Taxable investors lose money every single time they buy income-producing securities, and all investors overpay for the securities they buy. Yes, you read that correctly, and the title of this blog and its opening sentence are not click-bate. This little-known fact is not something that you will learn about in your MBA textbooks or hear financial gurus discuss on TV or at conferences. If you invest money on behalf of yourself or others, this article is relevant to your financial well-being.
How is it possible to lose money each time you buy a security that pays a dividend?
Great question. The simple answer is that you are “buying a dividend,” which represents a taxable liability of the investment fund. The reason you are buying a dividend is that the value of dividend or interest payments that an investment fund collects from its underlying holdings are included in the price or net asset value of the investment fund. We call this the distribution or dividend premium. The price of an investment fund is, therefore, equal to the value of its underlying securities, plus any dividends or interest received from the securities it holds. The premium at which an investment fund trades above its underlying index is shown by the chart below. The chart compares the difference in the percent change of VFINX, an S&P 500 mutual fund with the S&P 500 index. As you can see, VFINX always trades at a premium vs. the value of its underlying securities. Therefore, you consistently overpay when you buy income-producing assets.
If you are still unwilling to believe that you have been losing money your whole life by purchasing products that are supposed to increase wealth, let us consult BlackRock’s website, which states.
“Buying a dividend” refers to purchasing a mutual fund just prior to a distribution by that fund. If the fund is held in a taxable account, this generates an unnecessary tax bill. In essence, a portion of the investment is returned to the investor as a taxable distribution.1
The only correction I would make to BlackRock’s statement above is that you are buying a dividend as soon as the fund receives a dividend from its underlying securities (see chart above). An investment fund will likely receive a dividend on the first day of the period. Therefore, buying a dividend is not a phenomenon that occurs only before a distribution. There is a very high degree of certainty that you are buying dividends and incurring losses if you purchase an investment fund on any given day of the period.
Do you ever wonder why the price of an investment fund drops on the ex-dividend day by the amount of the dividend that will be distributed to its investors?
It drops because the dividend was a component of the price of the fund. Investment funds temporarily account for dividends received as assets of the fund. However, realized income (dividends) of an investment fund are not assets, they are liabilities. On the ex-dividend day, investment funds must correct their accounting and finally convert the dividends the fund has received from assets to liabilities. This process of fixing the accounting and then paying the dividend resets the price of the fund back to its fair value. The fair value of an investment fund is equal to the value of its underlying securities. Nevertheless, seldom will an income-producing investment fund will ever trade at its fair value. Generally, investment funds are overvalued each day by the cumulative sum of the dividends the fund has collected. Therefore, the dividend premium will grow over time with each passing day, as the chart above demonstrates.
Let’s look at an example. Today you buy $1,000,000 of an investment fund for $100 per share that pays a $1.00 per share dividend tomorrow, on the ex-dividend day. In less than 24 hours, the price of the fund you bought for $100 per share drops to $99 per share, and you will receive $1.00 per share in dividends. Let’s walk through the after-tax returns:
- The 10,000 shares you bought are now priced at $99.00 per share = $990,000.
- You will owe ordinary tax on your dividend. We will assume that your combined state and federal tax rate is 50%. So, to calculate your after-tax dividend payment, you multiply the dividend you received by your tax rate to calculate the taxes you will owe. ($10,000 * 50%) = $,5000. Therefore, after you pay your taxes, you have $5,000 left of your dividend.
- Let’s add everything up to calculate your after-tax return. $990,000 + $5,000 = $995,000
- Therefore, in less than 24 hours, you lost $5,000 or 50 basis points of your net worth.
FairShares product would have prevented this $5000 loss. On average, FairShares targets a fee of $1.50 per distribution, depending on the distribution size and other factors.
In conclusion, every time you buy an investment fund, 1) you are paying more than the fund is worth, and 2) if you are a taxable investor, you will lose money, and your investment will start off in the red.
FairShares patent-pending technology fixes this issue so that you can keep more of what you earn. Our analysis shows that for every $1.00 you lose today, depending on the time until you retire, your net worth upon retirement can be reduced by $32. If you believe that it is inherently unfair that you are throwing away your hard-earned money, contact your investment advisor or the investment funds that are managing your money and tell them enough is enough and that you want to #BuyFairShares. Fixing this issue is as simple as clicking a button.
Follow us on Twitter @BuyFairShares to stay up to date on the first investment funds that will offer FairShares products. Let the world know you want to #BuyFairShares!
1. https://www.blackrock.com/us/individual/resources/faqs/tax-information-faqs
Author
Jeremy Roseberry
CEO