AFR: Investing strategies dissected

Australian Financial Review, Smart Money, October 2010

To some, investing is a simple business: understand a company, buy its shares, sit and wait. Many people, some financial planners included, think this is the best way: sticking to what you know, not churning your holdings in pursuit of the next big thing, and building a safe portfolio with some dividend income and the likelihood of modest long-term growth.

To others, that’s boring. For them, investment is a game of strategy: techniques and tricks that give you an edge over the next punter.

Some investors thrive on these approaches, perfecting a particular model that works for them. Others put a great deal of effort into complicated little strategies only to find themselves no better off – or worse – than if they’d just bought and held like the herd.

For investors considering such strategies, there are a few key questions to consider.

1.What do you want to get out of it? Is this an approach to gain a quick buck? Income? Growth? A tax break?

2. What’s the tax situation? Most of the strategies analysed in this article will have a tax implication to them – be sure you know what it is.

3. Do you know what you’re doing? For example, it’s all well and good buying something for a tax benefit, but that’s not going to help you if the share you bought goes under.

4. What’s the risk involved? This applies particularly to gearing – borrowing to invest.

5. Is it legal? A handy one, this. We don’t mean something truly scurrilous like insider trading. But if, for example, you try dividend stripping but sell your stock before 45 days, you’ll have breached a rule and incur a penalty in terms of the treatment of your investment.

In this article, we look at a few strategies people have tried and tell you if they’re smart, hare-brained, efficient or just too much effort.

DIVIDEND STRIPPING

When a company awards a dividend, there is a set sequence of dates that determines who is entitled to it, and when. On the day it announces a dividend a company will also state the books closing date, or record date: all shareholders on the register on that date will receive the dividend. Remember that, since Australia is a T+3 settlement market, you will need to have bought the stocks three days before that in order to be on the register in time. The ASX facilitates this with what is known as the ex date: if you buy the stock before that date, you’re entitled to the dividend, and if you buy it on or after the ex date, you’re not. Then, some time later, comes the payable date when the company credits the dividend to your account or mails you the cheque.

Dividend stripping involves investing around these dates. The idea is to buy a share just before its ex date, giving you the dividend and any associated franking credits, then sell it again.

There are two problems with dividend stripping. One is that share prices usually fall on the date a stock trades ex-dividend. In theory, one would expect it to fall by exactly the same amount as the value of the dividend, although in practice it tends to vary: sometimes more, sometimes less, depending on a host of other factors like the behaviour of the broader market. If you sell it and it’s fallen by less than the value of the dividend, you’ve come out ahead. Otherwise, you haven’t.

The other is that the ATO is wise to this strategy and doesn’t much like it – particularly because the investor will be gaining franking credits which they can then use to reduce the amount of tax they pay. This has led to the 45-day rule, which Macquarie Bank explains to its clients as follows. “In order for an investor to be eligible to claim the benefit of a franking credit attached to a dividend, they must have held the share ‘at risk’ for at least 45 continuous days, or 90 for preference shares, not including date of purchase and date of sale.” If you don’t hold it for 45 days, you may be denied the franking credits.

‘At risk’ has a very specific meaning, says Patrick Broughan, a partner at Deloitte Touche Tohmatsu. It means having a net delta of 0.3, which means that you can hedge yourself for 70% of your exposure to the share (with an option or a CFD position for example) but have to be bearing at least 30% exposure to it. Provided you are holding that amount of risk, it doesn’t really matter where the 45 days fall in relation to the ex-dividend date. (Incidentally Broughan prefers the term ‘dividend harvesting’, saying dividend stripping has a tax avoidance connotation.)

Darren Johns, an independent financial advisor at Align Financial, says there is some merit in the approach on the tax side. “I think it’s a good arbitrage for people to invest through entities with low tax rates, such as self-managed super funds.” But on the income side, it’s a clear risk. “Investing in shares usually requires a timeframe of seven years, not seven weeks,” he says. “So investors consider dividend stripping ought to be fully aware of the risks of owning shares for such a short period of time. It is not a risk free investment strategy.” If tried at all, it is best done on a stock with a fairly steady share price so that the tax and dividend benefits are less likely to be wiped out with capital losses.

Remember, too, to factor in the brokerage costs of buying and selling.

USING A LIC TO GET FULLY FRANKED DIVIDENDS ON INTERNATIONAL SHARES

This may seem a somewhat obscure strategy, but it does have its followers. It involves investing in international shares using listed investment companies, partly because doing so allows you to get fully franked dividends, which you normally can’t do when buying an international share.

Listed investment companies represent an established part of the Australian market: they have a combined market capitalization of A$19 billion between 62 separate listed vehicles, as of September 2010. They give you exposure to a portfolio of shares by buying a single stock. Most of them, though, are domestic, including the biggest and longest-established funds.

There are, though, several that invest in international shares. They include AMP Capital China Growth Fund, one of the few listed investment vehicles anywhere in the world giving non-Chinese exposure to China’s domestic (A-share) stock market; Asian Masters Fund and Global Masters Fund, which are funds of funds giving exposure to a range of well-known international fund managers; LICs that are basically just listed managed funds, from Hunter Hall, Peters Macgregor, Platinum, Magellan and Templeton; India Equities Fund; and Orchid Capital, which is an Australian-German group specialising in pre-IPO investments in Asia.

The risk profiles of these products obviously vary dramatically, but generally they behave like any other Australian-listed share: you buy them, you sell them, they go up and down, and they distribute dividends. This has an interesting implication: in theory, it means you can invest in international shares and still get a fully-franked dividend, which you wouldn’t be able to do by buying international shares directly.

