Smith Manoeuvre

[kerdon]

I left out that I also got 37k in my non registered account, another 63k in my company investment account, I was incorporated when I was doing consulting for a while. Not sure if I should take all the money out to do this. My original plan was to draw it down when I retired.

The only debt I have is my mortage.

But have you borrowed against your home to invest....remember that when the market corrects and dividends get cut you still have to pay the LOC. If you sell and move to another place getting the SM set back up again can be difficult and CRA, doesn't like changes.

You need to ready into it more, you don't want to combine account, CRA wants everything separate for the SM. I have seen them disallow interest deductions, and other SM tricks because people weren't careful enough and the advisor was more concentrated on getting a commission on a mutual fund than tax strategies....then when CRA disallows their moves, usually the advisors says its not their fault for your poor accounting...etc.

Be careful read more on it.

[edrempel]

I read most of the pages and people always talk about HELOC.
What if I refinance my mortgage?

Here's my situation : I own a duplex in quebec and 40% of my loan is already interest-deductible (cause I live on the first floor with a basement and I rent the 2nd floor). I am refinancing and will have 70k$ equity, of that we are taking 40k$ for renos.

Can I take the balance (30k$) to invest and claim that portion to be interest-deductible???

It seems pretty simple, dunno if I misunderstood something.

Hi Choaslord,

Your situation sounds fine. Actually, you CAN use available equity in a rental property to invest or for the SM - as long as you keep it separate from rental mortgage.

The rental mortgage interest and your investment credit line are claimed on different lines on the tax return. If they are separate accounts and tracked separately, there is no problem doing both at the same time on the same property.


Ed

[edrempel]

Great thread.

Did a lot of reading and I would love to implement this strategy.

I still got $281k left on my mortage with 17k in my BMO readiline.

Am I a good candidate to start this?

Just not sure how much the investment needs to return to make this worth my while. I read that if my return is not high, it might not be worth it and I'm a bit confuse here, if I'm writing the interest off shouldn't I always be up?

Hi zzricezz,

Determining whether or not you are a good candidate for the SM has more to do with your temperament and risk tolerance. If you are the kind of person that would bail out or become more conservative after a market decline, then it is not the right strategy. If you are able to stick with it long term, it will likely work for you.

The amount of equity you have to start is only one factor in determining whether or not the SM makes sense for you. There are many ways to implement the SM. If you don't have enough equity to invest as much as you would like, you can always add an additional investment loan or do the Rempel Maximum strategy. (It is the largest lump sum that can be financed with your existing mortgage payment.)

The long term rate of return is important as does the type of investment income, but the breakeven point is probably lower than you think. The general rule is that you need to make about 2/3 of your interest rate over time to break even after tax with capital gains. For example, if your credit line interest is at 3% and your investment makes 2% capital gains (mostly deferred), over time you should approximately break even.

Whether the profit makes it worthwhile for you should not be a problem in the long term. If you maintain the SM, you can eventually borrow the entire $298K to invest.

It is not necessary to make a profit for the interest to be tax deductible.


Ed

[edrempel]

In my opinion, the SM needs to have a good positive cash flow (after paying the loan, dividend tax, commissions), otherwise it's not worth it. Long term capital gains will not pay your heloc at the end of this month.

Hi Jungle,

I'm not sure you are talking about the SM. With the SM, the you readvance the principal from each mortgage payment. Some of it is used to pay the credit line interest.

No investment income monthly is necessary to pay the credit line interest and the basic SM does not involve income being paid regularly from the investments.



Ed

[edrempel]

But have you borrowed against your home to invest....remember that when the market corrects and dividends get cut you still have to pay the LOC. If you sell and move to another place getting the SM set back up again can be difficult and CRA, doesn't like changes.

You need to ready into it more, you don't want to combine account, CRA wants everything separate for the SM. I have seen them disallow interest deductions, and other SM tricks because people weren't careful enough and the advisor was more concentrated on getting a commission on a mutual fund than tax strategies....then when CRA disallows their moves, usually the advisors says its not their fault for your poor accounting...etc.

Be careful read more on it.

Hi Kerdon,

The SM does not require dividends to make the credit line interest payments. With the SM, the you readvance the principal from each mortgage payment. Some of it is used to pay the credit line interest.

Moving to a new house is normally no problem, as long as you will have the 20% down. All you need to do is make sure that the credit line starting balance on your new home is the same as the final credit line balance on your old home. If you refinance a tax deductible loan, the new loan normally remains tax deductible.

Ed

[superping]

Been Burn before.

Trust me, it's horrible when you are 60k in debt and the stock market lost 50% of its value.

Not only I feel like my retirement plan was slipping away... I felt like I'm losing my home. Not fun. :cry:

I sold my home.. made 60k profit to pay off the debt. still have mutual fund with 70% of its value. :(

Head down.. walk out.. Back to real estate investment.

[edrempel]

Been Burn before.

Trust me, it's horrible when you are 60k in debt and the stock market lost 50% of its value.

Not only I feel like my retirement plan was slipping away... I felt like I'm losing my home. Not fun. :cry:

I sold my home.. made 60k profit to pay off the debt. still have mutual fund with 70% of its value. :(

Head down.. walk out.. Back to real estate investment.

Hi Been,

It sounds like you are not the right temperament for the SM. It is a long term strategy. Anyone doing it must have a long term outlook and be able to remain confident through the inevitable, temporary market downturns.

You should be careful with real estate investment with that out outlook as well. Real estate also falls by 30%, like it did in the 1990s, and it usually involves more leverage than the SM. I know a few real estate millionaires from the 1980s that declared bankruptcy in the 1990s.

By the way, what do you mean "mutual fund"? Did you invest in just one? Did you buy one with a tax-free monthly payout?

Ed

[grant]

I left out that I also got 37k in my non registered account, another 63k in my company investment account, I was incorporated when I was doing consulting for a while. Not sure if I should take all the money out to do this. My original plan was to draw it down when I retired.

The only debt I have is my mortage.
I assume your "company investment account" is actually an RRSP, which makes it untouchable.

How to perform your smith maneuvre:
Step 1: sell all your assets in non-reg account (remember what they are!)
Step 2: withdraw $37k from your non-reg account.
Step 3: pay down $17k on Readiline, and $20k on your mortgage
Step 4: increase the limit on your readiline as high as you can get
Step 5: borrow $37k from Readiline
Step 6: deposit $37k into your non-reg account
Step 7: re-purchase all the assets you previously sold.

Before SM:
Debt: $298k (281k mortgage + 17k readiline)
Investments: $100k ($63k rrsp + 37k non-reg)
DEDUCTIBLE debt: $0

After SM:
Debt: $298k (261k mortgage + 37k readiline)
Investments: $100k ($63k rrsp + 37k non-reg)
DEDUCTIBLE debt: $37,000

Simple, ya??

[Young Investor]

Hello everyone,
I have to begin by saying that was easily one of the most influential few hours of reading I have ever done. I actually read through the whole thread. I believe I am now very familiar with the SM. I would like some free advice on my personal financial situation, and how to best set myself up for a SM in a few years (yes I am to cheap to pay a financial advisor at the moment). Admittedly my knowledge of personal finance has some holes in it, but I am steadily learning more.

I am 22 years old and recently graduated from University. I am just beginning my new career as a teacher in MB where I will start at about 50K a year. My situation is somewhat unique on this forum as I am dealing with much smaller amounts of money due to the extremely low cost of housing in rural MB.

I recently purchased a house in the town I will be teaching in. I unfortunately did have to go with a CMHC insured down payment, but I am not too worried as the monthly payments are smaller than most of you probably ever paid for rent. I got the house for 95,000 (it is a three bedroom bungalow, finished basement, 25 yrs old, with a 40 by 50 garage, just to give you an idea of how low the housing market is compared to many of your examples). The payments are set at about $430 a month and I only pay about $2000 a year in taxes. There is a standard 20% per year early payment option.

I definitely plan to implement the SM in three years when my mortgage is up (I signed on for a 3 yr, 3.7% mortgage). I currently have no assets other than a 5K vehicle (which I fully own), however I also have no student debt. My wife (who will also be a teacher) will be done University in three years as well, putting us in a great position to be aggressive with whatever long term investing strategy we use.

I realize that some of you believe you should have more than 20% equity in your home before implementing this technique, but due to the relatively low cost of my home im not too worried. I believe that if I responsibly implement the SM and invest mostly in strong Canadian Dividend Blue Chips the worst thing that can happen is basically I break even on the whole deal, ending up with a paid house and a 90K HELOC (through a readvanceable mortgage option of course) that will be a huge tax write off for me. I don't honestly see how at this market level, anyone doing there homework could really lose.

My question for the forum is how would you go about gaining equity and investing experience in the next three years, with setting up the SM in mind? I could simply aggressively pay down my mortgage, but then I would still have no experience in DIY investing. I think if I utilize my TFSA properly I could build up some decent capital (afterall, I am locked in at 3.7%). Would you guys also recommend putting some money aside to begin investing in a dividend heavy portfolio just to get used to it (this idea seems to make sense to me, because the stakes would be so low relative to when I begin the SM). Any advice for a beginning investor would be welcome.

[Jungle]

Hi Jungle,

I'm not sure you are talking about the SM. With the SM, the you readvance the principal from each mortgage payment. Some of it is used to pay the credit line interest.

No investment income monthly is necessary to pay the credit line interest and the basic SM does not involve income being paid regularly from the investments.



Ed

Hi Ed

Good to see you on these forums. I read a lot of your commentary on MDJ and it's informative. In regards to the quote above, do you feel that by using the re-advancing mortgage amount to make the minimum payment on the heloc with just make the balance grow bigger and then it becomes more than the initial investment value over time?

Also in regards to moving, you say that as long as the new mortgage has a heloc set up with the same balance as the old one cra will accept this? Do you think CRA will say that you paid and old HELOC balance off with a new one and therefore did not purchase investments, just paid off debt?

[superping]

I realize that some of you believe you should have more than 20% equity in your home before implementing this technique, but due to the relatively low cost of my home im not too worried.

It's not that you should, Bank won't let you set up HLOC until you have 20% equity in your home.

One advice I can give you. DIY. Nobody cares about your money more than you do. Just setup an account at Questrade (or any discout brokerage) and buy some Index fund ETF. Now, the Dividend paying stocks are good buy too. Just buy and hold. Don't try to time the market.

You might have to set some priority on RRSP, TSFA and paying down mortgage. To see which one make more sense. If you can't afford them all, I think RRSP and TSFA should have higher priority than paying down mortgage.

[superping]

I assume your "company investment account" is actually an RRSP, which makes it untouchable.

How to perform your smith maneuvre:
Step 1: sell all your assets in non-reg account (remember what they are!)
Step 2: withdraw $37k from your non-reg account.
Step 3: pay down $17k on Readiline, and $20k on your mortgage
Step 4: increase the limit on your readiline as high as you can get
Step 5: borrow $37k from Readiline
Step 6: deposit $37k into your non-reg account
Step 7: re-purchase all the assets you previously sold.

Before SM:
Debt: $298k (281k mortgage + 17k readiline)
Investments: $100k ($63k rrsp + 37k non-reg)
DEDUCTIBLE debt: $0

After SM:
Debt: $298k (261k mortgage + 37k readiline)
Investments: $100k ($63k rrsp + 37k non-reg)
DEDUCTIBLE debt: $37,000

Simple, ya??

fyi .... if you sell your investment at a lost, you can claim tax credit for capital lost. But if you re-buy the same units within 30 days (not 1 year .. thanks Grant for pointing that out), you cannot claim your capital lost and you have to pay tax on any capital gain.

[superping]

Hi Been,

It sounds like you are not the right temperament for the SM. It is a long term strategy. Anyone doing it must have a long term outlook and be able to remain confident through the inevitable, temporary market downturns.

You should be careful with real estate investment with that out outlook as well. Real estate also falls by 30%, like it did in the 1990s, and it usually involves more leverage than the SM. I know a few real estate millionaires from the 1980s that declared bankruptcy in the 1990s.

By the way, what do you mean "mutual fund"? Did you invest in just one? Did you buy one with a tax-free monthly payout?

Ed

I'm a true fan of buy and hold. Unfortunately, I bought them near the peak and suffer a serious lost. At least, I still have those units. so I didn't cash-in the serious lost yet.

With SM, you pay interest every month. When stock goes down, you see flashing red numbers everywhere. And you still need to make interest payment out of your pocket. That's a negative cashflow. :(

With real estate, it's a rental property. The rent pay for the expense, possitive cashflow. You are right, the last housing crush was 10+ year ago.

Needless to say, just got myself into another SM. :p Darn low interest is just too tempting. I learned something. This time, I went for dividend paying stocks. That should give me some postive cashflow. :D

[Young Investor]

Thanks for the reply superping. I know about the 20% min for the Heloc, thats where I'm aiming to be 3 years from now. I agree with the DIY method to maximize any profits.

As far as TSFA vs. RRSP vs. Mortgage paydown goes, I think the most efficient use of my time and money might be to explore dividend and ETF stocks within my TFSA (CDZ looks like an easy bet, good dividend payouts, and basically diversifies my risk for me, even if I don't have a lot of money to invest. I hope this doesn't break the whole "recommending a stock" forum rule because I really have only a small bit of experience dealing with any of this stuff). Ordinarily in the SM I know that putting the stocks in my TFSA would eliminate the interest tax credit I would be attempting to get, however being that I'm obviously not borrowing the money invested I think this is smart way to go. Being that my mortgage is locked at 3.7, I believe I could quite easily get 4%+ dividend yields and any capital gains made on the stocks would be gravy. The other consideration is that I would gain experience in handling my investments online.

Is there any considerations you guys think I'm missing out here. I believe that in 8 or so years as I'm finishing my first SM (and likely looking to a new house), my wife should be making around 60k a year, and I should be around 70k. The 90K in a tax deductible loan should come in very handy at this point, and I can then be aggressive in yet another SM on a new house.

[grant]

fyi .... if you sell your investment at a lost, you can claim tax credit for capital lost. But if you re-buy the same units within 1 year, you cannot claim your capital lost and you have to pay tax on any capital gain.
It's actually 30 days. And totally irrelevant to making mortgage debt interest tax-deductible.

