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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Colley says: “There is a common misconception, which some advisors and accountants promote, that a franking credit is like a gift from the government that reduces the amount of tax payable by the fund. “Although this may be the outcome, it couldn’t be further from the truth, as franking credits are really a timing issue in relation to the tax to be paid.

“In effect, the tax paid by the company is potentially dividend income foregone by the shareholder, who later gets the opportunity to reclaim some of this tax via franking credits.

“A franking credit alters the timing of paying tax payable by the SMSF. This occurs at the time the company pays income tax which may end up as a franking credit on dividends paid to the fund and included in the fund’s income.” Colley says it’s also often not appreciated by trustees that their eligibility to claim franking credits against the tax payable by their SMSF has some limitations.

“The entitlement to use the franking credit may not be available where the company paying the dividend is involved in a dividend streaming or stripping arrangement or where there is a franking credit trading scheme in place.

“Remember, too, that to be eligible for the franking credit offset shares must satisfy the holding period rule that requires the superannuation fund to retain the shares ‘at risk’ for at least 45 days, excluding the days of acquisition and sale, and for some preference shares for at least 90 days.

“An exemption to this rule applies to small shareholdings where the total franking credit entitlement is less than $5,000.”

He says there are undoubted advantages from franking credits for SMSFs, especially in the pension phase, but it’s not a simple issue. Trustees would be well advised to get professional advice about how to maximise their use of franking credits.

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With Rio Tinto upping its payout to shareholders and JB Hi-Fi, Cochlear and OZ Minerals following suit this reporting season, it may be tempting for investors to buy up dividend paying stocks. However, according to Russell Investments’ latest paper, Dividends are the new black – Why the classics always come back in fashion, it is important for investors to consider more than just yields and know which companies are worth buying and which companies have unsustainable dividends.

The theme of income investing has experienced a surge in popularity recently owing to the attractiveness of dividends as a consistent source of positive returns and having less volatility in lower growth environments. On this, Russell’s new paper provides a ‘how to guide’ for getting the most out of dividends by indentifying companies whose dividends are likely to grow over time. This includes assessing multiple characteristics such as historical dividend yield, forward looking dividend yield, historical dividend trajectory and earnings variability over multiple time periods.

Russell’s ETF product specialist, Bronwyn Yates says the paper has given consideration to the role after-tax strategies play in the income investing theme, with the paper explaining how to make the most out of franking credits to achieve an alternative source of return for investors.

The Russell paper also looks at using different dividend strategies for different investment stages by highlighting the importance for those in the accumulation stage to think of dividends as a way to supplement growth in a volatile market. Those in decumulation should use dividends to supplement income to avoid drawing on capital.

Click here to read the full report.

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Investing for growth has long been in vogue for Australian investors, and with recent periods of long term growth, it is easy to see why. However, the often overlooked dividend may provide a more consistent source of return that can help investors tailor a portfolio to meet their needs.

While the Australian market is well known for its growth opportunities, it may be surprising to some that it is the old faithful dividend that has driven a significant component of our historical share market
return. As shown below, over the last 10 years dividends represent 4.1% of the total return of the Australian market with a further 1.4% attributed to franking credits.

Dividends – always in season

Any balanced and well diversified portfolio needs an element of growth, but income as a source of return should not be overlooked and left for the bottom drawer.

In high growth periods, we can see that dividends still provide a valuable contribution to the total return of the market. Dividends can play an important complement to the growth component of a portfolio, even in high growth environments.

In negative return periods, dividends can also provide a positive source of return that can minimise the impact of the negative return on the capital component.

Why dividends are so hot right now

However, it is in times of low or slow growth that we see a greater interest in dividend opportunities. As we see increasing indicators that we will continue to have a slow growth environment at least in the short term, dividends can play an important role in getting the most out of your portfolio return.

Furthermore, by comparing the sources of return of the Russell Australia High Dividend Index (below), it demonstrates dividends provide a consistent positive return source that has a much lower volatility compared to the price returns. So while an investor may not require income in itself, income as a source of return may be attractive with its lower volatility over market cycles and greater value of total return in slow growth environments.

Picking designer dividends from cheap imitations

Dividends can be used to give an illustration of the general health of company, including its growth prospects and its predictability and stability of earnings. However, it is important to know how to tell a designer from a cheap imitation.

Dividend yield alone is not a good indication of future income. High dividend yield figures may in fact be a result of extreme falls in price that potentially reflect market concerns regarding the sustainability and stability of a company’s earnings.

