Over the last five years, franking credits have been an attractive option to non-taxpaying investors, adding an average of 1.56% compared to returns from the

S&P/ASX 200 Accumulation index. This obvious return benefit has prompted investors who are able to fully utilise franking credits to ask whether they should be increasing their exposure to domestic equities. At first glance, the most obvious answer to this question would appear to be yesbut, as we discuss below, there is more to the equation than a simple return boost.

If we compare the annual returns of the S&P/ASX 200 Franking Credit Adjusted Total Return index to the S&P/ASX 200 Total Return index, we find that franking credits have provided a 1.56% pa return boost for tax-exempt investors who are able to take advantage of them.

Assuming all other variables are unchanged (risk, return and correlation to other asset classes), we can model two outcomes for our forward-looking (capital market) return assumptionsone that utilises franking credits and one that doesnt. In doing this, we are able to build optimal portfolios under both assumptions and compare the two, thereby establishing the optimal allocation to domestic equites for those investors able to take advantage of franking credits.

The chart on the following page shows the total expected portfolio return for each of our model portfolios (Yield, Balanced, Growth and Equity), utilising the franking credit capital market return assumption and the standard (or non-franking credit) capital market assumption for domestic equities. Not surprisingly, by using the franking credit capital market assumption, returns are enhanced across the board, with the greatest impact felt by those portfolios with larger allocations to domestic equities.

This finding alone leads many investors to overweight domestic equities within their portfolios. However, often this is without a full understanding of the impact on both the expected risk and return. To see the fuller picture, we need to introduce portfolio risk to the discussion.

Franking credits provide a boost to overall portfolio returns

A rational investor will seek to maximise the return generated for the risk takensomething we call portfolio efficiency. This means that those investors who have skewed their portfolio towards domestic equities to take advantage of the return boost from franking credits should be expecting to improve their risk-adjusted returns. The key question, of course, is to what degree franking credits justify increasing a portfolios allocation to domestic equities.

In the following table, we have again taken our model portfolios (Yield, Balanced, Growth and Equity) and gradually skewed the weight away from our standard strategic asset allocations (SAAs) to favour domestic over international equities (all other asset class weights remain unchanged). In this scenario, we are able to analyse the expected risk-adjusted return by looking at each portfolios Sharpe ratiothis is a ratio that measures the average return in excess of the risk-free rate per unit of volatility.

We can analyse the expected risk-adjusted return by looking at the Sharpe ratio

The results show that forYieldandBalancedinvestors there is actually no benefit in increasing their allocation to domestic equities. As we can see, when an investor deviates from our standard SAA weights (which is 50/50 domestic/international for Yield and a marginal preference for international in Balanced) we actually see risk-adjusted returns fall. Although the absolute return of the portfolio may rise slightly, its risk will increase more, likely undermining the benefit of any such move.

A modest benefit for Growth and Equity investors

As we move through the risk profiles toGrowthandEquity, however, we do start seeing a very modest improvement in risk- adjusted returns when an investor increases his or her exposure to domestic equities. The benefit to the Growth SAA peaks at around 55% while the Equity SAA peaks at around 60%. So, if a non-taxpaying investor were to increase the allocation to domestic equities from 50% to 55-60% of their total equity exposure they could, in fact, moderately increase the return of their portfolio in line with a similar level of risk. The improvement, as shown in the table, is at best modest. Any increase beyond these levels and we start to see risk-adjusted returns fall.

Domestic equities as a percentage of total equities in a balanced portfolio

As we can see, utilising franking credits does increase absolute return expectations, so skewing portfolios towards domestic equities can improve the overall expected return. However, the issue for investors is that this does come at the expense of portfolio diversification.

As we move more heavily towards one asset class, we start to lose the benefits of imperfect correlations between asset classesan important factor in portfolio construction. So, although a balanced investor can improve the expected return of his or her portfolio by increasing their allocation to domestic equities, in so doing, they take on a disproportionate amount of risk. Putting it another way, an investor who skews towards domestic equities in an attempt to benefit from franking credits simply ends up taking on more risk at the portfolio level. This outcome could be achieved in a more efficient way. One way is to reduce exposure towards defensive assets and skew towards growth assets (which includes both domestic and international equities) in a more diversified and disciplined way.

Domestic equities are not the only asset class where franking forms part of the investment decision. Hybrid securities also make payments with franking credits attached. Unlike domestic equities, which forms an asset class or sub-asset class in its own right, hybrids are typically considered to be part of the domestic credit sub-asset class. Such a concentrated cluster of securities does not lend itself well to making up a large part of a well-diversified portfoliobut there is still a case for increasing exposure to hybrids if franking credits can be fully utilised.

An allocation to hybrids should be made within the credit sub-asset class

In this case, the argument revolves around allocating more to hybrids within the credit sub-asset class rather than allocating more to credit as a whole, which would have a material impact on risk. We find that taking this approach modestly increases returns across the risk profiles, with a greater impact seen at the lower end of the risk spectrum (such as the Yield model portfolio) where domestic credit weights are highest.

For example, if we assume all of the domestic credit in a Yield SAA is allocated to hybrids (rather than traditional credit) then we expect about a 0.2% return upliftwhereas a Growth SAA investor could expect to generate an additional 0.05% from allocating the domestic credit component to hybrids. In this case, we assume a similar risk profile will be maintained, although we would expect a modest uplift in risk as hybrids are typically moderately higher risk than traditional credit. On the whole, skewing the portfolio towards hybrids at the expense of traditional credit improves the risk-adjusted returns for investors who can fully utilise franking credits. Beyond that, where investors may consider allocating to hybrids at the expense of other fixed income asset classes, we see a deterioration in the risk-return trade-off.

While franking credits are a valuable additional source of return (particularly for non-taxpaying investors), we can see that when the risk impact is considered, the numbers dont justify a higher exposure to domestic equities unless you are a Growth or Equity investor.

For investors with a lower risk tolerance (Yield and Balanced), our current SAAs are designed to provide the highest risk- adjusted returneven when franking credits are accounted for (an approximate 50/50 balance between domestic and international equities). However, at the sub-asset class level hybrids are favoured over traditional domestic credit.

For higher risk tolerances (such as Growth), a modest preference of 55% of the equity allocation towards domestic equities is justified, while for single asset class equity investors, a more pronounced skew of 60% is warranted. Again, using hybrids from domestic credit exposure improves the return expectationbut the impact is modest.

Overall, we see that portfolio diversification remains at the heart of optimising expected investment outcomes and we are reminded that looking at the whole picture, i.e. both risk and return, is extremely important.

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With Australian equities why focus on tax exempt share owners as this article does? Tax paying share owners get exactly the same benefit as tax exempt share owners, from receipt of franking credits with their dividends. All franking does, irrespective of the dividend receivers tax rate, is ensure franked dividends are taxed at the same rate as other forms of income.

While this is an article on portfolio diversification its worth noting that the introduction of franking credits killed the Australian domestic bond market and Hybrids were invented to counter that. If franking credits are to be abolished (surplus, surplus, surplus) the Govt responsible will have to kick start a bond market and manage a transition from Hybrids to Bonds. Not something that has received a lot of attention.