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. So, should these investors be increasing their exposure to domestic equities?

Data shows that franking credits provide a boost to overall portfolio returns. This finding leads many investors to overweight domestic equities within their portfolios. However, to see the full picture, we need to introduce portfolio risk to the discussion.

We analysed the expected risk-adjusted return of portfolios with exposure to franking credits within domestic equities by looking at the Sharpe ratio. The results showed us that for Yield and Balanced investors, there is actually no benefit in increasing their allocations to domestic equities. As we move through the risk profiles to Growth and Equity, we do start seeing a very modest improvement in risk-adjusted returns when an investor increases his or her exposure to domestic equities.

Increasing exposure to domestic equities can 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 classes – an important factor in portfolio construction.

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.

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. risk and return) is extremely important.