It makes perfect sense that investing in Australian companies, with the view to enjoying their dividend yield, has been the cornerstone of investing in this country for decades.
But a potential change to the rules around franking credits is poised to test that strategy. Record low interest rates here mean all investors have been chasing any sort of yield and, at 4.5 per cent, Australia is one of the highest-yielding countries in the world. But there’s been another reason to chase yield.
Additionally, the government has provided franking credits, where the investor is refunded tax the company has already paid, which has enhanced the yields to levels most investors in other countries can only dream of.
However, this could all be set to change with the dividend imputation discussion raised by opposition leader Bill Shorten earlier this year. For those who don’t know, he’s suggesting the cash credit part of the imputation system be cancelled so imputation credits can only be used to offset tax, but not given as a cash rebate over and above that. This would significantly affect many retirees who factor in and perhaps even rely on the cash credit as part of their retirement income.
Fund managers have been quick to criticise Shorten’s proposed changes to the dividend imputation system and even warned it could help fuel another housing bubble as the plan would prompt investors to move out of shares and back into property. Geoff Wilson, one of Australia’s leading fund managers, has asked Shorten to reconsider his proposal to implement a retirement tax and in a weekly email to his investors has urged them to sign a petition to signal their disapproval of the proposed change.
Whether this is fair or not isn’t the purpose of this article, but what is worthy of consideration from an investor perspective is, firstly, that even raising changes to dividend imputation sets in place a potential precedent that may develop to a full repeal of the rule. Secondly, with the first point in mind, how does one continue building a portfolio that has a focus on yield and therefore should help, or completely sustain, retirement income.
Focusing on Australian yield first, for many, Shorten’s changes, even if they’re enacted, won’t have a significant impact. If you’re working, you’re unlikely to be in a position where your net tax position allows you to be given a net cash credit. You can still use the franking credits to reduce your tax liability though.
However, the strategy around building a portfolio focused on yield is the same. Firstly, there should be more attention focused on broadening the number of companies you’re investing in. Many investors buy the highest-yielding companies with the highest franking available to maximise yield. While that makes sense to some extent, many investors chase these yields with almost no regard to the potential (and very often actual) loss of their capital, which can easily go down by more than the yield gained, often for several years.
It is far more prudent to invest in a wider selection of companies with demonstrably strong yield history, or the type of company that is likely to pay dividends, for example, those with strong excess cash flows. This makes the chance of losing significant amounts of your capital base less likely. One simple way to achieve this without having to pay a large amount in transaction costs, or having to do a significant amount of research, is to buy two Australian yield exchange-traded funds (ETF).
Almost all of these are invested in a variety of companies, normally 30 or more, that are deemed by the index the fund follows to be likely to pay out high yields, and these will reweight periodically (normally every six months) so there is no need to do significant research at a company level yourself. The reason why two is better than one is because the rules each fund uses can be very different, so it is very difficult to know which one is most likely to work well in a specific situation. It effectively reduces the risk that one strategy underperforms.
The second part of building a solid yield portfolio is to also invest in international yield. It’s true almost no other country has the same level of yield as Australia, especially when combined with the franking, but only investing in Australia can make investors miss many opportunities to build a more solid, consistent and sustainable yield with less likelihood of losing the capital base.
Having yield from many different countries balances any reliance on just Australia’s companies. The diversification provides a better chance of sustainability. Additionally you have the benefit of currency diversification where some currencies rise in value versus the Australian dollar at any particular point in time, making the yield received more valuable.
Furthermore, the yields in many regions can be high by international standards. Some of the ETFs available in Australia on the United States and Europe offer yields over 4 per cent. Over the past year, this has been particularly attractive for euro investors as the euro has appreciated against most currencies.
In summary, with Shorten’s announced changes, the times of full dividend imputation may be near an end. If investors want to continue to build a portfolio focused on producing yield, it is still very possible, but it is probably better done by using yield-focused funds, such as the various ETFs available in the Australian market, so the habit of picking a few high-yielding stocks is reduced and substituted by index strategies designed specifically to try and gather yield but with more diversification and protection of capital.
Equally, to have a truly sustainable yield portfolio, more international yield exposure needs to be included in the portfolio. Again there are various ETFs that give you this exposure simply and at low cost. In this new world, investors should be considering both aspects to build the most robust portfolio possible.
