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Careful what you wish for chasing franking

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.

5 Comments
JohnP
August 10, 2019

Would like to get either comments or general consensus on the articles re Dick Smith and franking credits. Looks like welfare payments from the taxpayer to the wealthy to me but considering the issue the company has already paid the tax directly maybe I am wrong.
Just that at he is being very upfront about this whereas others in a similar position to him have of course always been very quiet on this.
Dick Smith says it’s “outrageous” he received $500,000 in franking credits
See the links here :

https://www.smh.com.au/national/nsw/it-s-ok-for-dick-smith-but-retirees-are-in-a-very-different-place-20190717-p5284c.html

Dudley
August 10, 2019

It is simple enough.

To be receiving $500,000 franking credits his receiving entity must have received $500,000 / 30% = $1,666,666 gross dividends.

If the tax rate is 0% then his receiving entity will have received $500,000 as cash else the $500,000 is a [franking] tax credit against tax owed on the $1,666,666.

Personal income tax on $1,666,666 which would be about $723,096.70 requiring a payment of $223,096.70 in additional tax. There is lies Mr Smiths opportunity to donate.

SMSF Trustee
August 10, 2019

I don’t know Dick Smith’s personal financial situation, but it looks like he’s been paid $1.7 million in dividends. 30% of that is $500k, so he’s received those as franking credits as well.

His total share income, then, is $2.2 mn.

The question is how someone can received $2.2 mn in income and yet be on the zero tax rate so that there’s an entitlement to franking credit refunds rather than it just offsetting other tax paid.

It can’t be investments in his super pension mode because you can only claim tax free income on a capital amount of $1.6 mn. That would be about $64000 in dividends plus $19,000 franking – nowhere near enough to make this hoo haa.

So it must be in some other vehicle or simply shares in his own name.

Can only guess, since he’s reputed to be a great philanthropist, that he’s given all the income he’s earned away to get his total below the tax free threshold.

In which case, he must have already given the $500k away as well. If he’d only given the $1.7 mn away he’d still have $500k in income and he’d have to pay tax on that!

So it’s a publicity stunt that he’s made a big deal out of this.

But he flies planes, and stuff, so he must have living expenses way beyond $30,000 a year, so he must have enough net income for that. Or that’s in his wife’s name or a business name and he’s able to make sure his personal income is zero and they live off her investment earnings.

The point being that he’s already converted a heap of money that would otherwise have been paid as tax and allocated to the public sector’s priorities into donations to causes that he personally believes in. Good for him, that’s not a bad thing to do.

But it does mean that he’s not someone who really wants to pay tax – he’s arranged things so that he doesn’t do that!

And also the fact that this then results in him being in the zero tax bracket and being entitled to franking credits doesn’t make it a rort. It’s the way the system acknowledges that he ends up – despite his wealth – with zero or very low taxable income. Franking credits are part of the way a perfectly good system happens to work in his unique personal circumstances.

To argue that this unique situation means that the franking credit refunds system is wrong is just ridiculous.

Let’s not forget that, when he spends money on his wealthy lifestyle – from wherever he gets the money to do this without becoming a high income tax earner – he pays GST. That was one of the reasons the GST was introduced – to catch some tax from the wealthy who managed their affairs to pay little income tax, but couldn’t avoid it when spending.

Long winded way of saying there’s got to be more to this if we could look under the hood.

Dudley
August 10, 2019

“$1.7 million in dividends. 30% of that is $500k … total share income, then, is $2.2 mn”:

Assuming maximum possible franking credit of 30% of gross dividends:

Franking credit = $500,000

Cash dividends = $500,000 * ((100% – 30%) / 30%) = $1,166,666
Gross dividends = $500,000 * ((100% – 0%) / 30%) = $1,666,666

Total share income = Gross dividends + capital gain.

Lyn
August 10, 2019

AS a retiree, for once in my life I am going to ignore article re such complicated, high-falutin garble about ‘bolting’ on to franking credits. Who invented this term & who understands the term? I certainly don’t & have followed Fr. credits for 20 yrs so today I am off to ‘bolt’ on to my bolt of wool fabric to make myself a winter wool dressing gown, sewing being the only area in which I know the term “a bolt”. I will sit placidly at my sewing machine pondering what on earth the writer means re a bolt to do with Franking credits.

 

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