[edrempel]

I assume your "company investment account" is actually an RRSP, which makes it untouchable.

How to perform your smith maneuvre:
Step 1: sell all your assets in non-reg account (remember what they are!)
Step 2: withdraw $37k from your non-reg account.
Step 3: pay down $17k on Readiline, and $20k on your mortgage
Step 4: increase the limit on your readiline as high as you can get
Step 5: borrow $37k from Readiline
Step 6: deposit $37k into your non-reg account
Step 7: re-purchase all the assets you previously sold.

Before SM:
Debt: $298k (281k mortgage + 17k readiline)
Investments: $100k ($63k rrsp + 37k non-reg)
DEDUCTIBLE debt: $0

After SM:
Debt: $298k (261k mortgage + 37k readiline)
Investments: $100k ($63k rrsp + 37k non-reg)
DEDUCTIBLE debt: $37,000

Simple, ya??

Hi Grant,

The process you described is not the Smith Manoeuvre. It is the Singleton Shuffle. Using non-deductible investments to pay down debt and then reborrowing to invest is usually a good idea before starting the SM, but the SM is different. It is readvancing the principal from each mortgage payment to invest.

Ed

[edrempel]

Hi Ed

Good to see you on these forums. I read a lot of your commentary on MDJ and it's informative. In regards to the quote above, do you feel that by using the re-advancing mortgage amount to make the minimum payment on the heloc with just make the balance grow bigger and then it becomes more than the initial investment value over time?

Also in regards to moving, you say that as long as the new mortgage has a heloc set up with the same balance as the old one cra will accept this? Do you think CRA will say that you paid and old HELOC balance off with a new one and therefore did not purchase investments, just paid off debt?

Hi Jungle,

Thanks for comments. The process you mentioned of readvancing the mortgage to pay the interest on the HELOC is called "capitalizing the interest". It should not result in the HELOC growing more than the investments in the long run, since the interest rate on your HELOC should be low (between prime and prime +1%).

There is a tax benefit from capitalizing the interest, since the interest on the interest is normally also tax deductible. Therefore, you would not want to pay the tax deductible interest when you can use the same cash flow to pay off a non-deductible debt, like your mortgage.

When you said "minimum payment", is it not just the interest only you are paying?

CRA explains in IT-533, that refinancing a tax-deductible debt, the new debt is also tax deductible, as long as you can still trace the debt to investments that you still own. So, you should have no problem transferring your SM HELOC to your new home, if you start with the same balance you ended up with on your last home.


Ed

[edrempel]

Hello everyone,
I have to begin by saying that was easily one of the most influential few hours of reading I have ever done. I actually read through the whole thread. I believe I am now very familiar with the SM. I would like some free advice on my personal financial situation, and how to best set myself up for a SM in a few years (yes I am to cheap to pay a financial advisor at the moment). Admittedly my knowledge of personal finance has some holes in it, but I am steadily learning more.

I am 22 years old and recently graduated from University. I am just beginning my new career as a teacher in MB where I will start at about 50K a year. My situation is somewhat unique on this forum as I am dealing with much smaller amounts of money due to the extremely low cost of housing in rural MB.

I recently purchased a house in the town I will be teaching in. I unfortunately did have to go with a CMHC insured down payment, but I am not too worried as the monthly payments are smaller than most of you probably ever paid for rent. I got the house for 95,000 (it is a three bedroom bungalow, finished basement, 25 yrs old, with a 40 by 50 garage, just to give you an idea of how low the housing market is compared to many of your examples). The payments are set at about $430 a month and I only pay about $2000 a year in taxes. There is a standard 20% per year early payment option.

I definitely plan to implement the SM in three years when my mortgage is up (I signed on for a 3 yr, 3.7% mortgage). I currently have no assets other than a 5K vehicle (which I fully own), however I also have no student debt. My wife (who will also be a teacher) will be done University in three years as well, putting us in a great position to be aggressive with whatever long term investing strategy we use.

I realize that some of you believe you should have more than 20% equity in your home before implementing this technique, but due to the relatively low cost of my home im not too worried. I believe that if I responsibly implement the SM and invest mostly in strong Canadian Dividend Blue Chips the worst thing that can happen is basically I break even on the whole deal, ending up with a paid house and a 90K HELOC (through a readvanceable mortgage option of course) that will be a huge tax write off for me. I don't honestly see how at this market level, anyone doing there homework could really lose.

My question for the forum is how would you go about gaining equity and investing experience in the next three years, with setting up the SM in mind? I could simply aggressively pay down my mortgage, but then I would still have no experience in DIY investing. I think if I utilize my TFSA properly I could build up some decent capital (afterall, I am locked in at 3.7%). Would you guys also recommend putting some money aside to begin investing in a dividend heavy portfolio just to get used to it (this idea seems to make sense to me, because the stakes would be so low relative to when I begin the SM). Any advice for a beginning investor would be welcome.

Hi Young,

I'm originally from Winnipeg and have relatives in Manitoba (mostly Steinbach), so I know about the house prices.

Grant is right that you need to have 20% down before you can get a mortgage that works with the SM. There are no longer SM mortgages with CMHC.

Your rate is a bit high at 3.7%. We've been recommending to stick to 1-year rates at the moment and are getting 2.45%. Studies show that you save thousands long term by sticking with either short terms (1-year) or variable mortgages.

Paying down your mortgage before you invest would be probably be better than investing in a TFSA, if it would allow you to start the SM a lot sooner.

Being new to investing, we would recommend to stick with long term, broad-based investments. By some broad-based index funds/ETFs or mutual funds with good fund managers and don't try to time the market. The stats on market timers is disastrous. Make sure some of your investments are currently out of favour. We would not suggest trying to choose individual stocks until you are an experienced investor and do in-depth research on every stock.

By the way, you don't have to pay a financial advisor. They are normally paid by your investments.

Ed

[edrempel]

I'm a true fan of buy and hold. Unfortunately, I bought them near the peak and suffer a serious lost. At least, I still have those units. so I didn't cash-in the serious lost yet.

With SM, you pay interest every month. When stock goes down, you see flashing red numbers everywhere. And you still need to make interest payment out of your pocket. That's a negative cashflow. :(

With real estate, it's a rental property. The rent pay for the expense, possitive cashflow. You are right, the last housing crush was 10+ year ago.

Needless to say, just got myself into another SM. :p Darn low interest is just too tempting. I learned something. This time, I went for dividend paying stocks. That should give me some postive cashflow. :D

Hi superping,

With the SM, you can capitalize your interest, so you don't have to pay it from your cash flow. I'm not sure what red flashing numbers you mean, but you can reborrow the principal portion of each mortgage payment to pay the interest on your HELOC.

You don't need to use any cash flow for the SM.

Ed

[edrempel]

I left out that I also got 37k in my non registered account, another 63k in my company investment account, I was incorporated when I was doing consulting for a while. Not sure if I should take all the money out to do this. My original plan was to draw it down when I retired.

The only debt I have is my mortage.

Hi zzricezz,

Withdrawing the cash from your corporation can be a complex issue. How long has your corporation been inactive? If you cannot carry back a current loss to profits in the last 3 years, then the only option for removing cash may be dividends.

You need to figure out the most tax-efficient time and method to withdraw the cash.

Waiting until after you retire may or may not work. Depending on your tax bracket after you retire, dividends may have no tax at all or may be taxed punitively at more than 60% (including clawbacks on government income programs).



Ed

[Jungle]

Hi Jungle,

Thanks for comments. The process you mentioned of readvancing the mortgage to pay the interest on the HELOC is called "capitalizing the interest". It should not result in the HELOC growing more than the investments in the long run, since the interest rate on your HELOC should be low (between prime and prime +1%).

There is a tax benefit from capitalizing the interest, since the interest on the interest is normally also tax deductible. Therefore, you would not want to pay the tax deductible interest when you can use the same cash flow to pay off a non-deductible debt, like your mortgage.

When you said "minimum payment", is it not just the interest only you are paying?

CRA explains in IT-533, that refinancing a tax-deductible debt, the new debt is also tax deductible, as long as you can still trace the debt to investments that you still own. So, you should have no problem transferring your SM HELOC to your new home, if you start with the same balance you ended up with on your last home.


Ed

Thanks Ed, I understand now. I thought about my question again. I realized that by applying all the dividends to the mortgage, this will increase net worth overtop of the HELOC, self compounding on its interest only payments. And yes by minimum payment, I meant interest only payment.

Thank you for that CRA IT-533 bulletin. That's good to see you can transfer the debt to a new HELOC. Our bank Scotia can not do a direct HELOC port to new property. However they can set up a new HELOC account and transfer the debt.

Question: How much of your HELOC you use for the SM? For example, if you have 100,000K available, how much in stocks would you buy?

In regards to the portfolio, what sectors/industries do you recommend to diversify or to make tax efficient?


Thank you.
Jungle.

[superping]

Hi superping,

With the SM, you can capitalize your interest, so you don't have to pay it from your cash flow. I'm not sure what red flashing numbers you mean, but you can reborrow the principal portion of each mortgage payment to pay the interest on your HELOC.

You don't need to use any cash flow for the SM.

Ed

Ya right... such a great advice. Interest only payment is not enough. Use the future home equity to pay the loan interest. Enough Interest change, you will be in a rabbit hole. Recipe for a disaster.

Thanks god, I learned my lesson.

[Jungle]

Ya right... such a great advice. Interest only payment is not enough. Use the future home equity to pay the loan interest. Enough Interest change, you will be in a rabbit hole. Recipe for a disaster.

Thanks god, I learned my lesson.

That's actually how the SM works. Interest payments are enough, if you follow the strategy properly and purchase Canadian stocks that pay eligible dividends. In your previous post, you said that you didn't purchase dividend paying stocks for your SM. Also you stated that you over paid for stocks which at the time were at historically high prices.

Stock investing is a whole other animal but key to a successful SM strategy. I am not an expert analysis, but I try and purchase shares from solid Canadian companies, when their stocks are on sale. I will use the buy and hold strategy. I know there is a market crashes every decade and the markets do rebound after. Use this time to purchase more stocks. There have been some good opportunities since Oct 2008.

Interest rates are a risk with the SM. It's important to get the lowest possible HELOC rate. After this, you can deduct the interest paid. This helps lower interest cost some more. Interest rates are going up- from historical lows. However, they are not going to be "sky high" anytime soon. The economy is recovering too slowly for borrowing to be unprofitable right now.

You mentioned that rental properties are positive cash flow. A lot are not positive right now with housing prices being so high. There are so many other risks and negatives with rental properties. As the mortgage gets paid off, rental income is taxed at your marginal tax rate, unlike dividends. Also, hosing is illiquid, the costs to buy and sell is pretty much a crime. With maintenance, depreciation and landlord time /responsibility, tenant risk and vacancy, it's not as "ideal" as some people envision.

[edrempel]

Thanks Ed, I understand now. I thought about my question again. I realized that by applying all the dividends to the mortgage, this will increase net worth overtop of the HELOC, self compounding on its interest only payments. And yes by minimum payment, I meant interest only payment.

Thank you for that CRA IT-533 bulletin. That's good to see you can transfer the debt to a new HELOC. Our bank Scotia can not do a direct HELOC port to new property. However they can set up a new HELOC account and transfer the debt.

Question: How much of your HELOC you use for the SM? For example, if you have 100,000K available, how much in stocks would you buy?

In regards to the portfolio, what sectors/industries do you recommend to diversify or to make tax efficient?


Thank you.
Jungle.

Hi Jungle,

Glad to be helpful.

My strategy would not work for most people, so it may not help you. The amount of leverage that works for you would depend on your risk tolerance, your time horizon, your confidence in your investments and your long term goals.

In our case, we can tolerate significant temporary declines, have 20+ year time horizon, have strong confidence in the markets long term and especially our fund managers, and want to retire very comfortably.

So, we not only invested the maximum of our HELOC, we also did a 2:1 investment loan on it. If we leverage 7 figures and let that double a few times over 20 years (the markets have historically doubled every 7 years on average), we have a good chance or retiring comfortably.

Our strategy is not suitable for most people, though.

I also don't try to pick sectors or industries. Our focus is on finding the most skilled fund managers and then we let them make the specific investment choices. Our investment focus is on studying the fund managers to identify the ones we consider to be "All-Star Fund Managers". A big part of my confidence in the strategy comes from my confidence in the fund managers.

To diversify, we make sure every fund manager is doing something different from the others and that they have low correlations to each other. If they do the same thing, we would only need one of them. For example, if we can have 4 fund managers that each make 10%/year long term but have their good and bad years at different times, then we can make the 10%/year over time with less volatility than any one of the fund managers.

Tax efficiency is important, but secondary to having the best investments based on risk/return. Some mutual funds are available in very tax-efficient versions, but not all of our All-Star Fund Managers are available in those versions. Tax-efficient investments are mostly tax deferrals. Many investors make the mistake of looking for tax-efficiency first, but we think that you should focus on investment quality first and tax-efficiency second.

For example, many investors are really focused on dividends recently. We have some good investments with 6% dividends, but usually prefer great investments, even if they have little or no dividends.

Does that answer your questions, Jungle?

Ed

[edrempel]

Ya right... such a great advice. Interest only payment is not enough. Use the future home equity to pay the loan interest. Enough Interest change, you will be in a rabbit hole. Recipe for a disaster.

Thanks god, I learned my lesson.

Hi superping,

What happened with your SM? The numbers you mentioned look like a bunch of people we have seen that invested in mutual funds that paid a tax-free monthly ROC distribution. Did you do that?

It sounds like your investments dropped (like everyone did in 2008), but then you abandoned your strategy. I realize you still own the investments, which means you did not sell out at the low, but why did you give up on having tax-deductible debt? You said you sold your home and then paid off the tax-deductible HELOC. Why not keep it separate and at least have some tax deductions - or do I misunderstand your situation?

Ed

[edrempel]

Maybe this is a off topic question but if I want to 'borrow' money from my company and invest with it, can I write off the interest I would have to pay back my company? My accountant said there is standard interest rate charge and i can't borrow at 0%.

