and taxation.  To operate in a last holder of record system, investment funds and income-producing securities are required to account for realized income (dividends and interest) collected by the investment fund as assets, with no offsetting liability.  This accounting treatment is used daily until the last day of the payment period when those assets are finally recognized as liabilities.  This accounting treatment distorts and inflates the value of the investment fund above its fair value and subsequently causes a sharp drop in the NAV when the realized income is converted to a liability and paid to the last holders of record.  This paper examines how the accounting treatment of dividends and interest received by the underlying securities in an investment fund creates numerous unfavorable outcomes for investors.

We conclusively prove, by using real data, that the amount of realized income that has been accrued to an investment fund’s value is inversely proportional to an investor’s return.  That is, the more realized income that has been accumulated to an investment fund’s net asset value, the lower the return the investor will realize.  We also show how an investor can calculate or estimate the “dividend premium” in an investment fund and how this premium forces investors in non-qualified accounts to pay taxes they should not have to pay.  By rigorously analyzing the data we will prove the following:

• The last holder of record system imposes taxes on investors that they should not have to pay.
• The last holder of record system diminishes an investor’s buying power by artificially inflating the value of the security, which causes investors to pay more for a security than it is worth.
• We show how the Total Cost of Ownership of a security, which is the annual management fee plus any tax liability associated with the purchase of a dividend, can be up to 17 times more than what is stated in an investment fund’s prospectus.
• We show how the Total Cost of Ownership in FXAIX can be lowered by 94% if FXAIX removed the realized income from the NAV.
• We demonstrate how each dollar lost in unnecessary taxation can lower an investor’s net worth upon retirement by $32.00.
• We conclude that under a last holder of record system, volatility is unnecessarily increased as a result of the required crashes in the net asset value of the investment fund on each ex-dividend day that occur as a consequence of finally accounting for the fund’s realized income as a liability. This excess volatility negatively impacts the risk-adjusted return metrics that investors use to evaluate an investment manager’s performance.
• We will prove that an investor achieves a lower annualized yield on their investment as a result of purchasing fewer shares because of inflated asset prices.
• We will prove that the last holder of record system lowers the stated yield of the fund – a result of the security trading at a premium.
• We will prove that sellers, who meet the qualified income holding periods, and who have owned an investment fund less than a year will pay nearly twice as much tax as they should be paying upon the sale of their securities.
• We will prove how the same dollar of income is taxed twice under a last holder of record system.
• We will prove how the uneven and random accumulation of income to an investment fund’s NAV leads to a ~50% chance of both buyers and sellers of investment funds underperforming their total return benchmark in taxable and non-taxable accounts.

In the Discussion section we discuss the following:

• What the primary drivers are of the negative outcomes resulting from a last holder of record system.
• Why investment funds have a fiduciary duty to protect investors from these avoidable and unneeded losses as well as lowering the total cost of ownership of an investment fund.
• How an investor can potentially pay multiple dividend premiums in “fund of funds” structures like target-date funds.
• How higher yields exacerbate the problems defined in this paper.
• How all income-producing securities in the marketplace are overvalued as a result of the accounting treatment of dividends under a last holder of record system.
• We explore the possibility that systematic underperformance by investment managers could be related to, at least in part, by the fact that the securities they are purchasing are overvalued.
• Why declaring dividends daily leads to underperformance on a pre-tax and after-tax basis.
• How the dividend premium problem can be corrected very easily by improving the accounting of the investment fund.
• Why a new payment system is needed if dividends are removed from the NAV.
• A brief discussion of the minimal infrastructure required to implement a new distribution payment system.
• An explanation of how all participants in the global financial system will benefit from adopting a new distribution payment system.

The goal of this paper is to educate investors and raise awareness on this subject so that they can attempt to mitigate or avoid losses associated with the last holder of record system and the accounting treatment of dividends.  Unfortunately, the only day that it makes sense to make a trade under a last holder of record system is on the ex-dividend day.  We predict that once investors are educated about the shortcomings of the last holder of record system, they will demand a remedy, and rightly so.

We also propose a new and much-improved payment system that can very easily replace the last holder of record system.  Should an investment fund adopt this new system, they would have the best performing index funds in the world, coupled with the most efficient tax structure.  This new system can function within the existing market structure and requires no additional effort on the part of fund managers to administer.

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