Franking credits are the missing link in superannuation funds’ search for yield

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“Franking credits represent a valuable potential cash inflow for Australian superannuation funds,” says Raewyn Williams, Director of Parametric’s Research & After-Tax Solutions.

Franking credits, also known as imputation credits, are a type of tax credit that allows Australian companies to pass on a credit for tax paid at the company level to shareholders.  For an individual investor, the benefit is that these franking credits can be used to reduce income tax paid on dividends received, or may potentially be received as a tax refund.

The benefits extend to large institutional investors like superannuation funds and charities, many of whom are looking to adopt ‘smart beta’ strategies to enhance yield.  “Superannuation funds and many other institutional investors in Australia should be thinking about the difference between introducing a standard yield tilt and a franking-aware yield tilt into their passive Australian equities portfolio,” she said.

Ms. Williams said that Parametric’s focus on showing the value of active tax management across the spectrum of passive, smart beta, systematic alpha and full active portfolios led them to create a simple strategy to demonstrate the potential ways in which the cash-convertible nature of franking credits may assist superannuation funds in their search for yield.

Comparing a smart beta franking-aware strategy to a more typical tax-unaware strategy at a recent industry event Williams commented, “While no strategy can be guaranteed to work, research shows that over the past decade, accumulation-phase superannuation portfolios could have earned significant additional after-tax returns from franking by investing in the franking plus yield smart beta strategy.”

According to Williams, the Parametric analysis suggests there are three basic types of ‘smart beta’ superannuation fund investors:

  • A passive investor seeking return enhancements.  A franking-aware smart beta strategy could help generate the additional yield the investor is seeking, but the investor would need to tolerate potentially significant tracking error (or deviations) from a standard market-capitalisation weighted index.
  • An active investor dialing down active exposure in order to reduce fees.  Such a strategy could look particularly good to these investors, as they will be accustomed to tracking error against the index.
  • An active investor dialing down active exposure to embrace a more passive investment philosophy.  A smart beta strategy of this type may not achieve this type of investor’s desired objective of dialing down active risk, as it comes with many ‘active’ systematic bets.

“Our analysis has additional relevance for larger superannuation funds considering a segregation of their equity portfolios into separate accumulation and pension pools, given the extra importance of yield and franking to pension investors.”

“We presented our research findings for both a 15 percent taxed superannuation accumulation portfolio and a tax-exempt pension portfolio, allowing a large fund to compare the relative value of this type of strategy separately for their accumulation members and pension members.”

“We also measured the results on a risk-adjusted basis to better capture the risk-return trade-offs of adding franking-awareness to a yield strategy. Over the timeframe we analysed, we showed that although the franking credits are not a ‘free lunch’, for both accumulation and pension portfolios, they can be viewed as a good deal, relative to extra risk required to access them.”

Seattle-based Parametric Portfolio Associates LLC is a subsidiary of Eaton Vance Corp. and has 25 years of experience offering tax-managed investment solutions to U.S. retail investors. Since 2012, Parametric has been working with Australian institutional investors to explore ways to trade more effectively and efficiently.

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