Hi zzricezz,

There are specific rules against borrowing cash that you have in a corporation. If you are a primary shareholder and take the cash out as a loan, CRA generally will consider that to be a withdrawal as a salary.

The reason for this is that CRA does not want business owners to be able to avoid paying tax on income by loaning it to themselves indefinitely.

The rules about doing "non-arms' length" loans at the prescribed rate given by CRA from time to time generally do not apply to loans from your corporation.

You can either:

1. Just invest in you corporation. If you do, then all investment income is taxed at the highest rate (46% in Ontario), so try for tax-efficient investments or pay all investment income out to yourself personally.

2. Bleed the cash out of your corporation over time by taking as much as you can each year at lower tax brackets.

3. Invest in the corporation and pledge the corporate investments as collateral for a personal investment loan.

Ed

[edrempel]

Ya right... such a great advice. Interest only payment is not enough. Use the future home equity to pay the loan interest. Enough Interest change, you will be in a rabbit hole. Recipe for a disaster.

Thanks god, I learned my lesson.

Hi superping,

If you are confident in your investments and have a long term investing view for your investments, than why would you want to take cash out of them to pay interest? You can reinvest the dividends (or buy other investments) and then capitalize the interest.

This way, you don't use any of your cash flow to pay the interest, and all the money in your investments stays in the investments.

The risk of this is if you look short term. If you follow this strategy for the long term (say 20 years), your risk becomes reasonable. The major stock markets have at least doubled 100% of the time over 20 years since 1871.

Ed

[edrempel]

That's actually how the SM works. Interest payments are enough, if you follow the strategy properly and purchase Canadian stocks that pay eligible dividends. In your previous post, you said that you didn't purchase dividend paying stocks for your SM. Also you stated that you over paid for stocks which at the time were at historically high prices.

Hi Jungle,

Just so you are clear, you do not need to invest in dividend paying stock with the SM. Almost any stock or mutual fund is a valid investment for your interest to be tax deductible.

In addition, unless you earn under $41,000, there is a "tax bleed" from the tax on the dividends that reduces the return of the Smith Manoeuvre.

There is a common misunderstanding that income investments are required. CRA explains in detail in IT-533 that nearly any stock or mutual fund is fine, as long as its prospectus does not specifically prevent paying dividends.

Dividend stocks are a good long term strategy, but this seems to have become the fad lately. We normally try to avoid the sectors that are the current fad, since they are usually overvalued.

If you buy dividend stocks, you should stick with them next time they are out of favour, since selling them when they are down can wipe out years of growth and dividends. I still remember the late 90s when nobody wanted to own any stock that paid a dividend at all. Dividend stocks by definition are not growth stocks and generally underperform in strong stock markets.

Investing in 100% tax-efficient investments that pay no dividends or taxable distributions are normally the best choice for the Smith Manoeuvre. The investments are non-registered, so the tax consequences of the investments is an important factor.


Ed

[Germack]

I am not a big fan of the SM and I believe it is very dangerous for most people.

For the SM to work you need to be a DIY investor because you need to keep the fees low. As history has shown you cannot use a financial adviser for the SM who puts your money in MF with high MER (2.5%). This is a receipt for disaster. This strategy failed for the last 10,20,30, 40 and 50 years miserably.

Financial adviser like to tell you that over the long-term the stock market returned 10% per year but they forget to tell you how much it would have cost you to borrow that money for your investments.

The equity risk premium for the last 50 years has "only" been around 2.5% as compared to save government bonds. Subtract fees, the spread between the rate you can borrow and the Government of Canada can and you would have been already in the negative.

The saddest thing is that when times are good people overestimate their risk tolerance. The believe they can handle a lot of risks, but when the stock crashes they cant handle it and sell all their stocks and loose a s**tload of money.

Before investing always ask yourself: What if I'm wrong.

[S5]

The major stock markets have at least doubled 100% of the time over 20 years since 1871.

Can you explain exactly what you mean by this statement? Several 20 year periods have not done this for various well established stock markets(including dividends).

[edrempel]

Can you explain exactly what you mean by this statement? Several 20 year periods have not done this for various well established stock markets(including dividends).

Hi S5,

The worst-case scenario of major stock markets at least doubling every 20 years nearly always holds true - except for a couple of unique exceptions (as you correctly mentioned).

Since the last 10 years have been the worst 10 years ever for the US (and Canada I believe) other than the 1930s, many investors have forgotten the long term growth of the stock market.

The "major markets" we look at here are mainly the US, global and Canada. The most complete stats are about the US. We looked at the US annual returns since 1871. The worst 20-year period was 1929-48, which had a total gain of 84% (3.1%/year). This is nearly a double.

The 2nd worst 20-year period was 1930-49, which was a gain of 135% (4.4%/year). All other 20-year periods were far better. (The best was 1980-99 with a gain of 2,639%, or 18.0%/year!)

Most of the existing indexes around the world have much shorter records. The best study we have found is in the excellent book "Triumph of the Optimists" (Dimson, Marsh). It has results from 1900-2000 by decade (not by year). It shows the world stock market was barely even down in the 1930s - a minor loss of 0.3%/year for the 10 years.

The worst-case scenarios are mostly during the Great Depression of the 1930s. Every other calendar decade since 1900 was a gain for the world stock markets.

Looking at the 16 major countries of the last 100 years, only 6 even lost money during the 1930s (Belgium, France, Spain, Sweden, Switzerland and the US).

Looking for 20-year periods without a double, there were a couple of notable exceptions, such as Germany and Japan right after they lost the war (their bonds did far worse during that time and still have not even recovered).

Japan is down for the last 20 years after their super-bubble in the 1980s, but is still up 147% in the last 25 years. So, even Japan has more than doubled in the last 25 years.

The main reason for Japan's prolonged down period for the last 20 years was being over-valued after having one of the biggest bubbles of them all with a gain of 545% in only 10 years in the 1980s. The Japan stock market essentially went from 300 to 40,000 in its best 10 years!

We don't have year-by-year stats of every stock market for the last 100 years, but other than the ones I mentioned above, nearly every 20-year period for any of the major markets was at least a double.

The AVERAGE, of course, is far better than the worst-case scenario. The world stock market has averaged about a 500% gain over 20-year periods (9%/year) from 1900-2000.

But even worst-case scenarios are virtually always at least a double.


Ed

[riffr aff]

http://www.bmo.com/home/personal/banking/rates/readiline?nav=left


1 yr closed fixed = 3.3% (prime + .55%
3 yr open variable = 3.65% (prime + .7%)
5 yr closed variable = 2.65% (prime - .1%)

These rates don't seem too great for the SM.

I currently have a 5 yr fixed w/ BO for 3.869% locked in (old mortgage + new one).

How do I get a better rate while following Ed's advice that I stick to 1 yr terms, preferably with a variable rate?

** I just called BMO and they told me they don't offer a 1 yr variable.

Thanks!

[superping]

Hi S5,

The worst-case scenario of major stock markets at least doubling every 20 years nearly always holds true - except for a couple of unique exceptions (as you correctly mentioned).

Since the last 10 years have been the worst 10 years ever for the US (and Canada I believe) other than the 1930s, many investors have forgotten the long term growth of the stock market.

The "major markets" we look at here are mainly the US, global and Canada. The most complete stats are about the US. We looked at the US annual returns since 1871. The worst 20-year period was 1929-48, which had a total gain of 84% (3.1%/year). This is nearly a double.

The 2nd worst 20-year period was 1930-49, which was a gain of 135% (4.4%/year). All other 20-year periods were far better. (The best was 1980-99 with a gain of 2,639%, or 18.0%/year!)

Most of the existing indexes around the world have much shorter records. The best study we have found is in the excellent book "Triumph of the Optimists" (Dimson, Marsh). It has results from 1900-2000 by decade (not by year). It shows the world stock market was barely even down in the 1930s - a minor loss of 0.3%/year for the 10 years.

The worst-case scenarios are mostly during the Great Depression of the 1930s. Every other calendar decade since 1900 was a gain for the world stock markets.

Looking at the 16 major countries of the last 100 years, only 6 even lost money during the 1930s (Belgium, France, Spain, Sweden, Switzerland and the US).

Looking for 20-year periods without a double, there were a couple of notable exceptions, such as Germany and Japan right after they lost the war (their bonds did far worse during that time and still have not even recovered).

Japan is down for the last 20 years after their super-bubble in the 1980s, but is still up 147% in the last 25 years. So, even Japan has more than doubled in the last 25 years.

The main reason for Japan's prolonged down period for the last 20 years was being over-valued after having one of the biggest bubbles of them all with a gain of 545% in only 10 years in the 1980s. The Japan stock market essentially went from 300 to 40,000 in its best 10 years!

We don't have year-by-year stats of every stock market for the last 100 years, but other than the ones I mentioned above, nearly every 20-year period for any of the major markets was at least a double.

The AVERAGE, of course, is far better than the worst-case scenario. The world stock market has averaged about a 500% gain over 20-year periods (9%/year) from 1900-2000.

But even worst-case scenarios are virtually always at least a double.


Ed

Please show me the chart to proof your statistic. It's very misleading. you said 20 year because between late 1980 to early 1990, the internet was introduced (switch from industrial age to Information age). And the stock market grew exponentialy. That won't happen again. You even went back to 1900 and great depression in 1930.

As of today,
10 year average return on TSX index 3.46%.
20 years average return on TSX index is 8.6%
10 year average return for US index is -4.35%
20 year average return for US index is 7.44%

The best return on Japanese index is 2006 with 43.51 %, with average 20 year return of 4.82% as of today. Where is that 500% return come from.



The major stock markets have at least doubled 100% of the time over 20 years since 1871.

Using rule of 72 .. If you put your money in GIC.. paying 3.6% per year, your money will double in 20 years. No need to go back to the great depression :p

[edrempel]

http://www.bmo.com/home/personal/banking/rates/readiline?nav=left


1 yr closed fixed = 3.3% (prime + .55%
3 yr open variable = 3.65% (prime + .7%)
5 yr closed variable = 2.65% (prime - .1%)

These rates don't seem too great for the SM.

I currently have a 5 yr fixed w/ BO for 3.869% locked in (old mortgage + new one).

How do I get a better rate while following Ed's advice that I stick to 1 yr terms, preferably with a variable rate?

** I just called BMO and they told me they don't offer a 1 yr variable.

Thanks!

Hi riffr,

We are recommending to stick with a 1-year fixed today and are getting between 2.35-2.55% (depending on other factors). Who offered you 3.3%? That's very high for a 1-year fixed.

Variable rates are slightly lower than 1-year fixed today, but the general expectations are that we will have a .25% rate increase about every 2 months for much of the next year, so the 1-year should be lower for the year.

More importantly, we expect bigger discounts from prime within a year, so if you lock in for 5-year closed variable at prime -.6-.8%, you will be missing larger discounts for nearly all of the next 5 years. We were getting prime -.85% for years (sometimes even better), and are waiting for that to come back.

The 5-year fixed rates are mainly between 3.5-4.0% (such as yours), but by always sticking to only 1-year fixed or variable, we have averaged 4.0-4.5% for the last decade. So, why take a 5-year fixed that is hardly lower than an average rate, when you could take a big discount for a year or 2 and save a bunch of money???

It sounds like you took a "blend and append" ("append" meaning cut off your arm or leg). :) That's our version of "blend and extend".

They are usually horrible for you, but great for the bank. They add an additional amount to your mortgage, but charge you the posted rate on it. Nobody should take a posted rate. Discounts are always available by negotiating.

If you want our rate, we can refer you to our contact for whichever bank makes most sense for your situation, riffr. Just fill out the form on our web site.

Ed

[edrempel]

I am not a big fan of the SM and I believe it is very dangerous for most people.

For the SM to work you need to be a DIY investor because you need to keep the fees low. As history has shown you cannot use a financial adviser for the SM who puts your money in MF with high MER (2.5%). This is a receipt for disaster. This strategy failed for the last 10,20,30, 40 and 50 years miserably.

Financial adviser like to tell you that over the long-term the stock market returned 10% per year but they forget to tell you how much it would have cost you to borrow that money for your investments.

The equity risk premium for the last 50 years has "only" been around 2.5% as compared to save government bonds. Subtract fees, the spread between the rate you can borrow and the Government of Canada can and you would have been already in the negative.

The saddest thing is that when times are good people overestimate their risk tolerance. The believe they can handle a lot of risks, but when the stock crashes they cant handle it and sell all their stocks and loose a s**tload of money.

Before investing always ask yourself: What if I'm wrong.

Hi Germack,

You are right that the SM is a risky strategy - because it is borrowing to invest. It is only for people that have the temperament to stay invested through the market ups and downs.

It is only for investors with general faith in the long term growth of the market, and patience & discipline to stick with their investments in the inevitable bear markets that happen once or twice a decade.

You are right-on that the big risk is not the market, but the investor. If you are the type that will sell after a market decline, then the SM is not for you.

The breakeven point is far lower than you mention, though. The breakeven over 20 years is about 2/3 of the borrowing rate.

Bonds are not relevant to the SM. You can normally borrow at prime (prime +.5-1.0% today). This is 3.25% today and has been about between 4-5% for most of the last decade.

Don't forget that the interest is tax deductible, and you can invest very tax-efficiently to pay little tax on the growth of the investments.

A normal rate to borrow to invest is about 4%. After tax your cost is only 2.6% (with a 40% tax bracket). So, to make a profit, we need to invest in order to make more than 2.6% after tax long term. That would be about 3.2% before tax (lower when you consider compounding). That is a very low hurdle!

Doing the SM as a DIY investor is more dangerous, though. Investors tend to buy and sell at the worst times, and act like lemmings by all buying the same investments - whatever is popular (and therefore expensive) is what nearly everyone buys.

Based on Bogle's study called "Investors are getting killed in ETFs", the average investor in ETFs makes 4.5%/year less than the ETF they own, because they tend to buy them when they are popular.

The bad timing of the average of all investors loses 4.5%/year, which is far more than MERs that only average about 2.5%.

In short, investing wisely is a more important factor than the fees.

