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Dividend Franking And Investment Choices
July 12, 2010 by man
Filed under Uncategorized
Do-It-Yourself investors skew their portfolios towards shares that pay franked dividends. This is especially prevalent amongst trustees of SMSF’s who appear to over estimate the benefit of dividend franking credits.
Franked dividends are considered by many to provide a “free lunch”. Consequently, fully franked shares are overweight in the investment decision process.
It can be argued that investors should not favour fully franked shares over stocks paying unfranked dividends. Thewidely held justification behind this portfolio strategy is based on flawed assumptions.
Dividend Franking Myths
Below, we consider four widely held franking “myths”:
Myth 1: Higher franking dates suggest better future share performance
Analysts believe a company’s share price is driven primarily by the share market’s assessment of its after-tax profit. If they are right, then choosing one company’s shares over another based on current franking levels alone does not make sense.
Myth 2: Low marginal rate tax payer benefit more from franking credits
Some low tax rate shareholders (e.g. self managed super fund trustees) believe they get a better relative advantage (compared to higher rate taxpayers) as a result of receiving franked dividends.
Although there is no question that they receive an absolute advantage as a result of their lower tax rate, this will be the case regardless of the level of franking.
Myth 3: Markets incorrectly price the benefit of franking
It’s often suggested that shares offering fully franked dividends provide a benefit not available from unfranked shares. We hope that the above discussion will cause those with this point of view to reconsider.
However, even if you remain unconvinced by that discussion, it is unreasonable to expect that the share market would remove any such arbitrage profit opportunites.
Share markets are extremely efficient. They rapidly incorporate all known information and biases into share prices. The franking level of shares is not a secret and any benefit (real or perceived) is almost certainly already reflected in prices.
A rational investor would be prepared to pay more for the franked share compared with the unfranked share. Fund managers will continue to pay up for any franking benefit until the higher price exactly offsets the benefit.
Stock markets simply do not allow any obvious inefficiencies or “free lunches” to persist.
Myth 4: A smart super investment strategy – fully franked, high yielding Australian shares
An investment strategy that emphasises the level of franking is also likely to focus on higher dividend paying shares, to maximise the perceived benefit.
Not only does it defy the basics of a sound investment philosophy, such an approach implies an expectation of higher income and lower growth returns, effectively ignoring the relative tax advantage of capital gains tax over income tax.
Capital gains tax offers better opportunity for tax management than franking. Tax can be discounted and deferred (sometimes indefinitely) to reduce the overall tax rate.
The franked dividend investment strategy is misguided…
An investment strategy based predominantly on exploiting the perceived advantages of fully franked shares is naïve.
Although dividend franking should be a consideration, as a driver of investment strategy it ignores the importance of the primary variables in the portfolio construction equation – risk, liquidity, costs and a comprehensive tax approach.
An investment strategy that considers these broader issues is far more likely to meet your long term requirements.
