A thought-provoking article on tax-inefficiencies in mutual fund pricing by David C. Boydell in Advisor Perspectives
#taxefficiency#mutualfunds#systemicrisk
Boydell’s point
“Investors – your clients – are paying unnecessary taxes when they purchase stocks, equity mutual funds and other securities.
The accounting treatment used for dividends and capital gains (“distributions”) overvalues income-producing equities by an amount equal to the security’s accrued, but unpaid, distributions. This causes investors to pay tens of billions of dollars in taxes they do not owe. This problem is a known risk financial services firms and auditors recognize and is referred to as “buying a dividend.”
We all know about “dirty pricing” in the bond markets. When we buy individual bonds offered on the secondary market (OTC) we are quoted two prices: the price of the bond (the “clean price”) and the accrued interest due to the seller of the bond since the previous coupon date. The two prices together are referred to as the “dirty price.” When the next coupon is paid, the amount that represents the accrued interest paid to the seller by the new purchaser of the bond will not be taxed. The reason – it is return of the buyer’s capital. The process of deducting the accrued interest paid to the seller from the total coupon received by the buyer ensures the buyer pays taxes only on the interest that is earned.
When it comes to dividend-paying equities, the very same process occurs, but our securities markets have no mechanism to decipher between clean and dirty pricing. Essentially, if a single corporate issue security, mutual fund or ETF pays a dividend, we are quoted and must pay the dirty price. This is because the price of the equity includes the value of the unpaid distributions. Unfortunately for equity investors, they are unable to deduct the accrued income paid to the seller of the security from the total distribution received, resulting in substantial over taxation of investment income received.
The chart below shows the difference in the percent change of SPY versus the percentage change of the S&P 500 index, anchored from the ex-dividend day. The increase in price you are seeing is the income from the S&P 500 stocks being added to the value of the S&P 500 stocks that comprise SPY. The sharp drops shown in the chart represent SPY paying its accrued dividends to investors. One can see that these drops correspond to SPY’s ex-dividend dates. This chart demonstrates that, just like bonds, equities trade dirty.”