For example, Telstra’s recent yield has moved around 10% p.a. If we take an investor who made a $10,000 investment in Telstra 10 years ago, they would now be receiving income of around $370 per year.

We can see from this chart that by chasing yield alone your future income opportunities can be limited if the price is not sustainable.

However, by looking beyond yield alone, a number of other strong and sustainable income opportunities can be identified.

For example, BHP is not synonymous with being a high dividend paying stock. But under the same scenario, our investor would be receiving around $750 in dividends plus franking credits. This is in addition to the capital growth opportunities an investor can benefit from.

Therefore, if an investor looks beyond yield alone, they can benefit from a growing income stream that is delivering a greater dollar value while also maintaining the potential for capital growth over time.

Therefore instead of relying on a simplistic yield metric, there are additional characteristics that can be evaluated when identifying more sustainable dividend opportunities. The Russell Australia HighDividend Index for example, assesses dividend characteristics based on four key criteria:

• Historical dividend yield
• Forward looking dividend yield
• Historical dividend trajectory
• Earnings variability

By assessing multiple characteristics, and over multiple time periods, it provides a more robust way to evaluate dividend opportunities and ensure that future dividend opportunities are sustainable. Instead
of chasing the higher yielding stocks and creating portfolio turnover to do so, the more sustainable dividend opportunities allows you to minimise transactions and also the subsequent taxation
implications.

Franking credits – the perfect portfolio accessory

As after-tax investing grows in fashion, investors are seeking ways to include tax strategies to complement their portfolios. Dividends and their associated franking credits can be an ideal way to give the after tax portfolio return some much sought after enhancement.

By receiving dividends, investors also receive the benefit of franking credits that represent a tax credit that can be used to offset tax liabilities. For low or zero tax paying investors, such as those in pension phase, franking credits can be exchanged for cash through the Australian Taxation Office. In order to quantify this benefit when evaluating income opportunities, the dividends can be grossed-up to ensure the franking credit value is considered.

Therefore, a way to consider franking credits is an alternative source of return in addition to price and income return. To illustrate this, the grossed up total return of the Russell Australia High Dividend Index
can be deconstructed to unique sources of return, demonstrating that franking credits may provide material benefits to a portfolio on an after tax return basis in addition to other return sources.

How you can get the most wear out of your Dividends

By tracking the different capital and income return of the Australian equity market, we can see that as the capital value increases over time, so does the dollar value of the income. This is in contrast to cash, where the capital value and income return does not see growth over the long term.

Source: Shares = S&P/ASX300 Price Index and S&P/ASX300 Accumulation Index, Term Deposit = Reserve Bank of Australia 12 Month Term Deposit Rate (> $10,000)

If an investor does require an income stream to grow over time the growth of capital is also important. To enhance the potential of this growing income, the capital base needs to increase also.

A way to potentially do this is to reallocate some gains from the growth part of the portfolio to the dividend paying component, this will enable an increase in the capital base of the dividend component and further enhance the dividend opportunities. In practice, this may be implemented by re-allocating realised capital gains (eg distributable CGT of an actively managed fund) to a dividend strategy.

Alternatively there are strategies that combine growth and dividend objectives that support this concept.

How you can style your dividend strategy for all seasons

Dividends can play a key role in any investors’ portfolio. Dividends can deliver a more consistent source of return over the long term, while price values may be volatile in short term, but knowing that they will
continue to provide a sustainable component of the total return even in high growth environments. The added benefit of dividends is their associated franking credits and the tax benefits they can bring investors.

There are specific ways that different types of investors may wish to implement and use dividends in their portfolios throughout their investment lifecycle.

Accumulation

• Not all investors want income. However, dividends can provide a sustainable source of positive return that offsets the impact of negative price returns in volatile markets.
• Franking credits used to offset tax liabilities – useful for those with higher marginal tax rates
• Income can be used to offset or reduce expenses in gearing strategies such as margin lending interest.

Transition to Retirement (TTR)

• Income can be used in TTR strategies. Not only does the income provide a way to assist strategies such as salary sacrificing, but also the franking credits can be used to offset tax liabilities.
• By purchasing investment with dividends before retirement, using the income and deferring any sale of capital until the pension phase, capital gains tax implications can be deferred until investors are in a zero-tax environment.

Decumulation

• Use dividends to supplement income and avoid drawing on capital.
• By remaining invested in equities, sustainable dividend opportunities can provide growing income potential with capital growth opportunities.
• Use your franking credits to receive a cash payment from the ATO.

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