You assume that mutual funds will make the index less the MER. This is true in general, but not in specific. If you Google "Active Share", you will see that fund managers that invest very differently from the index usually beat the index long term - even after all fees.

Many fund managers beat the index long term after all fees, but those are not fund that invest similar to the index.

If you can beat the index long term after all fees, then you get financial advice for free.



Ed

[Jungle]

Based on Bogle's study called "Investors are getting killed in ETFs", the average investor in ETFs makes 4.5%/year less than the ETF they own, because they tend to buy them when they are popular.

The bad timing of the average of all investors loses 4.5%/year, which is far more than MERs that only average about 2.5%.

In short, investing wisely is a more important factor than the fees.

You assume that mutual funds will make the index less the MER. This is true in general, but not in specific. If you Google "Active Share", you will see that fund managers that invest very differently from the index usually beat the index long term - even after all fees.

Many fund managers beat the index long term after all fees, but those are not fund that invest similar to the index.

If you can beat the index long term after all fees, then you get financial advice for free.



Ed

Hi Ed

Is there anywhere I can read that study? Everyone you turn to always says, just buy a market price and don't try and time the market. Dollar cost average and but in regular intervals.

[riffr aff]

Hi riffr,

We are recommending to stick with a 1-year fixed today and are getting between 2.35-2.55% (depending on other factors). Who offered you 3.3%? That's very high for a 1-year fixed.

I called BMO to find out if they had 1 yr variable rates, asked what they did have and he told me 3.3% - same as their website. I didn't talk to the in-bank rep I normally deal with. Is the rate your quoting for a HELOC mortgage (ReadiLine is likely the one i'd use)?



Variable rates are slightly lower than 1-year fixed today, but the general expectations are that we will have a .25% rate increase about every 2 months for much of the next year, so the 1-year should be lower for the year.

yep. as the BoC goes so do the Banks. But then, the Banks sometimes raise rates when the BoC does nothing as well!




The 5-year fixed rates are mainly between 3.5-4.0% (such as yours), but by always sticking to only 1-year fixed or variable, we have averaged 4.0-4.5% for the last decade. So, why take a 5-year fixed that is hardly lower than an average rate, when you could take a big discount for a year or 2 and save a bunch of money???

It sounds like you took a "blend and append" ("append" meaning cut off your arm or leg). :) That's our version of "blend and extend".

ya, we're @ a blend and extend point (Sept 15th deadline for closing). We just bought our new house (sold the other). I need to determine a) should I try SM, b) do I want to pay about $1500 in penalties to break my original mortgage, c) keep paying the new mortgage @ a silly rate for 4 more months d) likely other things too



They are usually horrible for you, but great for the bank. They add an additional amount to your mortgage, but charge you the posted rate on it. Nobody should take a posted rate. Discounts are always available by negotiating.

I understand this Ed - i'm not totally green. As rates stand today, assuming I could get a 2.5% 1 yr, I lose out over 5 yrs if prime +/- averages 4.21% each year for the other 4 years. Given your quote of approx 3.5-4% avg, it's not that far off (but still off). If the next 4 yrs go above average, my current 5 yr rate isn't bad. Fine line.



If you want our rate, we can refer you to our contact for whichever bank makes most sense for your situation, riffr. Just fill out the form on our web site.

I did leave a msg on your website via "contact us" as per the MDJ blog - haven't heard back. The blog mentioned email, but your website's contact us is a form, not an email link. But i'll look into whether SM is right for me - i'm new to the trading game, but it does not intimidate me. Neither does carrying 2 houses a few months, or learning how to save 20% off our new car by importing it myself. I also didn't sell a thing when the market went down in 2008 - I bought when things were low and stayed the course.

Cheers, thanks for the response.

Ed[/QUOTE]

[Jungle]

Are there any complications to buying and selling stock for capital gains in a SM account?

For example, let's say I have my SM account. I have my shares, which were bought and intended to be held for a long time. In the same account, on the side, I purchase some more shares (using HELOC) and sell them for a capital gain. Will this affect anything ?

[edrempel]

Hi Ed

Is there anywhere I can read that study? Everyone you turn to always says, just buy a market price and don't try and time the market. Dollar cost average and but in regular intervals.

Hi Jungle,

You can just Google "Investors are getting killed in ETFs" or the general study is the QAIB study by Dalbar. Google "Dalbar QAIB". You can buy the study, or just read some articles about it.

The Dalbar study is a 20-year study that shows the average investor makes about 1/3 of the return OF THE INVESTMENTS HE OWNS. You can make 100% of the return by just buying and holding, but most investors buy whatever is currently popular (buy high) and sell when it underperforms (sell low).

For example, how many investors bought tech in the late 90s and sold in 2002, then bought something conservative and missed the huge 2003 rally, then bought into the income trust bubble, and are now buying commodities, gold and dividend stocks?

Investors are like lemmings, which is why the average equity investor makes about 3%/year long term, while the market makes 10-12%/year.

There are a variety of ways to avoid this, some of which are buy-and -hold, don't try to time the market, invest in unpopular areas, don't try to pick sectors/countries, etc.


Ed

[Germack]

ED,

I guess you meant Investors investing in Mutual Funds got killed as the Dalbar study you are referring to has shown.

The Dalbar study showed that while the S&P500 returned 8.35% over a period of 20 years the average investor in mutual funds earned a measly 1.9%. This was caused due to high fees and market timing.

[Jungle]

WOuld it be safe to assume that the SM strategy converts your mortgage to self paying, tax deductible loan? Kind of like a rental property, pays for it self from the income.

[edrempel]

I called BMO to find out if they had 1 yr variable rates, asked what they did have and he told me 3.3% - same as their website. I didn't talk to the in-bank rep I normally deal with. Is the rate your quoting for a HELOC mortgage (ReadiLine is likely the one i'd use)?


yep. as the BoC goes so do the Banks. But then, the Banks sometimes raise rates when the BoC does nothing as well!



ya, we're @ a blend and extend point (Sept 15th deadline for closing). We just bought our new house (sold the other). I need to determine a) should I try SM, b) do I want to pay about $1500 in penalties to break my original mortgage, c) keep paying the new mortgage @ a silly rate for 4 more months d) likely other things too


I understand this Ed - i'm not totally green. As rates stand today, assuming I could get a 2.5% 1 yr, I lose out over 5 yrs if prime +/- averages 4.21% each year for the other 4 years. Given your quote of approx 3.5-4% avg, it's not that far off (but still off). If the next 4 yrs go above average, my current 5 yr rate isn't bad. Fine line.


I did leave a msg on your website via "contact us" as per the MDJ blog - haven't heard back. The blog mentioned email, but your website's contact us is a form, not an email link. But i'll look into whether SM is right for me - i'm new to the trading game, but it does not intimidate me. Neither does carrying 2 houses a few months, or learning how to save 20% off our new car by importing it myself. I also didn't sell a thing when the market went down in 2008 - I bought when things were low and stayed the course.

Cheers, thanks for the response.

Ed[/QUOTE]

Hi riffr,

I assumed we contacted you last week. We talked to a bunch of people, but I could not identify you specifically. Yes, it is the Readiline I referred to. Rates just dropped again, so we are getting between 2.35-2.44% today from a couple of banks with good readvanceable mortgages.

I would have to know your rates and situation specifically to give you a proper recommendation, but I've never actually seen a blend and extend that was beneficial. You can always get a 2nd or pay the penalty or some other better option.

That is the problem with 5-year fixed - you almost always pay more, plus you often get stuck and have to pay the penalty. I have never seen official stats, but my guess is that about 1/3 of people that take a 5-year fixed end up paying the penalty and nearly all foreclosures are people that took a 5-year fixed. With a shorter term, you can always sell your home, but with a 5-year you are trapped. We have seen quite a few people with penalties of $20-40,000, but it is almost always still beneficial to pay the penalty to get out of them.

Your situation of paying 4.21% of more for years 2-5 of a 5-year today is about the average of the last decade, but rates will more likely be lower. Rates are really low today. Why would anyone want to gamble to try to be as low as an average rate, when you can get a couple of years at really low rates?

We have been recommending nothing but variable or 1-year for the last decade (1-year today), and most of our clients still have mortgages below 2%. For the last 2 years, we have been recommending 1-year fixed with very low rates. It's great to get the low rates, while they are available.

By taking a 5-year, you are locking yourself in and giving up all your flexibility for nothing. Try Googling "5-year fixed mortgage trap".

Your last paragraph sounds like you may have the right temperament for the SM. You need to be able to see it as a long term strategy and be able to remain invested through the inevitable bear markets, which you were able to do.

Ed

[edrempel]

Are there any complications to buying and selling stock for capital gains in a SM account?

For example, let's say I have my SM account. I have my shares, which were bought and intended to be held for a long time. In the same account, on the side, I purchase some more shares (using HELOC) and sell them for a capital gain. Will this affect anything ?

Hi Jungle,

It is important to keep your leverage investments separate from non-leveraged investments, so that you can track the transactions. In your situation, selling to claim a gain is fine, but if you withdraw any cash, it might affect the tax deductibility of your investment credit line.

If you can track that the investments sold were not leveraged, then it will have no effect, but if the leveraged and unleveraged investments are mixed up and you withdraw any money, then a proportionate amount of your investment credit line becomes non-deductible.

The general rule is that if you sell any investments, the amount you borrowed (book value) for those investments must be reinvested or paid down on the credit line. Otherwise, the interest on that much of the credit line is no longer deductible.


Ed

[edrempel]

ED,

I guess you meant Investors investing in Mutual Funds got killed as the Dalbar study you are referring to has shown.

The Dalbar study showed that while the S&P500 returned 8.35% over a period of 20 years the average investor in mutual funds earned a measly 1.9%. This was caused due to high fees and market timing.

Hi Germack,

Bogle's study on ETFs shows the same pattern for ETF investors. Over 5 years, the average ETF made 1.0%, while the average investor in those funds lost 3.5%. So the average loss of all ETF investors from buying and selling at the wrong times was 4.5%/year.

Note this is in addition to the average MER. The 4.5%/year underperformance was purely the trading loss.

The loss happened in all 14 sectors in the study, with the more volatile sectors having larger losses. In financials, the average trading loss was 18%/year.

This is the underperformance from the ETF return, not the index return, so the average underperformance from the index would be higher.

The Dalbar study has a similar pattern with mutual funds. The main cause is buying and selling at the wrong times. The MER is much less than the trading loss.

We suspect that with more history and parallel studies, we will find that, on average, ETF investors do worse than mutual fund investors, because ETFs are designed for trading. The more average investors trade, the worse they do.



Ed

[edrempel]

WOuld it be safe to assume that the SM strategy converts your mortgage to self paying, tax deductible loan? Kind of like a rental property, pays for it self from the income.

Hi Jungle,

Not quite. The SM does not require any cash flow, but that is because the investment credit line pays its own interest, not because of income from the investments.

This is because this is the most effective method. As you pay down your mortgage, you gain credit available in your credit line which you can use to invest and to pay the interest on the credit line.

The tax rule is that if the interest is tax deductible, then the interest on the interest is also tax deductible. So it is more effective to use your cash flow to pay down your mortgage which is not deductible than to pay the investment credit line interest.

In general, you should try to avoid having taxable income from the investments, since that reduces your refund and the benefit of the SM.

There are versions of the SM involving paying the interest from the investments, but they are less effective. The big benefit of the SM is when your investments compound over many years. So, the less income you take out of the investments, the better.


Ed

[Jungle]

Thanks for all your answers. What do people think about the future rates of the dividend tax credit for Ontario? Why is it going up each year?

[edrempel]

Thanks for all your answers. What do people think about the future rates of the dividend tax credit for Ontario? Why is it going up each year?

Hi Jungle,

Tax on dividends is designed to be integrated with corporate tax so that income in a corporation is taxed at about the same rate as the same income outside the corporation.

Tax on personal dividends is going up because corporate tax rates are going down. There is an announced schedule. Tax on dividends will go up about 4% by 2012 and then level off.

Also, right now, dividends received personally by people in low tax brackets (under $41,000) are taxed at negative rates (you pay less tax by getting a dividend), but this is being phased out totally by the end of 2011.

There are versions of the SM where you invest for dividends, but they are generally less effective than trying to defer tax on investment income. There is a "tax bleed" from receiving the dividends, because you have to pay some tax each year.




Ed

[Jungle]

Hi Jungle,

Tax on dividends is designed to be integrated with corporate tax so that income in a corporation is taxed at about the same rate as the same income outside the corporation.

Tax on personal dividends is going up because corporate tax rates are going down. There is an announced schedule. Tax on dividends will go up about 4% by 2012 and then level off.

Also, right now, dividends received personally by people in low tax brackets (under $41,000) are taxed at negative rates (you pay less tax by getting a dividend), but this is being phased out totally by the end of 2011.

There are versions of the SM where you invest for dividends, but they are generally less effective than trying to defer tax on investment income. There is a "tax bleed" from receiving the dividends, because you have to pay some tax each year.




Ed

I see thanks again.

[riffr aff]

one thing i'm trying to make sure i'm correct on w/ SM

Say my mortgage is $300,000. This means I could borrow up to $240,000 (80%). However, with the SM, one uses the HELOC to pay the interest on the HELOC (withdraw X for interest, redeposit X for interest payment).

Does this not increase the HELOC and start to use HELOC funds to pay interest, and not to invest, and thus making your portfolio (ignoring compound for now) much less than the $240,000? Pls correct me if I am wrong, but you will re-invest the re-advanceable HELOC increases, then pay interest, will you not also need more HELOC available? (i.e. don't spend the full re-advanceable portion of the mortgage b/c you need to pay for interest as well)

Again, if i'm wrong, no problem - just want to clear this up.

(example)

mortgage payment $500
mortgage payment $500
Invest $1000
interest charged on HELOC $50
mortgage payment $500
withdraw $50 for interest on HELOC, put toward paying HELOC interest (so $450 unused HELOC)
Invest $450

Is this correct? (essentially that SM won't allow for the investor to invest all of the 80% ...

