The Secret Broker: No, this is when franking credits actually were a big deal
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I got a phone call one day from a client, who ran a very large pension fund, saying he would like to introduce me to someone. That’s code, for “would you like to buy me lunch at my favourite restaurant?”
This was a bit strange for Brian, as he was rather boring and his fund was even more boring, but hey, what is a broker meant to do?
Boring or not a table was booked for Friday and promptly put into the diary, by hand (no Google Calendar sync email required, just a pen).
Brian ran what was called an index fund and his was indexed to the FTSE100. Every month, money from 26,000 workers would roll into the fund and Brian would give us 100 orders in the 100 stocks that made up the FTSE100 Index.
If the FTSE100 ended up 9.6% for the year, then Brian’s fund would be up 9.6% and if the FTSE100 fell 5.4% for the year, so would Brian’s fund. The trustees would be happy, the workers would be happy and Brian would be happy.
Everyone was happy!
Friday arrives and I book the afternoon off and arrive at the restaurant, where Brian introduces me to Charles. Seems a nice chap.
He tells me about Oxford and his “gap year” in Australia at the same ranch where Price Charles did his, whilst I tuck into my oysters and steak, washing it down with a cheeky Bordeaux, trying to look interested.
As coffee arrives, I go in for the kill and ask Charles how big his new fund is going to be. He says “zero” and goes bright red.
After I’ve spat out half a mouthful of my coffee onto the table, Charles put his hand on my arm and says “but don’t worry, it’ll be okay”. I hope so, I thought, as Brian’s favourite restaurant, The Guinea Grill, was not cheap.
Charles went on to explain, that whilst his fund had nothing in it, his job was to look at the FTSE100 stocks and short any which he thought would under perform and Brian’s fund will lend him the shares. This made sense, as Brian only ever sold shares when a company was removed from the FTSE100, otherwise he was always a buyer, as money for his fund only rolled in.
If Charles had shorted them, he would be the natural buyer.
What started out for me as a boring lunch turned into Charles becoming one of my biggest clients, as Charles could also go long on FTSE100 shares using the funds from the shorts, so his orders would be twice the size of Brian’s. A visit to the Aston Martin dealer was made over the weekend, as I put my name down for next year’s model.
Next year, when they added the returns of both funds together, Charles’ “zero” fund added an extra 2% performance. So now, FTSE100 up 9.6%, Brian’s fund up 11.6%.
Everyone is even happier!
So, to recap; anyone can lend out their shares, as long as there is a real legal agreement in place and our loan agreements read like a mortgage agreement. All rights remain with the original owner of the shares, including any dividends and franking credits.
These are paid in cash by the borrower, as part of the agreement… and this is where it gets interesting for Australians and something of a loophole the ATO took three years to close.
Also, another Australian bonus – as the stock is lent not sold, it should not affect any pre-CGT 1985 shares held in the portfolio.
Many years later, when I am sent over to our Australian office, Paul Keating had just introduced franking credits to dividends paid and my very first meeting upon arrival was all about their implications.
I asked what the franking credits meant for an overseas holder and a day or two later the in-house lawyer confirmed what I had hoped. An overseas holder would not be entitled to claim any franking credits. They would be lost forever.
A A$1.00 dividend paid was worth A$1.00 to a UK holder but A$1.30 to an Australia holder.
I had not even fully unpacked before I was off back to the UK to hunt for large UK funds with large holdings in Australian banks, ahead of dividend time.
Of all places, Leeds is where our biggest holder came from and agreements were put in place. They would lend us their Australian bank shares two days before they went ex-dividend and we would put them into our nominee account. The day after they went ex-dividend, we returned the shares and a cheque with their due dividend amount plus an extra 8%.
When the company sent out its fully franked dividend, we were able to claim them. We would receive 30% less 8% bonus fee, so we got net 22% extra.
Instead of getting a A$1.00 dividend, they got A$1.08 and we kept the $0.22. All without any risks taken.
Their trustees were as ecstatic as my bonus was!
But on 1st July 2000, the ATO changed the rules on us, to “needing to hold the shares for 45 days before they go ex-dividend” and consequently the costs involved made the profits too slim. So that was the end of the Aston driving days.
Next week, I will talk about how institutions got around the banning of shorting global bank shares in the GFC.
The Secret Broker can be found on Twitter here @SecretBrokerAU. Feel free to contact him with your best stock tips and ideas, as old Aston ignition coils aren’t getting any cheaper.