Future Focus: Are franking credits ‘free alpha’?
There’s always an opportunity cost.
Aussies love franking credits - so much so that they make up a key part of many investment strategies. This is not common tax policy - most countries do not have an equivalent tax credit system.
They’re woven into the national identity – a symbol of smart tax planning and steady income. Alongside no inheritance tax, negative gearing, and CGT main residence exemption, franking credits are the untouchables of Australian tax policy. Politicians have lost elections on the whisper they might be changed. They are so heavily entrenched into investment strategies, that sometimes they can drown out the bigger picture. We know they are valuable to investors, but their value is not as straightforward as it seems.
There’s no denying that franking credits add to your total return but it’s important to understand the trade-offs. The goal of investing is not to maximise or overemphasise one tax benefit, but to holistically find the best approach to achieve your goals. This means considering how a portfolio addresses the time horizon and cash flow needed to get what you want out of life.
Becoming a great investor is understanding the opportunity cost – what you are giving up – based on your chosen strategy. In this case, the consequence of Australian investors focusing on companies that pay franked dividends.
What are franking credits and how much do they improve your returns by?
First, it’s worth a quick run through on how franking credits work. When an Australian company earns income and pays taxes a credit is generated for the taxes which is passed to investors as party of dividend payments.
My colleague Mark has outlined how to calculate the face-value of a franking credit.
((dividend amount ÷ (1 – company tax rate)) – dividend amount) x franking percentage
For most listed Australian companies the tax rate is 30%. We can calculate the value of a franking credit for a company that pays a $1 dividend that is 100% franked using the formula:
(($1 ÷ (1 – .30)) – $1) x 100% = $0.43
It’s estimated that historically, franking credits add around 2% p.a. to the return of the S&P/ASX 200, which is 22% of the total return from 2011 to 2021. This is meaningful, and franking credits matter. The question is what are you giving up for being overweight companies with franked dividends in your portfolio?
The trade-offs investors make when chasing franking credits
When franking credits become a mandatory or overly influential factor in selecting investments for your portfolio, there may be material implications. This is what investors should be aware of.
1. Narrowing the investment universe
Searching for investments purely based on or heavily influenced by a tax credit means that you’ve got blinkers on for other investment opportunities that may better fit the goals you are trying to accomplish with your portfolio. You’ll also have a portfolio that’s filled with very similar companies – those that distribute their profits in the form of dividends and have paid sufficient tax to distribute franking credits. This isn’t a bad thing – but that often means that your portfolio will be filled with large, mature domestic companies.
In Australia, these companies are concentrated in the banks, utilities, telecommunications and resources sectors.
This often means ignoring exposure to international companies, or companies with better prospects for dividend and share price growth.
Narrowing your remit to focus on franking credits means that you are implicitly giving up growth potential and diversification benefits. This may lower the resiliency of your portfolio, especially as dividends and accompanying franking credits are never guaranteed.
2. Cashflow and income timing
Franking credits are attractive because they boost after-tax income. However, depending on the size of your portfolio, you may reduce the tax effectiveness with the income you receive from dividends.
For example, take an investor that is purely focused on companies that provide franked dividends. You make enough from your dividends to push your assessable income into a higher marginal tax rate. The 30% credit you receive from franking is now applied to a higher tax rate. It is offsetting a smaller proportion of your tax obligation.
‘Growth’ oriented investments which typically do not distribute income divert tax until disposal. This gives investors more flexibility in planning withdrawals and tax timing.
3. The opportunity cost of franking credits
The 2% boost from franking credits is a large addition to your return – but you’re not getting that for free. You’re missing out on other opportunities in your portfolio. You may reduce your capital growth opportunities as previously mentioned, as fully franked dividends usually come from mature companies.
You also narrow your focus and miss out on global diversification as companies listed overseas lack franking credits. This can mean missing out on whole industries like technology which is underrepresented in Australia. You miss out on exposure to the largest companies in the world. You may miss out on superior global opportunities.
Mark speaks in his article about the value of franking credits about how over-attachment to franking credits can lead to missed opportunities. The over-attachment is often due to emotional bias, rather than rational investment decisions.
What did this look like for investors? Investors who had home and franking credit bias over the last ten years missed out on the growth of the world’s largest companies. S&P provides a franking credit adjusted index that demonstrates the increase in returns based on franking credits. The index includes the ASX/300, some of which do not pay a dividend or have an attached credit.
The largest beneficiary of increased returns from franking credits are retired investors who are on a 0% tax rate. This cohort of investors would have achieved an 11.09% annual return over the last decade. The S&P 500 returned 1.5% more annually over that period. The return gap increases when you consider an investor on any marginal tax rate above 0%.
For some investors concentrating on franking credits may be the right decision. Particularly investors that aren’t focused on capital growth. However, for investors who are interested in franking credits’ return bolstering capabilities the exploration of returns over the last ten years is illustrative. Although returns are not guaranteed, neither are dividends or franking credits.
Aligning franking credits with your goals
Once you’ve weighed up what you’re missing out on when focusing on franking credits, the next question to tackle is how they can complement a portfolio instead of driving the investment decisions.
Step one: Start with your investment goals and the objective of your portfolio
Are you focused on deriving passive income from your portfolio? Are you accumulating and focused on capital growth? The role of franking credits will differ.
It helps to model true after-cash cashflows. It’s not as simple as looking at yield + franking credit to understand your total return. The specific impact on your own returns depend on your marginal tax rate.
Let’s go through an example. Let’s assume a fully franked dividend of $70, and $30 of franking credits. Those on lower tax rates receive a refund.
Step two: The past may not be replicated in the future
Franking credits and dividend income are not guaranteed. A resilient portfolio shouldn’t solely rely on these credits to continue to achieve satisfactory portfolio outcomes. Over decades, there may be tax policy changes. Your marginal tax rate, and therefore the after-tax return of your portfolio, can change. Companies may reduce, pause or cease dividend payments. There are a multitude of variables that will change your portfolio return.
As attractive as franking credits are they are not worth giving up portfolio resiliency.
Final thoughts
The benefits of franking credits are real and tangible. It can be difficult for investors not to chase these seemingly guaranteed return boosters by further concentrating a portfolio to maximise their impact. This concentration may seem wise in the short-term with steady income and the added tax benefit but over the long-term may generate lower growth and higher concentration risk.
The right portfolio is rarely the one that focuses on the highest tax refund. Franking credits can be powerful for your return outcomes, but only when supported in a diversified portfolio.
Invest Your Way
For the past five years, Mark and I have released a weekly podcast and written on morningstar.com.au to arm you with the tools to invest successfully. We’ve always strived to provide independent, thoughtful analysis, backed by the work of hundreds of researchers and professionals at Morningstar.
We’ve shared our journeys with you, and you’ve shared back. We’ve listened to what you’re after and created a companion for your investing journey – Invest Your Way. Invest Your Way is a book that focuses on the investor, instead of the investments. It is a guide to successful investing, with actionable insights and practical applications.
If anyone would like to support this project you can buy the book at the below links. It is also available in Kindle and Audiobook versions. Thanks in advance!