[Jungle]

one thing i'm trying to make sure i'm correct on w/ SM

Say my mortgage is $300,000. This means I could borrow up to $240,000 (80%). However, with the SM, one uses the HELOC to pay the interest on the HELOC (withdraw X for interest, redeposit X for interest payment).

Does this not increase the HELOC and start to use HELOC funds to pay interest, and not to invest, and thus making your portfolio (ignoring compound for now) much less than the $240,000? Pls correct me if I am wrong, but you will re-invest the re-advanceable HELOC increases, then pay interest, will you not also need more HELOC available? (i.e. don't spend the full re-advanceable portion of the mortgage b/c you need to pay for interest as well)

Again, if i'm wrong, no problem - just want to clear this up.

(example)

mortgage payment $500
mortgage payment $500
Invest $1000
interest charged on HELOC $50
mortgage payment $500
withdraw $50 for interest on HELOC, put toward paying HELOC interest (so $450 unused HELOC)
Invest $450

Is this correct? (essentially that SM won't allow for the investor to invest all of the 80% ...

I believe you are correct except on the first sentance, you can borrow up to 80% of your home's value, subtract the mortgage balance.

EDIT* Not sure if your mortgage amount is the same as your house value.

[riffr aff]

I believe you are correct except on the first sentance, you can borrow up to 80% of your home's value, subtract the mortgage balance.

EDIT* Not sure if your mortgage amount is the same as your house value.

right. I did mean "house is worth 300k" I can get a HELOC up to $240k. thanks for catching that.

[Young Investor]

Thanks for the advice Ed. My hometown is close to Steinbach.

My next question is what exactly is it that your company does for SM mortgage investors? I assume you basically streamline the process for people? I have extensively read your posts on other sites and I am interested in the "Rempel Maximum." I am somewhat suspicious of your claims concerning your ability to pick "all-star mutual fund managers," but I did read on another site that you personally invest this way (as well as your employees), this carries a lot of weight for me. Do you continue to invest this way? Your logic appears sound, but so many other articles I have read focus on limiting MERs. Assuming you can actually pick the best mutual fund managers, I agree that the MER would be worth it.

What sort of fee structure does your company charge Ed? Are there varying levels of help/advice?

I have been to your website, but didn't find a whole lot of answers for my questions.

[Shaf]

Thanks for the advice Ed. My hometown is close to Steinbach.

My next question is what exactly is it that your company does for SM mortgage investors? I assume you basically streamline the process for people? I have extensively read your posts on other sites and I am interested in the "Rempel Maximum." I am somewhat suspicious of your claims concerning your ability to pick "all-star mutual fund managers," but I did read on another site that you personally invest this way (as well as your employees), this carries a lot of weight for me. Do you continue to invest this way? Your logic appears sound, but so many other articles I have read focus on limiting MERs. Assuming you can actually pick the best mutual fund managers, I agree that the MER would be worth it.

What sort of fee structure does your company charge Ed? Are there varying levels of help/advice?

I have been to your website, but didn't find a whole lot of answers for my questions.

Ditto. I have similar questions regarding Ed's service...

[superping]

I don't know Ed personally and I don't work with him or against him. So I can't say if he's a good advisor or not.

But I had been burn by bad financial advisor before. So I want to give other people some warning.

1. The bad advisor will set you up with a loan with higher rate than the bank. This is where they get their commision from. Mine was 1% higher than the bank.

2. The bad advisor will tell you that your investment will always go up and there is minimum risk (telling you that he knows what he's doing. and there is 0 risk). The true is, nobody can predict the market. Investment on equity may goes up or down. If you stay in the market for long term (10- 20 years), you will probably have enough time to recover after a crush.

3. Bad advisor will set you up with high MER fund (2-3%) and tell you that it's worth it to pay for the MER because your money will be managed by "professional". The true is if the fund makes 8% return (compare to the 6% return on index) MER takes 3%, and you get 8 - 3 = 5%. If the fund lost money, say -17%, MER is 3%, you are really losing -17 + -3 = -20% when the graph show that this fund lost only 17%, compare to the average market lost of 19%... wow, what a great deal. you saved 2% (not). Plus, you get the T5 for capital gain (because it's actively manage fund) that you have to pay tax on, even when the fund just lost 50% of its book-value in previous year and you didn't cash anything yet.

4. The funds that the bad advisor show you will lock-in for 7 years with >5% DSC (deffered sale charge).:cry: This DSC is where they get the HUGE commission from. If you cash in before 7 years, you have to pay that DSC to the fund company. The advisor makes that 5% commission when you give him the cheque. So everytime you see him, it's a good idea to buy more fund. And when you see a down-turn, the advisor will tell you to switch funds. Even worst, 2 years down the road, he proposes funds with different company (with better return) and he will tell you that it's worth it to pay for 4% DSC to redeem early and buy funds new funds.:evil:

5. Everytime you see him, he will have new hot product to introduce to you. All of them seem risk-free with better return. :confused:


you have been warned, choose your advisor wisely

[Shaf]

I don't know Ed personally and I don't work with him or against him. So I can't say if he's a good advisor or not.

But I had been burn by bad financial advisor before. So I want to give other people some warning.

1. The bad advisor will set you up with a loan with higher rate than the bank. This is where they get their commision from. Mine was 1% higher than the bank.

2. The bad advisor will tell you that your investment will always go up and there is minimum risk (telling you that he knows what he's doing. and there is 0 risk). The true is, nobody can predict the market. Investment on equity may goes up or down. If you stay in the market for long term (10- 20 years), you will probably have enough time to recover after a crush.

3. Bad advisor will set you up with high MER fund (2-3%) and tell you that it's worth it to pay for the MER because your money will be managed by "professional". The true is if the fund makes 8% return (compare to the 6% return on index) MER takes 3%, and you get 8 - 3 = 5%. If the fund lost money, say -17%, MER is 3%, you are really losing -17 + -3 = -20% when the graph show that this fund lost only 17%, compare to the average market lost of 19%... wow, what a great deal. you saved 2% (not). Plus, you get the T5 for capital gain (because it's actively manage fund) that you have to pay tax on, even when the fund just lost 50% of its book-value in previous year and you didn't cash anything yet.

4. The funds that the bad advisor show you will lock-in for 7 years with >5% DSC (deffered sale charge).:cry: This DSC is where they get the HUGE commission from. If you cash in before 7 years, you have to pay that DSC to the fund company. The advisor makes that 5% commission when you give him the cheque. So everytime you see him, it's a good idea to buy more fund. And when you see a down-turn, the advisor will tell you to switch funds. Even worst, 2 years down the road, he proposes funds with different company (with better return) and he will tell you that it's worth it to pay for 4% DSC to redeem early and buy funds new funds.:evil:

5. Everytime you see him, he will have new hot product to introduce to you. All of them seem risk-free with better return. :confused:


you have been warned, choose your advisor wisely

Thanks for that feedback. Those are similar concerns I have with using a FP.

I have not read through this whole thread, and want to know wht is teh best way to use this strategy.

Would you take equity from the house and invest in stocks with high dividends? Or what would you invest in to make the mortgage essentially tax deductable?

[multimut]

I have no interest or need for SM, but took a look at this thread to see what's being discussed, and thought I'd throw in my 2 cents on the areas of:

* need for advice
* value of active management

There are tremendous advantages for DIY investors in terms of costs, but I agree that the vast majority of people are not suited to be DIY investors. Here is a prior post I made on the topic: http://forums.redflagdeals.com/170k-invest-portfolio-manager-worth-862894/4/#post11163652

In terms of active management, I disagree with the concept of "star manager" or the idea than any advisor can help you pick the managers that will outperform in the FUTURE.

Here's an story told by Warren Buffet to explain why active management detracts from returns: http://money.cnn.com/2006/03/05/news/newsmakers/buffett_fortune/index.htm

As to the study regarding "Active Share" that suggests "really really" active managers do beat the index, well that is the only study I've heard of that suggests this, and I would suggest that the study has issues with "survivor bias", as managers that are making concentrated bets are more likely to do much better (and stay in business), or do much worse (and hence close the fund).

To further make this point, one of the biggest star managers of all time was Bill Miller of Legg Mason. He beat the S&P consistently every year for 15 straight years. Then his luck changed, and his long term track record at the end of 2008 was at the bottom of this category. I'm sure those of us who have some experience will recall names of other "Star" managers over the years, who flamed out eventually. The truth is that there is no way anyone can pick the managers who will outperform in the future. It's very easy to do all sorts of analysis of past returns and correlations, but the truth, which is always printed in small print is that past performance is no indication of future performance.

[edrempel]

Thanks for the advice Ed. My hometown is close to Steinbach.

My next question is what exactly is it that your company does for SM mortgage investors? I assume you basically streamline the process for people? I have extensively read your posts on other sites and I am interested in the "Rempel Maximum." I am somewhat suspicious of your claims concerning your ability to pick "all-star mutual fund managers," but I did read on another site that you personally invest this way (as well as your employees), this carries a lot of weight for me. Do you continue to invest this way? Your logic appears sound, but so many other articles I have read focus on limiting MERs. Assuming you can actually pick the best mutual fund managers, I agree that the MER would be worth it.

What sort of fee structure does your company charge Ed? Are there varying levels of help/advice?

I have been to your website, but didn't find a whole lot of answers for my questions.

Hi Young & Shaf,

This is not the right forum to talk a lot about our service, but in short, our main focus is comprehensive financial planning. The main difference with us is that we are financial professionals - not sales people. Our entire process is designed to be an effective, professional relationship. It is a "sales-presentation-free zone".

We provide a professional, written plan for every client at no charge. It may seem obvious for a financial planner to plan finances, but we are not aware of any other financial advisor that provides a professional written plan for every client without a fee. A financial plan documents what is important to you and the financial steps to achieve it in all areas of your life. We find the plan is key to determine the best strategies to use and keep focused on long term. The plan and strategies make a much bigger difference in your life than Investment A vs. Investment B. We also find that there are far more powerful ways to implement the SM when we look at your entire financial picture.

If the SM makes sense for you, then we arrange it all. We determine the best setup method for you, refer you to the bank that will have the best product/rate for your situation, write up your plan to include it, arrange appropriate investments with "All Star Fund Managers" and then e-file your tax returns. I am also an accountant and registered e-filer.

For mortgages, we have seen the studies that you almost always save money with 1-year fixed or variable, so we avoid the "5-year fixed mortgage trap" (Google it). We work directly with a few banks (we are not mortgage brokers), and get special pricing. Today, we are recommending 1-year fixed and are getting rates between 2.15-2.44%, which we think is smarter than variable today. Issues related to the mortgage rate, the credit line rate, fees, and how well each one works with the SM determine which is the best mortgage for you. We also offer "Ed's Mortgage Referral Service", even if you only want a mortgage.

We invest with "All Star Fund Managers" that have all beaten their index over long periods of time after fees and where we believe it is skill (not luck). This takes a lot of research, since every fund manager has periods of under-performance. These fund managers do exist. The study on Active Share by 2 Yale researchers confirmed it by showing that for the group of fund managers that have portfolios with less than 20% overlap in holdings with the index, the average fund manager beats the index even after fees. It showed that "closet indexers" dragged down the performance of fund managers, so if you take them out, then the "truly active" fund managers outperform. This study was very comprehensive and adjusts for "survivor bias" and many other possible explanation factors. It is available on the internet or on our web site. Google "closet indexers vs. stock pickers" for an article on it. All our fund managers have portfolios very different than their index.

Everyone in our firm invests 100% of their investments with the same fund managers we recommend for our clients. This seems obvious to us, since they are the ones we believe are the best investors. Even if our fund managers only keep up with the index (after fees), investing this way allows us to be paid by the investments, so that we can provide our comprehensive, professional advice at no charge.

We debated between being commission-based or fee-based, but decided that commission-based was more suited for a long term relationship. Canadians are not used to paying professionals. We don't even pay our doctors directly. Being fee-based would mean that clients would be "on the clock" whenever they phoned, which would mean they would hesitate to call with questions or have review meetings. The key for successful financial planning is working together long term, which we find works much better for us in a commission-based environment where the client

We do usually recommend DSC for long term investing, since it means we don't need to charge a commission. If you invest long term, you never have to pay this fee. We structure it so that you should never have to pay the DSC, as long as you follow your plan. If we recommend changing your portfolio, there is no cost to you. We feel we earn this because we do the complete planning up front.

We are selective on who we take on as clients. We provide a comprehensive, professional service, so we only work with people that will work 100% with us. We find this is most effective for our clients. If you have more than one advisor or work partly with an advisor, then nobody is looking at your overall plan, your long term goals, your overall tax situation and your total investment allocation. Also, there is a tendency to always buy high by putting all new money with whoever did best last year. This also tends to make the investment focus short term.

When clients invest 100% of their serious long term investments with us, then we can effectively plan all areas of their finances for no charge in a professional, "sales-presentation-free zone" designed for a long term relationship.

We offer free, educational seminars and webinars as an easy first step to meet us.



Ed

[multimut]

We invest with "All Star Fund Managers" that have all beaten their index over long periods of time after fees and where we believe it is skill (not luck). This takes a lot of research, since every fund manager has periods of under-performance. These fund managers do exist. The study on Active Share by 2 Yale researchers confirmed it by showing that for the group of fund managers that have portfolios with less than 20% overlap in holdings with the index, the average fund manager beats the index even after fees. It showed that "closet indexers" dragged down the performance of fund managers, so if you take them out, then the "truly active" fund managers outperform. This study was very comprehensive and adjusts for "survivor bias" and many other possible explanation factors. It is available on the internet or on our web site. Google "closet indexers vs. stock pickers" for an article on it. All our fund managers have portfolios very different than their index.


Ed, I'm sure you provide a great service to your clients and are a great advisor, but I have to comment on your assertion that your research can identify which managers will outperform in the future.

It is easy to pick managers based on past record and find ones that have consistently outperformed IN THE PAST. To find those who will outperform IN THE FUTURE is an entirely different story.

This "Active Share" study gives high hopes to advisors who want to be able to claim that they can pick the best managers in advance. But Warren Buffett says you can't do it. The best institutional investment consultants with the most research resources will admit (off record) that they can't really do it.

