If Labor's franking credits proposal comes to fruition, more and more investors will move away from their home bias and begin looking offshore for higher returns, writes Citi Australia's David Zammit.
The recent announcement by the Labor party that if elected, they will eliminate cash refunds of excess dividend franking credits, has sparked much debate about whether or not the current policy is a generous tax loophole or simply part of a tax system designed to avoid the double taxation of income.
Regardless of which side of the debate you fall on, a fact that’s not being discussed is the significant home bias of the Australian investor and just why franking credits are at the centre of such heated political discussion.
According to ATO data from 2016, an SMSF between $500,000-$1 million currently has less than 1 per cent of their assets invested in overseas shares compared with more than 25 per cent in Australian shares.
Undoubtedly, our dividend franking system is unique and often results in a boost in the overall yield from Australian company shares, particularly for those on a low tax rate.
But how does this compare to investing in other asset classes, and is the benefit so great that it warrants most Australian share investors holding only domestic equities in their portfolios?
Before we answer this question, let’s quickly recap on just why Australian shares paying fully franked dividends have been so widely popular to the Australian investor.
When talking about returns from an investment, advisors and other experts generally talk in terms of the ‘gross’ return, or the return before tax is paid on the income.
Depending on who owns the investment and what tax rate they are on, the after tax return can vary widely. For those on a higher marginal tax rate, the franking credits attached to the dividend can serve to reduce their overall tax liability.
While for those on a low marginal tax rate or for those with an SMSF, any excess franking credits are refunded in cash.
But how does the after tax return for these investors actually stack up against the returns earned on other asset classes that don’t benefit from dividend imputation?
A recent report by the ASX and Russell Investments compared the after tax returns of various asset classes based on a taxpayer on the lowest marginal tax rate (MTR), a taxpayer on a highest MTR, and an Australian super fund paying tax at the flat rate of 15 per cent.
When comparing a portfolio of Australian shares with a portfolio of global shares (hedged) over the 10 years to December 2016, the global shares outperformed Australian shares by 0.6 per cent for an investor on the highest MTR.
The after tax return was the same for the investor on the lowest MTR, and for the super fund, the Australian shares outperformed by 0.1 per cent.
For the same period, global bonds (hedged) significantly outperformed Australian bonds for all investors, with an investor on the lowest MTR 1.0 per cent better off, an investor on the highest MTR 0.6 per cent better off, and a superannuation fund 1.1 per cent better off after tax.
Interestingly, after tax, an investor with a portfolio of global bonds would have been better off by 1.3 per cent (lowest MTR), 0.9 per cent (highest MTR) and 1.4 per cent (superannuation fund), compared with an investor with a portfolio of Australian shares.
While the impact of tax on global assets was noticeably larger than the impact of tax on Australian assets, the overall after tax return on global assets was superior compared with Australian assets.
Seeing the significant outperformance, even after tax, of global markets over the past 10 years, it begs the question why Australians are still reluctant to go global with their investments, or even to diversify their portfolios away from domestic equities.
In an investment portfolio, the power of diversification comes from having exposure to multiple sources of risk and return.
Various countries’ business and financial market cycles are often at differing stages and by investing in a country or region with faster economic growth than one’s own, potentially higher returns from that growth may be captured.
There is a surprisingly widespread belief that portfolios exposed to emerging markets, different currencies, or illiquid asset classes actually increase overall risks, when, in fact, historical data shows the opposite is true.
For the unadvised investor, the challenge of understanding global markets and the attractiveness of investing domestically makes a global diversified portfolio difficult to achieve. This is compounded by the perception that global markets have generally been difficult to understand and expensive to access directly.
It is therefore not a surprise finding out that investors' exposure to global markets is limited.
However, if changes to franking credits do come into place, we envisage more and more investors will start looking offshore to seek higher returns.
With this push, we expect investors will become more open to investing globally, and Australians will begin to move away from the home bias that has characterised most local share portfolios to date.
David Zammit is the head of banking and wealth management distribution at Citi Australia.