How to improve investment returns without taking inappropriate risks
Abnormally low interest rates mean not-for-profit (NFP) boards can no longer depend on term deposits to deliver reliable and appropriate returns on invested funds. As a result, NFPs are looking to higher risk, but potentially higher returning, assets. In this environment, NFP boards should take into account the opportunities for franking credits to enable investment strategies to deliver better returns for little or no additional risk.
As interest rates have fallen, term deposit rates have declined sharply as well, falling to 3% or less. This presents NFP boards with a significant decision. Do they continue to invest all of their funds into term deposits and accept the sharp drop in income? Or do they shift into higher risk assets?
According to Nick Walter, a Macquarie Investment Adviser who works closely with NFP boards, many NFPs are developing long-term investment policies to guide their investment approach in higher risk markets.
“Frustrated by the lack of income on term deposits, my NFP clients are moving beyond cash investment to a longer-term endowment investment approach.”
He says that, as they consider new options for investment, NFP boards should pay close attention to the potential benefit that comes with their Deductible Gift Recipient (DGR) status.
“As a NFP you have a favourable tax status that gives you an opportunity to derive an additional income stream not available to tax-paying investors.”
NFPs continuing to rely on term deposits are missing out on low risk opportunities to generate better returns.
Making better use of your favourable tax status
Many NFPs are eligible for refunds of franking credits.
Franking credits or ‘imputed tax credits’ come attached to ‘franked dividends’, which are paid out by some companies from after-tax profits.
If a regular tax payer receives a franked dividend, this person can then reduce the tax paid on their dividend by an amount equal to the imputed tax credits.
However, because NFPs typically don’t pay tax, most NFPs can get a full refund of their franking credits – increasing the income they receive from their investment in certain Australian equities.
An NFP is eligible for this refund if they have an ABN, are resident in Australia and are at least one of the following:
- a registered charity endorsed by the ATO to access income tax exemption
- endorsed by the ATO as a DGR in its own right
- specifically named as a DGR in the Income Tax Assessment Act 1997.
Potential for higher investment returns with little additional risk
Nick Walter says that the combination of getting a franking credit refund, and the tendency of Australia’s largest companies to pay higher fully franked dividends, can offer NFPs attractive returns.
“If you invest part of your portfolio in carefully chosen Australian shares, you can get the benefit of fully franked income, with an annual franking credit rebate paid directly back to your organisation. The natural yield of Australia’s largest companies is 4.5%. But, including franking credits, it can go up by more than 1.5%.
“So, even for an NFP board with a highly conservative investment policy that invests between 30% and 50% in Australian equities, this can equate to an additional 0.5-1.0% of investment returns each year.”
|ADVANTAGES OF FULLY FRANKED DIVIDENDS FOR NFPs||CBA shares (Fully franked income)||Westfield shares (Unfranked income)|
Franking credit refund
Managing risk with a conservative, diversified portfolio
Nick Walter advises NFP boards to take a disciplined approach to transitioning from cash to a broader investment portfolio.
“The board needs to recognise that an investment strategy with higher returns comes with higher risk, but that risk can be managed.”
To mitigate investment risk, he suggests consideration is given to the following four areas.
Engaging a professional investment manager
“This should be someone you trust to help you translate the NFP’s objectives into an Investment Policy Statement. You need unanimous support for your investment policy. Your adviser will help you to reach common ground that everyone is comfortable with and then custom-create a portfolio to support your NFP’s goals.”
Taking a conservative approach to portfolio structure
“You still keep some of your funds in defensive assets, such as cash and fixed income, but you allow the possibility of higher returns by diversifying across other asset classes. That might include some property, some alternative investments and some shares weighted towards stocks with a natural high yield and fully franked income.”
Documenting your investment policy carefully
“Your adviser will help you to agree on and document your investment policy in a formal statement that should clearly state your bias towards fully franked income. Having a policy statement means no single board member is responsible for investment decisions. It also means your portfolio can be actively managed in response to market volatility without needing to involve the board in individual decisions.”
Creating an Investment Committee
“Having created its investment policy, the board can delegate responsibility for its execution to an Investment Committee. The committee is then responsible for engaging with the investment manager, ensuring compliance with the policy, monitoring investment performance and reporting back to the board. Ideally, the committee should meet with investment managers one a quarter. Ask your manager to customise their report to match your needs.”
Nick Walter says that NFPs continuing to rely on term deposits are missing out on low risk opportunities to generate better returns.
Over the long term, historically, a conservative NFP portfolio that includes the value of franking credits can generate significantly better income than a portfolio with just cash or Term Deposits.
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