As to the "active share" study eliminating suvivorship bias, I have strong doubts that they were able to truly eliminate survivorship bias -- it is persuasive, and the data used to try and get rid of survivor bias is not that reliable. The study makes no claims about eliminating "backfill bias" which is another issue. I know that everyone can find some study out there that will support there point of view, but the common sense explanation as told by Warren Buffett is hard to refute. And most studies support Buffett's view.

And it is highly ironic that at the time they finished their "Active Share" study, the manager with one of the highest "Active Share" scores, and who had an impeccable track record of consistently outperforming over LONG periods of time, was non other than... BILL MILLER. Yet today, his long-term track record is at the bottom of his category.

[edrempel]

Ed, I'm sure you provide a great service to your clients and are a great advisor, but I have to comment on your assertion that your research can identify which managers will outperform in the future.

It is easy to pick managers based on past record and find ones that have consistently outperformed IN THE PAST. To find those who will outperform IN THE FUTURE is an entirely different story.

This "Active Share" study gives high hopes to advisors who want to be able to claim that they can pick the best managers in advance. But Warren Buffett says you can't do it. The best institutional investment consultants with the most research resources will admit (off record) that they can't really do it.

As to the "active share" study eliminating suvivorship bias, I have strong doubts that they were able to truly eliminate survivorship bias -- it is persuasive, and the data used to try and get rid of survivor bias is not that reliable. The study makes no claims about eliminating "backfill bias" which is another issue. I know that everyone can find some study out there that will support there point of view, but the common sense explanation as told by Warren Buffett is hard to refute. And most studies support Buffett's view.

And it is highly ironic that at the time they finished their "Active Share" study, the manager with one of the highest "Active Share" scores, and who had an impeccable track record of consistently outperforming over LONG periods of time, was non other than... BILL MILLER. Yet today, his long-term track record is at the bottom of his category.

Hi Multimut,

Thanks for your comments. They are a good summary of what we call "index fund programming" that is widely discussed. Please note a couple of points.

Warren Buffett's comments are that the average amateur investor is better off with an index fund. But he obviously believes top fund managers can beat the index. For example, he believes that he will continue to beat the index!

His view is best shown in his classic article "The Superinvestors of Graham-and-Doddsville" (http://www.edrempel.com/pdfs/superinvestors.pdf ), which is quite entertaining. He talks about 9 guys he met many years ago that all followed Ben Graham's style and that he thought ahead of time would be good fund managers. All 9 beat the index by very wide margins during their career.

My favourite is Bill Guerin, whose career was during the exact mythical secular bear market period from 1966-83. You have to feel for a guy whose entire career was this exact period. During those 19 years, the S&P500 made 8%/year, but he made 33%/year, beating the index by 25%/year.

He notes that, while most fund managers underperform, a very large portion of the ones that outperform are from the same investing style - Ben Graham value investing.

The Active Share article is also a fascinating read. (You can Google it to read my articles about it.) It measure Active Share as the degree that a fund's holdings differ from the index. An Active Share of 0% is an index fund, while an Active Share of 100% means no holdings are in common with the index. This is not "active investing" or a measure of activity, as you are implying.

The conclusions of the study are that:

1. In the category of fund managers of 80-100% Active Share (less than 20% holdings in common with the index), the AVERAGE fund manager beat the index after fees.
2. The fund managers with high Active Share tended to maintain it, and so can be predicted ahead of time.
3. Nobody should buy a "closet indexer" - a managed fund that is similar to the index. One of the bad effects of the index movement is the rise of closet indexers that make up about 30% of the industry (probably more in Canada). If the top 10 holdings of your fund have more than 2 holdings in common with the top 10 of the index, you probably have a closet indexer. You can't beat the index unless you are very different from the index.

The study is an in-depth scholarly study, unlike most of the studies supporting indexes that are mostly a one-click sort of funds. The Yale researchers painstakingly eliminated survivorship bias and backfill bias, as well as many other possible explanations, including including size of holdings, size of fund, momentum, cash position, “tracking error” correlation to the index, turnover of holdings, expenses (MER), number of holdings, age of fund, manager tenure and cash in-flow/out-flow. Even when you account for all these factors, the high Active Share fund managers still beat the index after all fees.

Bill Miller has an Active Share of about 75%. Not bad, but not in the highest group. He has always had a large holding in tech, which has been out of favour for a long time. Part of how he beat the index was a beta of 1.3 (his fund is 30% more volatile than the index). There is a good chance he will outperform again in the next bull market.

The widespread belief that nobody can beat the market is based on the "Efficient Market Theory", that finance scholars have all but dismissed. Virtually no university finance professors believe it any more. The flaw is it's assumption that the average investor is rational, which is obviously false. Most investors buy on emotion, just follow trends and tend to buy expensive sectors and sell low-priced sectors (even most professionals). The huge booms and busts we have had in the last 15 years and professors of Behavioural Finance like Richard Thaler are clear evidence that the EMH is false.

In short, we spend our time searching for characteristics of top fund managers and different methods that have been proven to beat the index, and then try to identify the fund managers that fit it.

The unique part of our investment process is that it is not me that is picking the country/sector that I think will do well or the fund that has done well recently. We focus on finding the top fund managers and letting them make those choices.

To use a hockey comparison, we see our role as choosing an All Star team and finding who plays well together, but it is not me out there stickhandling with the puck and trying to outperform NHL players.

We do believe this is the best way to invest, which is why everyone in our firm has 100% of their investments with the same fund managers we recommend for our clients.

Even if we only get similar returns to the index, our clients are far ahead, because their funds pay the full cost of comprehensive planning advice. This is important because we find from experience that having a good plan and the right strategies has a much larger effect on the wealth of our clients than Investment A vs. Investment B.




Ed

[S5]

Even if we only get similar returns to the index, our clients are far ahead

I love how you simply dismiss the most likely scenario, trailing the index.

Just for the record, do you set your customer's asset allocation? Obviously you let your "all star" managers do their thing but how do you allocate the ice time between all these superstars?:)


I think it's possible smaller investors who don't have the time/interest to DIY are getting good value with Ed's setup. Getting financial planning advice for "free" likely makes it good value overall despite the high MERs. Paying an hourly rate isn't feasible for smaller portfolios. I certainly wouldn't recommend it for those with larger assets and/or the interest to educate themselves about personal finance and investing.

[multimut]

Warren Buffett's comments are that the average amateur investor is better off with an index fund. But he obviously believes top fund managers can beat the index.

Ed, I'm not looking to get into a lengthy debate. I just post on RFD for amusement and to share some knowledge in my areas of expertise and interest (and to be alerted to deals!).

I just cut and past some of Buffett's comments from this piece: http://money.cnn.com/2006/03/05/news/newsmakers/buffett_fortune/index.htm, which reflects his views on the current (i.e. 2006 time frame) state of the investment industry:

* Indeed, owners must earn less than their businesses earn because of "frictional" costs. And that's my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.
* On Professional Managers: These newcomers explain to each member of the Gotrocks clan that by himself he'll never outsmart the rest of the family. The suggested cure: "Hire a manager -- yes, us -- and get the job done professionally." These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.
* On consultants/advisors helping to pick "top managers" or "all-star managers": financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don't suggest it to them.

There are so many people in the investment industry now... so many managers, so many value managers, so many Graham-Dodd managers, so many middlemen, and such high costs now, that beating the PROPER index, AFTER fees is very difficult.

Like I said before, I do think the average individual is better off getting advice. Good advisors do perform a valuable service, but the main service is keeping people on track and on plan.. but I disagree that you (or any other advisor) can pick a line-up of all-star managers that will outperform AFTER fees. It's not the same as your All-Star hockey players analogy, not even close. And if you can really do what no other consultant can do, you should apply to head up one of the major investment consulting houses in NYC or Chicago, because they can't do it.

I don't expect to change your opinion, and I'm not looking to get into a big debate. But two of my other interests are Golf and attractive women. That Planner that works for you looks pretty good in the picture. Is she hot? Does she golf?

[canadiankorean]

There must be people back in 2005 that have started this.

Can we get some feedback on their success or struggles?

I'd like some real examples of people that have attempted this.

Thanks

[riffr aff]

back on topic ....

from what i've read the HELOC is to be used ONLY for the SM - to avoid tax confusion I assume. As we are to deduct the interest paid on the HELOC from our taxes I have the following question.

Doesn't using the HELOC to pay the interest on the HELOC confuse how you calculate the interest you pay on the money borrowed for the investments? How should this be handled?

I don't want to get myself into trouble w/ CRA ...

[sslinn]

The interest on the interest is also tax deductible. You will not have any issues if you use the LOC strictly for the SM.

[riffr aff]

The interest on the interest is also tax deductible. You will not have any issues if you use the LOC strictly for the SM.

ok, thanks sslinn. It's too bad we can't use this LOC for anything but the SM as it is a nice rate (compared to my personal LOC).

Is it impossible to use the money in the HELOC? or does it just make tax-time too insane?

[Germack]

There must be people back in 2005 that have started this.

Can we get some feedback on their success or struggles?

I'd like some real examples of people that have attempted this.

Thanks

It is pretty obvious that these people did not do well due to the market crash in 2008. The market crashed ~50% therefore everyone with a 2:1 leverage got basically wiped out completely.

I would like to know how many of ED's client bailed out during the market crash of 2008. These people must have lost a sh*tload of money.

[grant]

It is pretty obvious that these people did not do well due to the market crash in 2008. The market crashed ~50% therefore everyone with a 2:1 leverage got basically wiped out completely.
Stocks crashed but real estate in canada hardly moved.

imagine your smith maneuvre results in you owning: $500,000 home with a $400,000 mortgage (80%), the proceeds of which were used to buy $400,000 of stocks. At this point your leverage is 1.8:1.

Now the stock market crashes, and your assets are: $500k home, $200k stocks, and $400k mortgage. You've lost $200k, but your net worth is still $300k, so you're nowhere close to wiped out.

[MyLifeInBrampton]

There must be people back in 2005 that have started this.

Can we get some feedback on their success or struggles?

I'd like some real examples of people that have attempted this.

Thanks

Started in May 2005 with 100K on HELOC @ Prime (Current 2.75%).

Just checked the investment account and its now a bit over 136K. During the years made between 200-1000 a month in dividends. Interest is about $200/month, so it always covers and some months have extra money. Interested deducted on income taxes, dividends are a lot less taxable.

So lets say I made 5K/year in dividends/tax back and 36K total capital profit.

I have had banks, income trusts, preferred shares, etc on the account.

Best investment: Bought BMO 1000 @ 36 last year with 10% dividend.

Worst investment: Bought Riocan 1000 @ 20 3 years ago, and had to wait 3 years to sell (It went down to 14!).

You have to keep an eye on the stocks and put limit orders to protect yourself.

PS. At the worst, I was down to 73K but the market has recovered nicely and the dividends always covered the interest on HELOC.

[Jungle]

ok, thanks sslinn. It's too bad we can't use this LOC for anything but the SM as it is a nice rate (compared to my personal LOC).

Is it impossible to use the money in the HELOC? or does it just make tax-time too insane?

You can ask for another sub-account, your bank might have this feature.

[Jungle]

Started in May 2005 with 100K on HELOC @ Prime (Current 2.75%).

Just checked the investment account and its now a bit over 136K. During the years made between 200-1000 a month in dividends. Interest is about $200/month, so it always covers and some months have extra money. Interested deducted on income taxes, dividends are a lot less taxable.

So lets say I made 5K/year in dividends/tax back and 36K total capital profit.

I have had banks, income trusts, preferred shares, etc on the account.

Best investment: Bought BMO 1000 @ 36 last year with 10% dividend.

Worst investment: Bought Riocan 1000 @ 20 3 years ago, and had to wait 3 years to sell (It went down to 14!).

You have to keep an eye on the stocks and put limit orders to protect yourself.

PS. At the worst, I was down to 73K but the market has recovered nicely and the dividends always covered the interest on HELOC.

Thank you for your feedback. I think what makes this successful is:
1. Buying stocks at great prices. (take's a lot of risk out)
2. Having a basket of stocks, different sectors, etc.
3. Having patience and faith in the market, when prices drop.

[riffr aff]

You can ask for another sub-account, your bank might have this feature.

thanks Jungle. I'll ask BMO this weekend.

[Jungle]

It is pretty obvious that these people did not do well due to the market crash in 2008. The market crashed ~50% therefore everyone with a 2:1 leverage got basically wiped out completely.

I would like to know how many of ED's client bailed out during the market crash of 2008. These people must have lost a sh*tload of money.

I'm sure people bailed. But you have to embed in your brain, buy and hold. Don't let it get to you. I learned the hard why, when I sold in the market crash as a new investor. I was leverage and then speculated to gain money back. Too bad I didn't just keep the shares I bought. Would have been up 50%++ today. I didn't see in the long term future. Just short term panic.

[consumerPI]

Hi, does anyone know if there are any Financial advisors in Toronto that provides a professional written plan without a fee?

I'm at a point where I should sit down with someone but want to come up with a list of 2-3 including Ed before making a decision on who to go with. Ideally in Toronto.


Hi Young & Shaf,

This is not the right forum to talk a lot about our service, but in short, our main focus is comprehensive financial planning. The main difference with us is that we are financial professionals - not sales people. Our entire process is designed to be an effective, professional relationship. It is a "sales-presentation-free zone".

We provide a professional, written plan for every client at no charge. It may seem obvious for a financial planner to plan finances, but we are not aware of any other financial advisor that provides a professional written plan for every client without a fee. A financial plan documents what is important to you and the financial steps to achieve it in all areas of your life. We find the plan is key to determine the best strategies to use and keep focused on long term. The plan and strategies make a much bigger difference in your life than Investment A vs. Investment B. We also find that there are far more powerful ways to implement the SM when we look at your entire financial picture.

If the SM makes sense for you, then we arrange it all. We determine the best setup method for you, refer you to the bank that will have the best product/rate for your situation, write up your plan to include it, arrange appropriate investments with "All Star Fund Managers" and then e-file your tax returns. I am also an accountant and registered e-filer.

