Franking credits boost yields on Australian equity portfolios and can be targeted during the stock selection and portfolio construction processes.
However, to maximise the benefits of franking credits and address any additional risks a franking strategy may contain, super funds need to be careful.
Franking credits are not a ‘free lunch’ and how the equity portfolio is constructed really matters.
A recent paper by the research team at Parametric revisited earlier work with a more detailed examination of how franking strategies can be used in an income-seeking portfolio.
We show how super fund members in pension phase should benefit more from a cleverly constructed franking-aware equity portfolio than those in the accumulation phase – an important insight as super funds consider their retirement product design.
All members, though, can benefit from the fund adopting sophisticated optimisation techniques to boost yield from franking credits, rather than settling for blunt screening or tilting approaches.
Optimisation portfolio construction techniques can deliver another important benefit to funds over blunter screens or tilts.
A sophisticated fund manager can design a finely-tuned portfolio to cater to an individual fund’s objectives and risk appetite for things like yield, tracking error, concentration, sector and style factor risks, turnover and volatility.
In the hypothetical 11-year backtest of an S&P/ASX 200 portfolio presented in the research (which did not consider fees or transaction costs), the use of optimisation techniques, rather than a simple screened approach for favouring stocks with higher franked dividends, delivered an additional 20 basis points a year in excess after-tax returns, with less volatility and lower tracking error for a super fund member in the accumulation phase.
For pension phase members, the after-tax return pick up was higher, at 26 basis points a year. These hypothetical results excluded off-market share buybacks, which the paper notes in reality are additional opportunities for pension portfolios with income-seeking objectives.
Here we discuss several key trends that could whet a super fund’s appetite for pursuing franking credits to help with an income-seeking portfolio. These are:
- After-tax investing: The SIS Act now obliges funds to consider member outcomes net of fees and taxes. More compellingly, funds now understand that after-tax approaches can add value in a material way.
- The risk-awareness trend: Super funds can now assess the merits of chasing higher franking returns given the risks involved by using formal risk budgeting and risk-adjusted return frameworks and metrics. The fine control offered by 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, but the risks remain similar, when pension (tax-free) investing is the focus. Funds considering pension asset segregation can evaluate the merits of higher-franking Australian equity strategies as a stand-alone proposition for their pension members.
- 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. But 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” super funds, the paper says, recognise that their members define ‘risk’ differently as they move into and through retirement, and are beginning to challenge the industry’s anchoring bias around market-cap indices. If risk was redefined to cover issues like volatility, downside and tail risk, inflation risk and maximum drawdown, then franking strategies could be judged against a different risk paradigm entirely.
Raewyn Williams is the managing director of research at Parametric Australia.
