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This is the second article in a three-part series. It is meant to describe a flaw in securities market structure.
In my previous article, I discussed a known risk in our financial markets called "buying a dividend." Buying a dividend is a market-structure risk that costs investors billions in unnecessary taxation. All or a portion of the first dividend, short-term capital gain, and long-term capital gain an investor receives after purchasing an income-producing security represents the return of a portion of their initial investment. This return of an investor's capital should never be taxed. However, the accounting systems used by Wall Street do not account for the portion of these distributions that are a return of capital and instead incorrectly tax 100% of the distribution.
The first article in this series pointed out that the bond markets have an identical problem. However, the bond markets separate the value of the bond (the clean price) from the accumulated interest at purchase. The accumulated interest paid to the seller is deducted from the total coupon payment received on the investor's 1099. Deducting the accumulated interest paid from the total coupon received ensures the bond buyer is taxed accurately based on the interest income they earned. If the buyer is not able to claim this deduction, they will pay taxes on income they never earned. Unfortunately, no such mechanism exists in the equity markets resulting in tens of millions of 1099s produced annually, which overstate your clients' taxes.
How many of your clients would be okay with paying taxes they do not legally owe?
We know the answer.
Depending on the size of the account and amount of trading, your clients could be paying tens of thousands of dollars in unnecessary taxation every year. Without a doubt buying a dividend is the most critical market structure problem currently facing the investment community.
When you buy a home, a title company ensures the property has a clean title before it is transferred into your name. Any debts against the property are satisfied before the title transfer. The buyer will agree to assume these debts in writing before the purchase if liens exist. This standard process ensures hidden costs or liabilities are not assumed by the buyer unknowingly. Investment advisors, as fiduciaries, should demand the same assurances when we buy equities on behalf of our clients.
How to estimate a client's anticipated loss
Let's say our client purchases 12,000 shares of VDIGX (Vanguard Dividend Growth) for $37.83 on December 1, 2021. Three calculations are needed to account for his total unnecessary tax loss: long-term gains, short-term gains, and accumulated dividends. VDIGX reported two distributions on the ex-dividend date (December 29). One distribution was the year's fully loaded capital gains of $1.3862 per share (fully loaded, meaning the entire gain has been realized and is now a component of the security's price). 87.22% of the capital gain was long-term and 12.78% of the capital gain was short-term gain. The second reported distribution was the dividend amount for the payment period equal to $0.3038 per share. At the time of purchase, our estimate for the embedded dividend is $.2599 per share. We will assume the investor has a rate of 15% for dividends and long-term capital gains and a tax rate of 30% for short-term capital gains.
The equation to determine Bob's loss is:
Tax Loss = (S * D) * T
Where:
S = the number of shares purchased
D = the estimated distribution per share at the time of purchase
T = Tax rate of the distribution being calculated. Please note distributions have different tax rates.
We calculate the loss associated with each distribution as follows using the equation above:
Loss on dividend – (12,000*$.2599) * 15% = $467.82
Loss on short-term capital gain – ((12,000 * ($1.3862*12.78%)) * 30% = $637.76
Loss on long-term capital gain – ((12,000 * (1.3862*87.22%)) * 15% = $2,176.27
Total Tax Loss Realized by This Investor – ($467.82 + $637.76 + $2,176.27) = $3,281.85
On the ex-dividend date, VDIGX was trading at $39.31. The annual expense ratio for this fund is 27 basis points. The annual management fee to own 12,000 shares of this fund is $1,273.64.
We have a problem. This fund, like most funds, publishes its expense ratio everywhere. They should. It is part of the overall costs of this fund. Yet the unnecessary tax cost of this fund at purchase for this investor is almost three times the annual expense ratio.
The Securities Act of 1933 is very clear – disclosure of risks that an investor would deem material is required by law. Certainly, when the hidden costs of an investment fund are ~300% greater than the annual management fee, investment advisors deserve to have the real-time disclosure they need to determine if purchasing a security is in the investor's best interest.
We all have a legal right to understand these hidden costs before committing capital. When advisors understand these hidden costs, they can modify their trading strategy to minimize these unnecessary losses and allow clients to keep more of what they earn. They can also search for an alternative fund with a lower/better distribution risk profile.
The technology to produce real-time disclosure of these material risks exists. We are hopeful financial services firms, who take their fiduciary duty seriously, will comply with our disclosure laws and act to provide real-time disclosure to investors and investment advisors.
In September of 2022, the SEC asked my company, FairShares, to give senior SEC staff a presentation on the deficiencies in current disclosures. The SEC asked FairShares to present a plan on: 1) the type of disclosure investors deserve; 2) any rules/laws needing change or regulatory hurdles encountered; and 3) to describe the technology needed to protect investors from these market structure risks. FairShares presented the SEC with a "Blueprint to Create an Efficient Market." If the SEC implements this plan, 142 million investors will be protected from tens of billions of annual losses, and our markets will take a giant step forward in terms of efficiency. We remain hopeful the SEC will implement this blueprint in an expedited fashion. After all, protecting investors is the SEC's top priority.
Until then, advisors should consult with their compliance consultants and legal counsel to determine what compliance-related documents should be updated to adequately disclaim this risk and disclose it to clients.
David C. Boydell has been a financial advisor for 29 years. He is a co-founder of FairShares, Inc.
FairShares is offering its Distribution Risk Analytics software to advisors and the public. With this software, you can understand the hidden costs in the securities you buy for your clients. By leveraging this tool, you can protect your clients from avoidable losses and increase the after-tax return of any income-producing portfolio.
For VettaFi/Advisor Perspectives subscribers, we are pleased to provide you a free three-month trial of our disclosure software application. Please get in touch with us through our website www.fairshares.com and click on "Beta Testers Wanted" in the navigation menu.
Stay tuned for part three of our series. Here at VettaFi/Advisor Perspectives, we will give you actionable strategies that you can use to mitigate client losses and maximize after-tax portfolio returns.
The content should not be relied upon as legal or financial advice. This content does not constitute an offer or sale of securities or any other mechanism for purchasing securities. No party may rely on this content as legal advice or financial advice and all parties reviewing this content are advised to rely solely on their own legal and financial advisers for any specific issues.
Read more articles by David C Boydell
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