For mortgages, we have seen the studies that you almost always save money with 1-year fixed or variable, so we avoid the "5-year fixed mortgage trap" (Google it). We work directly with a few banks (we are not mortgage brokers), and get special pricing. Today, we are recommending 1-year fixed and are getting rates between 2.15-2.44%, which we think is smarter than variable today. Issues related to the mortgage rate, the credit line rate, fees, and how well each one works with the SM determine which is the best mortgage for you. We also offer "Ed's Mortgage Referral Service", even if you only want a mortgage.

We invest with "All Star Fund Managers" that have all beaten their index over long periods of time after fees and where we believe it is skill (not luck). This takes a lot of research, since every fund manager has periods of under-performance. These fund managers do exist. The study on Active Share by 2 Yale researchers confirmed it by showing that for the group of fund managers that have portfolios with less than 20% overlap in holdings with the index, the average fund manager beats the index even after fees. It showed that "closet indexers" dragged down the performance of fund managers, so if you take them out, then the "truly active" fund managers outperform. This study was very comprehensive and adjusts for "survivor bias" and many other possible explanation factors. It is available on the internet or on our web site. Google "closet indexers vs. stock pickers" for an article on it. All our fund managers have portfolios very different than their index.

Everyone in our firm invests 100% of their investments with the same fund managers we recommend for our clients. This seems obvious to us, since they are the ones we believe are the best investors. Even if our fund managers only keep up with the index (after fees), investing this way allows us to be paid by the investments, so that we can provide our comprehensive, professional advice at no charge.

We debated between being commission-based or fee-based, but decided that commission-based was more suited for a long term relationship. Canadians are not used to paying professionals. We don't even pay our doctors directly. Being fee-based would mean that clients would be "on the clock" whenever they phoned, which would mean they would hesitate to call with questions or have review meetings. The key for successful financial planning is working together long term, which we find works much better for us in a commission-based environment where the client

We do usually recommend DSC for long term investing, since it means we don't need to charge a commission. If you invest long term, you never have to pay this fee. We structure it so that you should never have to pay the DSC, as long as you follow your plan. If we recommend changing your portfolio, there is no cost to you. We feel we earn this because we do the complete planning up front.

We are selective on who we take on as clients. We provide a comprehensive, professional service, so we only work with people that will work 100% with us. We find this is most effective for our clients. If you have more than one advisor or work partly with an advisor, then nobody is looking at your overall plan, your long term goals, your overall tax situation and your total investment allocation. Also, there is a tendency to always buy high by putting all new money with whoever did best last year. This also tends to make the investment focus short term.

When clients invest 100% of their serious long term investments with us, then we can effectively plan all areas of their finances for no charge in a professional, "sales-presentation-free zone" designed for a long term relationship.

We offer free, educational seminars and webinars as an easy first step to meet us.



Ed

[superping]

Hi, does anyone know if there are any Financial advisors in Toronto that provides a professional written plan without a fee?

I'm at a point where I should sit down with someone but want to come up with a list of 2-3 including Ed before making a decision on who to go with. Ideally in Toronto.

All the financial advisor got to eat too. They have to earn money by fee or commission.

You might want to look at the bank to see if they offer any financial advisor service. At least, they earn salary and don't make commission. Or If you want to set up a meeting with advisor, Get a few investment book from library before talk to them. So that they don't wow you on basic stuff. Keep in mind that the most convincing one will probably be the best sale person. The good one may be honest and you may not want to hear him out. don't pick the one who promise the best return. Obviously, past return is not a good indicator for future return.

There are 2 pieces to SM. The loan and the investment. If you want to DIY for SM:
1. Get a HLOC with the bank. The best way to do it is to obtain 2-in-1 mortgage/HLOC. Because when you pay your mortgage down, your HLOC increase automatically. The best time to do it is when you need to renew your mortgage (otherwise, you might have to pay for penalty). You have to do a re-financing and probably pay for appraisal + legal cost. The interest is so low, I don't think Bank is willing to pay for your legal cost+appraisal. If you are too lazy to shop around, find a mortgage broker. They will find the best rate and best product for you. Normally, you will be able to get (mortgage + HLOC = 80% of your appraised home value)..

2. Find an investment. Find some software or free service at the bank to find out what is your risk torerent. High MER/Active fund or low MER/passive fund is your choice (search google on "low fee ETF vs mutual fund" to see the different). Regardless, I recommended an investment that pay some dividend. If you go for capital gain only, your ROI is 0% until you sell it. Hopefully, you sell high and buy low for maximum ROI. If you have not experience 2008 crush, I will tell you this, there is a good chance of you putting in more money when your investment is doing well (buy high) and you sell it when it crush (sell low). If you have a financial advisor, it's an extra break to remind you that you should not sell low. But if you are really stress and sleepless, no advisor will stop you. When you pick your investment, set up a monthly contribution and distribution. So that you don't get distract with performance (buy high). Keep your investment AWAY from your daily banking (different bank or discount trading). So that you don't see them every day. Or you will be dreaming about them. :lol:

SM is a way to make your mortgage tax-deductible. But there is a risk to it. If your investment goes to zipo or reduced, you are still liable for the full amount of borrowed money, in this case will cost you your home if you can't pay it back.

** fyi.. that bad financial advisor managed to convince me because he also invest in the same investment that he recommended. There is one different, I got to pay 5.5% DSC on my investment. But he got a 5.5% discount + loyalty fee when he buys that same investment. Now, he bought a rental property too .. dam, I should ask him to pay for my advice. :)

[edrempel]

Hi Multimut and S5,

I understand your points and agree with you in general. However, just consider for a moment the difference between the average fund manager and the All Star Fund Manager.

For example, if your fund manger is Warren Buffett, would you say the most likely scenario is that he will underperform the index?

There are a lot of fund managers, but not a lot of value managers, especially Graham-and-Dodd style value managers. How many new Graham-and-Dodd value managers can you name that started in the last 10 years?

As Warren Buffett says: 'I have seen no trend toward value investing in the 35 years I've practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult.'

The Yale study on Active Share showed that, in general, the quality of fund management is quite a bit lower than it was. In rough numbers, here are the categories of fund managers and their share of the market:

Fund Managers in order of return (on average) 1985 2009
Stock pickers 70% 30%
Index funds 0% 10%
"Sector bets" (sector rotators/market-timers) 30% 30%
"Closet indexers" 0% 30%

For more detail, see: http://www.milliondollarjourney.com/closet-indexers-vs-stock-pickers-truly-active-managers-outperform.htm .

The stock pickers on average were shown to beat the index after all fees, but there is a much smaller percentage of them now than in 1985. Meanwhile, the new funds are almost entirely index funds or "closet indexers". The closet indexers are funds with more than 60% of the holdings in the fund being the same as the index. Of course they underperform, because you can only beat the index if you are different from the index.

Closet index funds are the worst choice of all, but tend to sell well. People tend to feel comfortable investing with them, since they only have poor returns when everyone else does and their holdings are big, well-known and currently popular companies.

The main problem in the financial industry is that it is focused on selling product - not on being an investment/financial professional. Most of the large consulting firms and the average financial planner will recommend funds that are currently popular or performed well recently. Even when they have an All Star Fund Manager, they tend to dump them the first time they underperform. All Star Fund Managers nearly always have portfolios very different from the index, so there will be times when they underperform. But there are quite a few that have beaten their index by a lot in the long run.

The other important point is that the most valuable part of financial advice is creating a plan and using the right strategies. Both of these will make a bigger difference on your future lifestyle than your investment return.

Without a written plan (e.g. a specific written retirement goal), most people invest far too little and far too conservatively to have any chance of having the retirement that they want. Most Canadians in their 20s-40s today will need $1-2 million when they retire to have the retirement that they want, but they invest half in interest-bearing investments and only their extra cash and only when they feel good about the market, so they end up with $200-500,000 only.

Without a plan, you are right that the main problem most people have is sticking to a goal. As the old saying goes: "They don't plan to fail. They fail to plan."

The strategy chosen is also more significant than the investment return generally. For example, if Person A maxes his RRSP, properly implements the right version of the SM and ends up making 8% on their investments, he will probably end up wealthier than Person B who invests in RRSP only without advice, even if he ends up making 12%/year.

Simple example of why the strategy is more valuable than the investment return: 2 people have $200/month available cash. Person A invests it at and makes 12%/year and ends up with $182,000 after 20 years. Person B uses the $200/month to finance the interest-only payment (after tax refund) on a $100,000 investment loan. He invests more conservatively, because of the leverage, but ends up making 8%/year. He end up with $466,000 in 20 years - $366,000 more than the loan.

There are many other effective strategies, other than leverage, but it is a clear example of where the strategy is more valuable than the investment. We find, in general, without advice, most people don't know what strategy to do. For example, how many people would have the confidence to use their $200/month to fund a $100,000 investment loan?

We actually find that it is usually people with smaller portfolios that don't get advice. Most of the DIY portfolios we have seen over the years are less than $50,000. Nearly all are less than $100,000. The reason for this is that there is usually not much focus on the risk of the strategy.

For example, if your portfolio is $5,000, then a risky investment seems to make sense, since how much can it fall anyway? When your portfolio is $50,000, you try being more diversified. If you ever get to $500,000, the strategies you did with $5,000 or $50,000 rarely make any sense at all. Few people have the confidence and knowledge to be DIY at $500,000. Then at $5 million, that is even more true.

We think the main reasons that DIY portfolios are usually small is partly because of investment mistakes, but also because there is a fear that tends to settle in once the portfolio gets larger. The fear makes them lose their focus.



Ed

[multimut]

Hi Ed. As I stated in my last post, I have no interest in a long debate. I didn't expect to change your opinion, and you're not going to change mine. The posts are interesting for others to read and evaluate on their own.

From my last note, my only questions for you were:
a) Hot or Not?
b) and Golfer or not?

[edrempel]

Hi Ed. As I stated in my last post, I have no interest in a long debate. I didn't expect to change your opinion, and you're not going to change mine. The posts are interesting for others to read and evaluate on their own.

From my last note, my only questions for you were:
a) Hot or Not?
b) and Golfer or not?

Hi Multimut,

I enjoy the discussion. Finding what actually works in finance and debunking financial myths is my passion.

As for your questions, all I will say is - not a golfer. Sorry. :)


Ed

[multimut]

As for your questions, all I will say is - not a golfer. Sorry. :)


Oh well. You think she has any interest in learning golf? How about Yoga?

Cheers.

[Germack]

For example, if Person A maxes his RRSP, properly implements the right version of the SM and ends up making 8% on their investments, he will probably end up wealthier than Person B who invests in RRSP only without advice, even if he ends up making 12%/year.

Simple example of why the strategy is more valuable than the investment return: 2 people have $200/month available cash. Person A invests it at and makes 12%/year and ends up with $182,000 after 20 years. Person B uses the $200/month to finance the interest-only payment (after tax refund) on a $100,000 investment loan. He invests more conservatively, because of the leverage, but ends up making 8%/year. He end up with $466,000 in 20 years - $366,000 more than the loan.


What happens to person B if your assumptions are wrong?

I invest in a balanced portfolio containing equities and bonds. Not to maximize the chances of getting rich, but to achieve a comfortable retirement and to minimize the odds of dying poor.

If equities will collapse I will be saved by my bonds and will still have a decent retirement. If equities performed well I only lost a somewhat higher standard of living.

However if Person B is wrong he will be ruined.

[florch]

Hi all

I cut my teeth on this thread some time ago and have been using this technique for a few years. I have been invested about 2/3 real estate, 1/3 stocks and have done well on the former, and as expected (= the market) on the latter. Also, my income has increased somewhat and I haven't allocated every cent as per the plan, as we plan to upgrade to a larger home and continue to use the SM.

We have been using Manulife One, which at the time I started was the best option. It has not been the best product for some time, but it has not been worthwhile to switch either.
The Non-deductible portion is getting very low, and 3.5% I think is still OK for the LOC portion.

So now that there will be some cost involved in switching mortgages anyway, as well as increasing the non-deductible portion, I am exploring my options.

Very Roughly I'm going from 15% not deductible, 85% deductible, to about 50% ND, 50% D. I have 3 sub-accounts.

So Man1 = 3.5% ND, 3.5% D, $14/mo fees
National's AI1 seems to be 3% ND, 4% D, $5 or $7.50 in fees - IF I understand their website.

I know Man1 is non-negotiable - both rates and fees. Is NB AI1 negotiable?

Are there other products that are worth a look these days?

I'm going to go browse around here and look at some bank websites while I wait for the community's wisdom;)

Thanks in advance

[Jungle]

I believe NB is offering prime+0.5 heloc without any haggling. When I last spoke with a broker, they could offer this rate. Some report getting lower if you are an engineer, but you have to take their $120/year annual fee MC.

[edrempel]

ok, thanks sslinn. It's too bad we can't use this LOC for anything but the SM as it is a nice rate (compared to my personal LOC).

Is it impossible to use the money in the HELOC? or does it just make tax-time too insane?

Hi riffr aff,

What mortgage do you have? Most of the Smith Manoeuvre mortgages allow you to split the credit line into 2 or many credit lines. Then you can use one for the SM and one for whatever else you need.

It is very important to keep them separate. If you mix them, you can lose the deductibility of the credit line. This is because the interest is deductible because of the purpose of borrowing money. For example, let's say you have a credit line with $100,000 borrowed to invest. Then you have $10,000 of extra cash, so you pay it down on the credit line to save some interest until you need it. A month later, you take the $10,000 out to spend. Now only $90,000 of the credit line is deductible. This is because you paid off $10,000 of it and then reborrowed for a non-deductible purpose.

If you borrow for 2 purposes, partly for investing and partly for spending, you can elect which one you are paying down with extra cash, but you have to be able to track everything and risk losing your deductibility if you are not careful.

If you mess it up, it can usually be fixed, but the best advice is to always keep the tax deductible credit line separate from anything else.


Ed

[edrempel]

It is pretty obvious that these people did not do well due to the market crash in 2008. The market crashed ~50% therefore everyone with a 2:1 leverage got basically wiped out completely.

I would like to know how many of ED's client bailed out during the market crash of 2008. These people must have lost a sh*tload of money.