Platinum, for example, says of its Platinum Capital listed investment company: “The distinguishing feature of the company compared with our unit trust products is that it is taxed at source and distributes a dividend – usually fully franked – rather than a unit trust distribution.” A look at Platinum Capital’s dividend history confirms that all dividends awarded since 1996 have included at least some element of franking: its most recent one, on September 2, was a net 5 cents per share with a further 2.14 cents per share of franking, to give a grossed-up dividend of 7.14 cents per share.

So does this approach make sense? Really, the bigger decision should be whether you like the LIC itself. Names like Platinum and Templeton have outstanding track records in global investing, so there’s nothing wrong with trying their products in a listed form; other LICs represent some of the few ways of getting pure exposure to India and China. The franking credit side should be considered a bonus rather than the defining issue – and remember that an international mutual fund will already be making its investment decisions partly with tax in mind. Bear in mind too that LICs, as closed-end products, can trade at big discounts or premiums to their net tangible assets, meaning the true value of their holdings: this can work to your favour or against you but does mean your LICs won’t always represent the actual value of what they’ve invested in.

Broughan says that this method may in fact involve more several of tax. “If you assume the Australian LIC holds a portfolio interest in a US company, then any dividends that the Australian LIC receives from the US company will be subject to Australian tax,” he says. “That will give rise to franking credits, but the assumption is the US company will already have been subject to US tax. So you’re getting, in effect, two waves of tax.”

CASH EXTRACTION

The idea of cash extraction is to switch out of your existing shareholdings into instalment warrants, without triggering a capital gains tax event. Instalment warrants generally involve two payments, one up front and one later; they give you the right, but not the obligation, to buy an underlying share. They are popular because they give you exposure to shares at half their actual cost but give you entitlement to all dividends and franking credits from the outset.

The ASX, which publishes a fact sheet on this approach, gives the following example. You have 1,000 shares of XYZ, and want to release some cash but keep your exposure to the shares. They are trading at $42 per share (so your portfolio is worth $42,000) and instalment warrants are priced at $22.30 each. You submit a shareholder application document to the warrant issuer, who will hold the shares in trust on your behalf (so there’s no capital gains tax event since they haven’t been sold), give you 1,000 instalment warrants over the same share, and give you a cash sum of $19,700.

The result is you can use that cash for other purposes, without being taxed on any gains you’ve already made on the shares; and you still get the same exposure to XYZ’s income and capital growth, though you will eventually have to make the second payment on the warrant (the term within which you have to do so will vary on the warrant and the provider).

The ASX says: “Using existing share holdings, you can use instalments to diversify an investment portfolio in the share market. This strategy is ideal for those who have significant capital in existing share holdings and do not wish to trigger a capital gains tax event or invest further funds into the market.”

On the risk side, the ASX points out that instalments are issued by a number of different investment banks and that each is unique. This is true. It is vital to understand the exact terms of your warrant – the level of gearing involved, the timing for paying the second instalment, and the exact relationship to the underlying share.

Also, remember that there is risk involved in any geared exposure to the stock market. “People tend to see instalment warrants as an income style investment, and discount the risks involved with them,” warns Johns. “If the share price falls you’re still committed to the second payment. They are a good investment provided the investor is aware of the risk associated with them.”

Also, it is worth being aware that the tax treatment of instalment warrants is not altogether clear. “It’s fair to say there is a bit of uncertainty around instalment warrants at the moment,” says Alison Noble at Deloitte. The federal government has said it will legislate to confirm the existing accepted approach of instalment warrants – that they bring full entitlement to dividends and franking credits – but Noble says there is a technical interpretation that there is a trust, resulting in a create a capital gains tax event, “which is not how they have been taxed in the past. The announced changes are going through a period of consultation and we don’t yet have the laws to clarify the current approach.” Consequently the ATO has not issued new product rulings on instalment warrants for some time, and movements toward clarifying legislation were delayed by the recent federal election.

GEARING INTO ETFs TO MILK A MARKET TREND

Another investment approach is to combine margin lending with exchange-traded funds.

ETFs are like LICs in that they give you exposure to a portfolio by buying a single stock. In most cases – and in all cases in Australian ETFs – they give you exposure to an index, such as the S&P/ASX 200 or some international stock market. They differ from LICs in that they will always closely reflect the value of the underlying index – they don’t drift to a premium or discount like LICs do.

Gearing into an ETF is much like any other share. According to Graham Smith at State Street Global Advisors, which is one of the main producers of ETFs worldwide (including the one that tracks the S&P/ASX 200), its funds are available on all margin lending lists, including BT Wrap, Citi Margin Lending, Macquarie, Leveraged Equities, CommSec, E*Trade/ANZ, and Westpac. He adds that they are available on direct market access contracts for difference (CFD) platforms like ManGlobal and Macquarie CFDs – another way of accessing leverage; and that the SPDR 200 product can also be used as collateral for the exchange traded options market.

Clearly, it’s easy to gear with them then; and if you’re comfortable with being leveraged, then there’s no strong argument against doing it through ETFs. “ETFs are liquid, highly diversified and fairly well tax managed, so if an investor is borrowing to invest it’s not going to create unnecessary capital gains and therefore taxes,” says Johns.

And is it a good time to be gearing into the markets anyway? “I think the 10 year outlook for stocks is good,” says Johns. “I think if you’re going to borrow money in 2010 and the timeframe permits you not to withdraw from the market until 2020, with the market under 4600 [as it was at the time of the interview] there are plenty of opportunities for the next decade.”

iShares, which are ETFs offering exposure to overseas markets, represent an easy way of getting geared overseas exposure. There are other considerations in leveraging your overseas investments, though: for one thing, returns from overseas are affected by movements in currencies.

On the tax side, gearing into ETFs is no different than gearing into any other shares: you are entitled to a deduction on the interest paid.