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 credits 1 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. In this short note we discuss why measuring franking credits is important, particularly for low tax Australian investors. The importance of franking Figure 1 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. 1 FTSE/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.
Figure 1. The after tax value of different returns for different Australian investors. $1.43 $1.21 $1.00 $1.00 $1.00 $0.90 $0.85 $0.85 $0.73 $0.76 $0.51 $0.51 Pension Super Top Individual (49%) Fully Franked Dividend Long Term Capital Gain Short Term Capital Gain Unfranked Dividend Source: ATO, Plato using 2014/15 tax rates. How large is franking? In Table 1, we compare the performance of the normal S&P/ASX Accumulation Index with one of the new tax aware series which fully values franking from the perspective of tax exempt investors such as charities or pension phase superannuation funds. Over the three years to December 2014, the new S&P/ASX200 Franking Credit Adjusted Daily Total Return Index (Tax-
Exempt) ( S&P/ASX200 Tax Exempt ) outperformed the regular S&P/ASX 200 Accumulation Index (which doesn t measure franking credits) by some 7.2% overall, or 1.8%pa. Table 1. Australian Share performance before and after franking 3 years to December 2014. S&P/ASX200 Accumulation (Without Franking) S&P/ASX200 Total Return Tax- Exempt (With Daily Franking)* Difference 3yrs to Dec 14 Accumulated 52.7% 59.9% 7.2% 3 yrs to Dec 14 pa 15.1% 16.9% 1.8% 2012 20.2% 22.2% 2.0% 2013 20.2% 22.0% 1.8% 2014 5.6% 7.2% 1.6% Source: 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. 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.
Dec 2004 May 2005 Oct 2005 Mar 2006 Aug 2006 Jan 2007 Jun 2007 Nov 2007 Apr 2008 Sep 2008 Feb 2009 Jul 2009 Dec 2009 May 2010 Oct 2010 Mar 2011 Aug 2011 Jan 2012 Jun 2012 Nov 2012 Apr 2013 Sep 2013 Feb 2014 Jul 2014 Dec 2014 New S&P/ASX indices measure the Figure 2. US S&P500 versus Australian S&P/ASX200 Price Indices 10 years to 31 Dec 2014. 2500 US S&P500 price Aust S&P/ASX200 Price 2000 1500 1000 500 0 Source: Plato, S&P Dow Jones local currencies 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, 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.
Dec 2004 May 2005 Oct 2005 Mar 2006 Aug 2006 Jan 2007 Jun 2007 Nov 2007 Apr 2008 Sep 2008 Feb 2009 Jul 2009 Dec 2009 May 2010 Oct 2010 Mar 2011 Aug 2011 Jan 2012 Jun 2012 Nov 2012 Apr 2013 Sep 2013 Feb 2014 Jul 2014 Dec 2014 New S&P/ASX indices measure the Figure 3. S&P500 versus S&P/ASX200Total Returns over 10 years to 31 Dec 2014. 2500 US S&P500 Total Return Aust S&P/ASX 200 Accumulation Aust S&P/ASX200 TR Tax Exempt 2000 1500 1000 500 0 Source: Plato, S&P Dow Jones local currencies. 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.
Table 2. Active performance comparisons for the Plato Australian Share Income Fund before and after franking. Panel A Excluding Franking 1 year 2 years p.a. 3 years p.a. Since Inception p.a. (9/9/11) Plato Income^ 16.0% 14.8% 18.6% 18.0% S&P/ASX 200 Accumulation Index 14.6% 12.6% 16.3% 15.5% Active +1.4% +2.2% +2.3% +2.5% Panel B Including Franking 1 year 2 years p.a. 3 years p.a. Since Inception p.a. (9/9/11) Plato Income with franking^ S&P/ASX 200 Tax Exempt 19.1% 17.6% 21.5% 20.7% 16.2% 14.3% 18.1% 17.2% Active +2.9% +3.3% +3.4% +3.5% Active Difference +1.5% +1.1% +1.1% +1.0% ^Performance is gross of fees and expenses. Data is as at 28 February 2015. Past performance is not a reliable indicator of future performance.
Summary 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. Disclaimer This communication has been prepared by Plato Investment Management Limited ABN 77120730136 Authorised Representative No. 304964 of Pinnacle Investment Management Limited AFSL 322140. Interests in the Plato Australian Shares Income Fund ARSN 089 548 443 are issued by Pinnacle Fund Services Limited, ABN 29 082 494 362, AFSL 238371 (Pinnacle) as Responsible Entity of the Fund. Please read the latest Product Disclosure Statement available at www.plato.com.au in its entirety before making any investment decision. This communication was prepared for multiple distributions and any advice contained in this presentation is general advice. It has been prepared without taking account of any person s objectives, financial situation or needs, and because of that, any person should before acting on the advice, consider the appropriateness of the advice having regard to their objectives, financial situation and needs. Any person considering action on the basis of this communication must seek individual advice relevant to their particular circumstances and investment objectives. This communication is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to an investment. Any opinions, forecasts or recommendations reflect the judgment and assumptions of Plato Investment Management Limited (Plato) and its representatives on the basis of information at the date of publication and may later change without notice. Any projections contained in the information are estimates only. Such projections are subject to market influences and contingent upon matters outside the control of Plato and therefore may not be realised in the future. Past performance is not a reliable indicator of future performance. Pinnacle and Plato believe the information contained in this communication is reliable, however no warranty is given as to its accuracy and persons relying on this information do so at their own risk. To the extent permitted by law Plato and Pinnacle disclaim all liability to any person relying on the information in respect of any loss or damage (including consequential loss or damage) however caused, which may be suffered or arise directly or indirectly in respect of such information. Unauthorised use, copying, distribution, replication, posting, transmitting, publication, display, or reproduction in whole or in part of the information in this document is prohibited without obtaining prior written permission from Plato.