Measuring the returns from franking
Figure 1: The after tax value of returns for different Australian investors*
Table 1: Share performance - before and after franking*
Figure 2: Ten-year performance - Australian versus US share indices*
Figure 3: S&P500 versus S&P/ASX200 total returns - ten years to 31/12/14*
Table 3: Comparing fund returns*
In this article, Dr Dom Hanson of Plato Asset Management discusses why measuring franking credits is important, particularly for low tax Australian investors.
In 2000, franking credits became fully refundable to low tax Australian investors, helping to supplement the returns for superannuation funds and tax exempt investors. For tax exempt investors such as pension phase superannuation funds, franking credits increase returns significantly. Unfortunately, up until now most commonly used investment performance benchmarks and performance surveys have excluded franking credits1 based on our observations. Pleasingly, S&P Dow Jones Indices, who calculate popular indices such as the S&P/ASX200 in Australia and the S&P500 and Dow Jones Industrials in the US, has just launched a new series of S&P/ASX tax- aware indices which measure the impact of franking credits on the returns of Australian shares. We welcome the new S&P/ASX tax-aware indices and hope with their launch Australian investors will pay far more attention to the level of franking credits that both the market and their portfolios are generating.
The importance of franking
Figure 1 (above) highlights the tax differences between pension, super and the highest individual tax rate and the value of franking credits for pension and accumulation phase superannuation. Figure 1 displays the after tax value for $1 of pre-tax return for the different investors. For the pension investor $1 of pre-tax capital gain (short or long) as well as unfranked income (interest, rental, overseas dividend, unfranked dividend) is worth $1. However, $1 of fully franked dividend is worth $1.43 since the pension investor gets a $0.43 franking credit refund. Franked dividends are also worth the most for super investors at $1.21, $0.21 more than their cash value, with long term capital gains worth $0.90 whilst short term gains and unfranked income are worth $0.85.
Comparing Australian and US returns
We believe one failure of the Australian investment industry is that franking is largely invisible, with investment returns conventionally reported pre-tax, excluding franking. In our opinion, most investment surveys in Australia will have very little mention of franking credits, and many investors tend to forget about income altogether. We are often asked why the US equity market continues to set new all time highs, whilst the Australian market is still well below its pre GFC highs as highlighted in Figure 2 (above, click to scroll to Figure 2).
Figure 2 is actually quite misleading in our view. These two indices – indices which are quoted daily in the paper headlines and on television - are actually price indices. They only consider the value of share prices, completely disregarding any dividends received, let alone franking credits. Share market indices that incorporate dividends are called accumulation or total return indices. Accumulation indices reflect the actual returns that buy and hold investors would have received, normally excluding franking. In Figure 3 (above, click to scroll to Figure 3), we chart the accumulated returns on the S&P/ASX200 and the S&P500 plus the accumulated returns that a pension investor would receive by including the value of franking credits using the S&P/ASX 200 Tax Exempt Index.
Including dividends, the higher yielding Australian market has achieved a similar return as the US S&P500 in local currency terms before accounting for franking. In accumulated terms the S&P500 rose 109% (7.7%pa) over the 10 year period, whilst the S&P/ASX200 Accumulation Index rose 107% (7.6%). When one takes into account the value of franking which is only available to Australian investors, the S&P/ASX200 Tax Exempt has outperformed the S&P500 by a significant margin, rising some 139% (9.1%pa). Franking credits provided an additional 1.5% pa to the returns of the S&P/ASX200 over the 10 years for a tax exempt investor, representing 17% of the total after tax return of 9.1%pa.
Figure 3 also shows that the Australian market has set new all time total return highs both excluding and including franking credits. Therefore in accumulation terms, buy and hold investors have now made up all the losses of the GFC period.
Comparing fund returns
We have only looked at the franking level on a broad market index thus far. Let us now look at how active returns can be compared before and after franking credits. To do so we will examine the before fee returns for the Plato Australian Share Income Fund, a fund managed specifically for tax exempt investors. Table 2 compares performance before franking credits in panel A and after franking credits in Panel B.
As one would expect the total returns in Panel B which incorporate franking credits are substantially higher than the total returns in Panel A which exclude franking. In addition, the active returns of the Plato strategy with franking are approximately 1% higher than the active returns excluding franking. So not only does the Plato strategy add value before tax, it adds even more value after tax. In fact approximately 1/3 of the Plato value add for a tax exempt investor is in the form of additional franking credits over and above the level of franking of an index fund. Of course, we expect this to be the case, as the Plato strategy is specifically managed from the perspective of a tax exempt investor who fully values franking credits.
We would not expect, however, that every fund manager would look better on an after tax basis. Plato adopts an income style of management, which naturally generates more franking than a market index. Other styles with more focus on capital growth may quite likely generate less income and less franking than the market. The important point we are making is that if one is managing money for tax exempt investors, one should measure performance from that perspective. With the launch of the new S&P/ASX tax aware indices, we now have performance benchmarks which do incorporate franking.
When Australians retire, their superannuation investments become tax free, and since 2000, this has meant that they have received full refunds of Australian franking credits. For a given level of pre-tax return the only thing pension investors can do to improve after tax returns is to generate more franked income, which is worth 43% more than any other form of return. Therefore, franking credits are very valuable for tax exempt Australian investors like pension phase superannuation funds, yet they are often overlooked. Up until now, performance has generally been reported on a before tax basis, excluding franking credits, and thus underestimating the returns tax exempt investors earn on Australian shares. The S&P/ASX200 has generated 1.5%pa in franking over the past 10 years, representing 17% of the total returns for a tax exempt investor. We have shown that overlooking the value of franking credits can make performance comparisons across markets or between active strategies quite misleading.
We welcome the new S&P/ASX tax-aware indices and hope with their launch Australian investors will pay far more attention to the level of franking credits that both the market and their portfolios are generating.
This article appeared in mFund News. To stay informed on market and investment updates, subscribe to mFund News.
About the author
Dr Don Hamson has over 20 years investment management experience and is Founding Managing Director of Plato Investment Management. Prior to establishing Plato, Don was Head of Active Equities, Asia Pacific and a member of the global Senior Management Group at State Street Global Advisors . Prior to State Street, Don was Chief Investment Officer at Westpac Investment Management whereby he was instrumentally involved in the mergers of BT and Rothschild with Westpac's financial services division to form the new BT Financial Group and prior to this was responsible for the Westpac Dividend Imputation / Tax Effective Australian Share Fund.
Don started his career with Arthur Andersen before becoming a Lecturer in Finance at University of Queensland and subsequently a senior analyst and member of the Investment Committee at Queensland Investment Corporation.
1FTSE/ASFA did release franking credit inclusive benchmarks some years ago, but we believe these are rarely quoted in the financial press. Unfortunately the FTSE/ASFA 200 index is slightly different in make up to the S&P200 index. Russell did launch a performance survey which included franking credits, but have recently stopped that survey.
*Sources for figures and tables:
Figure 1: ATO, Plato using 2014/15 tax rates
Table 1: S&P Dow Jones - *S&P/ASX200 Franking Credit Adjusted Daily Total Return Index (Tax-Exempt. Data as at 31 December 2014. Past performance is not a reliable indicator of future performance
Figure 2: Plato, S&P Dow Jones local currencies
Figure 3: Plato, S&P Dow Jones local currencies
Table 2: Performance is gross of fees and expenses. Data is as at 28 February 2015. Past performance is not a reliable indicator of future performance.
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