With the near-death experience of losing refundable franking credits now behind us, it is timely to consider how they can be used – and abused – in equity portfolio construction.
What we know (and like) about franking credits as a yield source is:
- A dividend of $100, fully franked, converts to $121 in the hands of a taxable (accumulation-phase) superannuation fund and $143 in the hands of a fund portfolio in tax-free retirement phase. This reflects the 30% corporate tax rate that most companies still face.
- Many studies show that franking credits are not fully valued in equity prices. So strategies that participate in run-ups to dividend ex dates are likely buying into franking return streams at discount prices.
- As the past financial year in Australia has reminded us, companies who manage their capital through off-market share buybacks can legally stream franking credits to investors who most value them.
- Franking credits reflect underlying corporate tax paid by the dividend-paying company. Some managers argue that a store of franking credits is a sign of the strong underlying revenues and financial health of the company as a quality signal on the stock for the investment manager.
- As long as the investor is materially exposed to the economic risk on the stocks (what is called a ‘delta’ of 0.3), Australia’s tax rules generally allow investors to explicitly value franking credits and target higher yields from franking through thoughtful portfolio construction.
Focus on more than ‘bolting on’ franking
However, as we have warned in previous research, a superannuation fund or other sophisticated investor must be careful about how their managers take advantage of the franking credit opportunity set. To take a well-conceived set of ideas around equity portfolio exposure and simply ‘bolt on’ some tactics around franking credits can be folly.
Here’s why. Let’s take three funds with different ideas about future returns on Australian equities.
Fund A does not believe in active management and finds a manager to simply track the S&P/ASX 200 to harvest large-cap returns at low fees.
Fund B, a believer in active management, has a manager who holds health care and industrial stocks based on its research ideas.
Fund C adopts a ‘smart beta’ approach and asks its quant manager to overweight stocks with value characteristics and underweight stocks with growth and momentum characteristics. Perhaps Fund C reasons that value investing, as a long-cycle bet, is finally ready to pay off and growth and momentum are becoming crowded trades.
Now, enter franking.
Each fund then asks its managers to also invest in (or ‘tilt into’) stocks to generate a return from franking credits. This may seem like a good idea, given that over the past two decades (and last calendar year), franking credits have added 1.51% annually to the gross return of an S&P/ASX 200 index portfolio. The long-term volatility of this income source is only 0.50%. But by viewing a S&P/ASX 200 portfolio as a bundle of stock (‘idiosyncratic’) risks, sector and style factor risks (which can be identified using risk models), we see that adding a franking tilt can create problems for each of our three funds.
Problems created by franking tilt
Fund A, our passive investor, suddenly introduces tracking error into its portfolio, which can be as high as 2.5% each year. This active risk seems counter to the Fund’s passive investment philosophy. Our risk model also tells us that Fund B’s franking tilt involves taking (relative to benchmark) short positions in health care and industrial stocks. But the manager is identifying these as sectors to upweight in the Fund’s portfolio based on its bottom-up research insights. So the franking tilt could effectively unwind the manager’s best (pre-tax) investment ideas.
Risk-modelling of a franking tilted portfolio also shows us that from a style factor risk perspective, higher-franking stocks exhibit short value and long growth and momentum characteristics, which is the opposite of Fund C’s favoured risk positions. So Fund C could be committing the same investment crime as Fund B – inadvertently unwinding its best investment ideas by simply ‘bolting on’ a franking tilt without appreciating how this changes the risk exposures of the portfolio overall.
None of this is to suggest that pursuing higher returns from franking is a bad investment strategy. Rather, we caution investors to consider the full implications of favouring certain stocks and sectors simply because of appetising franking yield, to make sure this is compatible with the broader investment theses underpinning the portfolio. One way to do this is to avoid a ‘bolt on’ approach to franking: Instead, work with an investment manager who can use optimisation techniques to model different risk/return scenarios to show how franking ideas can be pursued compatibly with other investment ideas, rather than competing against those ideas.
Analysis sourced from the author’s 2017 research paper, “A Fresh Look At Franking”, with additional franking return and volatility calculations updated to 31 December 2018.
Raewyn Williams is Managing Director of Research at Parametric Australia, a US-based investment advisor. This material is for general information only and does not consider the circumstances of any investor. Additional information is available at parametricportfolio.com.au.