The demographic shift leading demand for retirement products, the trend to factor investing strategies and questions over market-cap benchmarks are combining to raise awareness for the importance of franking credits. But it’s not as simple as it seems.
A new paper from implementation manager Parametric, ‘A Fresh Look at Franking’, revisits earlier work which showed that franking credits did not provide super funds and other investors with a free lunch. Adopting a franking-seeking strategy, in fact, introduced new risks into a portfolio which needed to be considered.
Parametric has now updated that 2014 paper with a more detailed examination of how a portfolio can be optimised such that the net overall returns due to franking credits are higher and how major trends in the investment landscape have prompted a fresh way of looking at the benefits.
The authors of the latest paper, led by Raewyn Williams, Parametric Australia managing director and head of research, say that while the fresh approach still does not deliver a free lunch, it should enable a sophisticated manager to cater for an individual fund’s objectives and risk appetite for things like yield, tracking error, concentration, sector and style factor risks, turnover and volatility.
In one of the samples from its research, Parametric shows that the use of optimisation, rather than the usual simple screened approach for favouring stocks with higher franked dividends, delivers an additional 20bps a year in excess after-tax return, with less volatility and lower tracking error.
An important consideration given the demographic trend of an ageing membership base for most funds, is that the benefits in the retirement phase a re significantly higher than in the accumulation phase.
Using the same sample data, Parametric shows the optimized pension phase portfolio achieved a 51bps after-tax annualised excess return, compared with 25bps for the simple screened approach.
The other authors of the paper are: Martha Strebinger, investment strategist; Vassilii Nemtchinov, director of research, equity strategies research and product development; and, Travis Bohon, senior quantitative analyst.
The group nominates five key trends in current investment thinking which should whet a fund’s appetite for pursuing the benefits of franking credits in a targeted way. These are:
- After-tax investing. While APRA now obliges funds to consider member outcomes net of fees and taxes, it is clear that after-tax approaches add value in a material way, and this should be the central motivator for a fund.
- The risk-awareness trend: Funds are now able to assess the merits of chasing higher- franking returns given the risks involved by using formal frameworks and metrics which express the qualities of the franking strategy on a risk-adjusted return basis. The fine control offered by the optimisation techniques of portfolio construction allows funds to honour their new, formally articulated risk convictions and preferences in a very targeted way.
- The formulation of CIPR pension solutions: Relative to accumulation outcomes, the returns from franking increase considerably, but the risks remain similar, when pension (tax-free) investing is the focus. Funds considering, or in the process of, segregating their pension assets from their accumulation assets have the opportunity to evaluate the merits of higher-franking Australian equity strategies as a stand-alone proposition for their pension members. This is especially true when the Australian equity market offers up off-market share buyback opportunities which are, increasingly, being priced to be attractive to pension, but not accumulation, portfolios.
- The rise of factor-based investing: The risks analysed in the paper reflect the standard notion of deviations from a market cap-weighted S&P/ASX 200 portfolio. With the advent of factor-based investing, what if some superannuation funds adopt explicit factor-tilted indexes as their new benchmarks? This would immediately change the risks of a higher-franking portfolio as measured.
- The benchmark sensitivity trend: Some “forward-thinking” funds, the paper says, acknowledge that market-cap indices’ investment objectives may not really align with success in the eyes of their members because members define ‘risk’ differently. This challenges what is arguably the industry’s anchoring bias around market-cap indices. Abandoning this anchor could redefine risk to cover issues like volatility, downside and tail risk, inflation risk and maximum drawdown.