Martha Strebinger
Superannuation funds looking to deliberately tilt their Australian equity portfolios to maximise the benefits of franking credits need to address the significant risks inherent in such an investment approach, says the US fund manager, Parametric, in a new research paper titled “A Fresh Look At Franking”.
The paper highlights that franking credits can be a meaningful source of extra returns, but they “are not a free lunch”.
However, the authors, Raewyn Williams, Martha Strebinger, Vassilii Nemtchinov, and Travis Bohon, say there are certain steps that superannuation funds can implement to control the risks associated with a higher franking strategy.
“The research highlights that how a manager constructs the portfolio is critical.
“Fund managers can build better portfolios (given higher franking objectives) by moving from a simple screening portfolio construction process to a sophisticated optimisation approach.
“There’s also an important insight about customisation: A franking-aware fund manager with sophisticated optimisation skills can construct a finely-tuned portfolio that best reflects exactly what the superannuation fund wants.
“The superannuation fund can express its objectives and appetite in relation to matters like yield, tracking error, concentration, sector and style-factor risks, turnover and volatility.
“This still does not make franking credits a ‘free lunch’, but it does allow the fund manager to focus on delivering a set of higher-franking equity outcomes to a superannuation fund client’s exact dietary requirements.”
The research report says the importance of building better portfolios to derive the full benefits of franking credits is particularly relevant on an after-tax basis.
“From a pre-tax perspective, the superannuation fund investor is indifferent between the franked and unfranked dividends (in the paper’s hypothetical example, each security yields 5% and has an overall return of 8%), as shown below:
“An after-tax perspective, however, tells a different story: There is a clear preference for the fund to receive the franked rather than unfranked dividend, providing a yield of 6.07% (a 9.07% total return) for accumulation members and a yield of 7.14% (a 10.14% total return) for pension members. Both results outperform the unfranked dividend alternatives after tax.”
The authors say the hypothetical example showing the difference between pre-tax and after-tax returns of 1.82% (accumulation) and 2.14% (pension) is a principle worth highlighting in this low return environment. “Simply incorporating the value of franking credits in performance reporting results in a material uplift in absolute after-tax returns.
“What this means in a practical sense is that a superannuation fund’s Australian equity portfolio will, after tax, typically be making a bigger return contribution to the underlying member’s retirement goals than all the pre-tax performance reporting on the equity strategy would suggest.”
The report also identifies five trends in investment thinking that the authors predict will influence how higher-franking strategies are viewed by superannuation funds.
“The most high-profile trend is the industry’s development of CIPR (soon-to-be-renamed Comprehensive Income Product for Retirement) solutions for members in retirement phase. The risk-adjusted return case for a franking tilt is stronger for pension portfolios than for accumulation portfolios, which can add to a fund’s investment case to segregate pension from accumulation assets.
“Other investment trends influencing funds’ appetite for higher-franking strategies are after-tax investing, formal risk-adjusted return approaches, the rise of factor-based investing and re-defining ‘risk’ beyond the standard concept of benchmark-relative ‘tracking error’.
“All of these trends are likely to make funds more, rather than less, interested in higher-franking strategies like those presented in this research,” the authors say.