Hi Germack,

You are right that the crash in 2008 was a challenge, but none of our clients had a margin call or cashed out. The key to being successful with the SM is to only do it as a long term strategy, avoid any chance of a margin call, and only do it when the investor has faith in the market long term.

There were quite a few clients, of course, that started in 2007-8 and most are still down, but we don't expect it will take long to be back in the black. The markets have historically recovered quite quickly from market crashes. Of the 25 market declines in the S&P500 since 1871 (excluding the 1930s), 88% recovered in 1-2 years and 100% recovered within 4 years from the bottom.

The belief that markets stay down for a long time is a popular myth, but the S&P500 has consistently recovered far quicker than most people believe.

Clients with a 2:1 leverage loan would be a minority, but for us, all of those loans are No Margin Call Loans. We did hear from the main trust companies that specialize in investment loans that they had thousands of margin calls early in 2009, but none were our clients.

Because we have faith in the markets long term, we recognized the market bottom and were very busy encouraging clients to invest back then. It looked obvious with pessimism being so rampant! I published an article on the internet in March 2009 at the market bottom called "Irrational Pessimism" (http://www.milliondollarjourney.com/irrational-pessimism.htm ).

We also had some clients that borrowed large amounts near the bottom. They were up 50% in 6 months! We also had some that had started earlier that "doubled down" (much as I dislike that term) by investing more after the decline.

For investors that have faith in the market and their investments long term, major crashes like 2008 are just great buying opportunities.

In fact, many investors believe that it is hard to beat the indexes. However, all it takes is to wait for the 1 or 2 big buying opportunities of each decade and invest much larger amounts those years.




Ed

[edrempel]

Started in May 2005 with 100K on HELOC @ Prime (Current 2.75%).

Just checked the investment account and its now a bit over 136K. During the years made between 200-1000 a month in dividends. Interest is about $200/month, so it always covers and some months have extra money. Interested deducted on income taxes, dividends are a lot less taxable.

So lets say I made 5K/year in dividends/tax back and 36K total capital profit.

I have had banks, income trusts, preferred shares, etc on the account.

Best investment: Bought BMO 1000 @ 36 last year with 10% dividend.

Worst investment: Bought Riocan 1000 @ 20 3 years ago, and had to wait 3 years to sell (It went down to 14!).

You have to keep an eye on the stocks and put limit orders to protect yourself.

PS. At the worst, I was down to 73K but the market has recovered nicely and the dividends always covered the interest on HELOC.

Hey Brampton,

We are in Brampton too. Way to go on your investments.

Just so you know, what you are doing is not the Smith Manoeuvre. You are doing ordinary leverage. The SM involves reborrowing the principal from each mortgage payment to invest and capitalizing the interest.

We modelled the SM using dividends and found that the "tax bleed" of tax on the dividends every year meant that your investments need to average about 1%/year higher to keep up with non-dividend-paying tax-efficient investments.


Ed

[edrempel]

I'm sure people bailed. But you have to embed in your brain, buy and hold. Don't let it get to you. I learned the hard why, when I sold in the market crash as a new investor. I was leverage and then speculated to gain money back. Too bad I didn't just keep the shares I bought. Would have been up 50%++ today. I didn't see in the long term future. Just short term panic.

Hi Jungle,

Thanks for the insightful comment. Your experience is what most investors did and what the human brain tries to persuade you to do. You're right - buy and hold is the key, especially for leveraged investments.


Ed

[riffr aff]

Hi riffr aff,

What mortgage do you have? Most of the Smith Manoeuvre mortgages allow you to split the credit line into 2 or many credit lines. Then you can use one for the SM and one for whatever else you need.

If you mess it up, it can usually be fixed, but the best advice is to always keep the tax deductible credit line separate from anything else.


Ed

BMO ReadiLine.

Can I split this type of account?

[edrempel]

What happens to person B if your assumptions are wrong?

I invest in a balanced portfolio containing equities and bonds. Not to maximize the chances of getting rich, but to achieve a comfortable retirement and to minimize the odds of dying poor.

If equities will collapse I will be saved by my bonds and will still have a decent retirement. If equities performed well I only lost a somewhat higher standard of living.

However if Person B is wrong he will be ruined.

Hi Germack,

The equity investor is not necessarily ruined if the market crashes. They just have to stay patient and wait for the inevitable recovery. We have the S&P500 since 1871. Of the 25 negative periods in calendar years (excluding the 1930s), 22 of them (88%) recovered fully in 1-2 years and the 100% recovered in 4 years or less from the bottom.

The point of my post was that the strategy is more important than the investment choice. In that example, the leveraged investor ended up far ahead of a non-leveraged investor with far higher returns.

You bring up another example. The investment strategy of choosing your asset allocation probably makes more difference in your long term return than the which specific investments you have.

Many investors invest too conservatively to have any chance of having the retirement they want. Bonds will reduce the volatility of your portfolio, but in the long term, the investor with more faith in the market that invests 100% in equities will end up far ahead of bond or balanced investors.

Your financial plan and the strategies you choose are the main keys to financial success. Most investors get so focused Investment A vs. Investment B, which is less significant.



Ed

[edrempel]

Hi all

I cut my teeth on this thread some time ago and have been using this technique for a few years. I have been invested about 2/3 real estate, 1/3 stocks and have done well on the former, and as expected (= the market) on the latter. Also, my income has increased somewhat and I haven't allocated every cent as per the plan, as we plan to upgrade to a larger home and continue to use the SM.

We have been using Manulife One, which at the time I started was the best option. It has not been the best product for some time, but it has not been worthwhile to switch either.
The Non-deductible portion is getting very low, and 3.5% I think is still OK for the LOC portion.

So now that there will be some cost involved in switching mortgages anyway, as well as increasing the non-deductible portion, I am exploring my options.

Very Roughly I'm going from 15% not deductible, 85% deductible, to about 50% ND, 50% D. I have 3 sub-accounts.

So Man1 = 3.5% ND, 3.5% D, $14/mo fees
National's AI1 seems to be 3% ND, 4% D, $5 or $7.50 in fees - IF I understand their website.

I know Man1 is non-negotiable - both rates and fees. Is NB AI1 negotiable?

Are there other products that are worth a look these days?

I'm going to go browse around here and look at some bank websites while I wait for the community's wisdom;)

Thanks in advance

Hi Florch,

Manulife One has never been the best, since their fixed rates have always been quite a bit higher than most of the other banks. It only works for people with little or no mortgage.

National works well, as do a few other banks. You can save more money by avoiding the "5-Year Fixed Mortgage Trap" and sticking with 1-year fixed or variable mortgages. The rates are then quite a bit lower than the 3-4% rates you were quoted.

If you want to make sure you have the best mortgage and rate for the SM, we have a free, no obligation, SM mortgage referral service (http://www.edrempel.com/mortgage_referral.php ).

We have contacts with all 7 Smith Manoeuvre mortgages, know the pros and cons for each with the SM, and try to always have the very best rates. Today, we are recommending 1-year fixed mortgages. Variable rates are similar, but will likely float up over the next year and we are expecting deeper discounts on variable by a year from now.



Ed

[edrempel]

BMO ReadiLine.

Can I split this type of account?

HI riffr aff,

Yes, the BMO Readiline can be split into as many credit lines as you want. Keep the main one for the SM, since only one credit line readvances automatically.





Ed

[Jungle]

We modelled the SM using dividends and found that the "tax bleed" of tax on the dividends every year meant that your investments need to average about 1%/year higher to keep up with non-dividend-paying tax-efficient investments.


Ed

Ed can you explain this a little more?

[edrempel]

Originally Posted by edrempel

We modelled the SM using dividends and found that the "tax bleed" of tax on the dividends every year meant that your investments need to average about 1%/year higher to keep up with non-dividend-paying tax-efficient investments.


Ed
===================================

Ed can you explain this a little more?

Sure Jungle,

We have software that calculates the projected future benefit of the Smith Manoeuvre that allows us to compare various strategies.

One version of the SM is the Smith Manoeuvre with Dividends. We have some mutual funds that pay a 6% eligible fixed dividend. If your Smith Manoeuvre investments pay a taxable dividend, you can pay it directly onto your mortgage. Then you can reborrow that same amount from the investment credit line to invest.

The dividend strategy involves investing in dividend-paying investments and using the dividends to pay off the mortgage more quickly.

To see how well this worked, we compared a 10% growth fund to a fund with a 6% dividend plus 4% growth.

The result was that the dividend strategy paid the mortgage off (converted it to tax deductible) almost 5 years sooner, but had a 21% lower benefit over 25 years. The dividend strategy needed to make a return .8% higher to be equal. So a 6% dividend plus 4.8% growth had about the same benefit as no dividend and a 10% growth.

The reason for this is that there is a "tax bleed". Every year, there is tax payable on the dividend. Even though receiving the dividend allowed the mortgage to be converted more quickly, the tax on the dividend was a much more significant factor.

In short, having a dividend REDUCED the return of the strategy. The dividend strategy is for people that want to pay the mortgage off INSTEAD of making more money.

We have seen some people try the SM with Dividends by buying dividend-paying stocks (almost entirely Canadian banks and utilities) in order to generate dividends. The dividend on individual stocks is lower than the 6% dividend on the mutual fund, but is essentially the same strategy (but with less diversification). Since our investment choices are limited with either dividend strategy, we would expect a lower return, not a higher return.

Even though we developed this strategy, we have found it has very limited use. Nearly all clients are better off with the normal Smith Manoeuvre with tax-efficient investments growing over time an no dividends.





Ed

[riffr aff]

Thanks Ed

I tend to be an online type of CSR interacting type.

Any idea how I make seperate accounts in my HELOC w/o having to talk to the bank rep who takes far too much of my time w/ her personal stories?

Cheers,

(I like automation for account set up!)

RR



HI riffr aff,

Yes, the BMO Readiline can be split into as many credit lines as you want. Keep the main one for the SM, since only one credit line readvances automatically.







Ed

[Hemos]

Ed can you explain this a little more?

Thanks Ed for the details. Would you think that in a case like Quebec, where you can deduct only investment interest from investment income, dividend income could outperform the capital realisation strategy?

[Icedawn]

Sure Jungle,

We have software that calculates the projected future benefit of the Smith Manoeuvre that allows us to compare various strategies.

One version of the SM is the Smith Manoeuvre with Dividends. We have some mutual funds that pay a 6% eligible fixed dividend. If your Smith Manoeuvre investments pay a taxable dividend, you can pay it directly onto your mortgage. Then you can reborrow that same amount from the investment credit line to invest.

The dividend strategy involves investing in dividend-paying investments and using the dividends to pay off the mortgage more quickly.

To see how well this worked, we compared a 10% growth fund to a fund with a 6% dividend plus 4% growth.

The result was that the dividend strategy paid the mortgage off (converted it to tax deductible) almost 5 years sooner, but had a 21% lower benefit over 25 years. The dividend strategy needed to make a return .8% higher to be equal. So a 6% dividend plus 4.8% growth had about the same benefit as no dividend and a 10% growth.

The reason for this is that there is a "tax bleed". Every year, there is tax payable on the dividend. Even though receiving the dividend allowed the mortgage to be converted more quickly, the tax on the dividend was a much more significant factor.

In short, having a dividend REDUCED the return of the strategy. The dividend strategy is for people that want to pay the mortgage off INSTEAD of making more money.

We have seen some people try the SM with Dividends by buying dividend-paying stocks (almost entirely Canadian banks and utilities) in order to generate dividends. The dividend on individual stocks is lower than the 6% dividend on the mutual fund, but is essentially the same strategy (but with less diversification). Since our investment choices are limited with either dividend strategy, we would expect a lower return, not a higher return.

Even though we developed this strategy, we have found it has very limited use. Nearly all clients are better off with the normal Smith Manoeuvre with tax-efficient investments growing over time an no dividends.

Ed

I will ponder this a bit more later, but my off the cuff reaction is that you may be comparing slightly different animals. Doesn't the version with dividends result in a comparatively lower amount of debt over time and so there's slightly less risk involved? (i.e. my understanding is that for the same net worth, having lower debt is less risky. eg. risk profile of someone with 100K assets and 90K debt is higher than someone with 10K assets and 0K debt)

[MyLifeInBrampton]

Hey Brampton,

We are in Brampton too. Way to go on your investments.

Just so you know, what you are doing is not the Smith Manoeuvre. You are doing ordinary leverage. The SM involves reborrowing the principal from each mortgage payment to invest and capitalizing the interest.

We modelled the SM using dividends and found that the "tax bleed" of tax on the dividends every year meant that your investments need to average about 1%/year higher to keep up with non-dividend-paying tax-efficient investments.


Ed

Yes, but the dividends make me happy. :) And made me keep going.

I would not recommend this strategy today because interest rates are rising and I expect them to keep rising. I am now winding down this strategy as it does not make sense anymore.

Debt free and TFSAs seem to be the better option today.

[slavka012]

I will ponder this a bit more later, but my off the cuff reaction is that you may be comparing slightly different animals. Doesn't the version with dividends result in a comparatively lower amount of debt over time and so there's slightly less risk involved? (i.e. my understanding is that for the same net worth, having lower debt is less risky. eg. risk profile of someone with 100K assets and 90K debt is higher than someone with 10K assets and 0K debt)
My thoughts exactly. You trade those 0.8% for lesser risk.

[edrempel]

Thanks Ed

I tend to be an online type of CSR interacting type.

Any idea how I make seperate accounts in my HELOC w/o having to talk to the bank rep who takes far too much of my time w/ her personal stories?

Cheers,

(I like automation for account set up!)

RR

Hi riffr aff,

My suggestion would be to find a more professional bank mortgage rep. :)

We are not aware of any bank that allows you to setup secured credit lines online. Even the bank reps have to send in apps signed by the client. We know our mortgage contacts well, so we can get anything done with just an email on our part, but there is more work involved between the mortgage rep and the client to have our instructions implemented.


Ed

[riffr aff]

Hi riffr aff,

My suggestion would be to find a more professional bank mortgage rep. :)

We are not aware of any bank that allows you to setup secured credit lines online. Even the bank reps have to send in apps signed by the client. We know our mortgage contacts well, so we can get anything done with just an email on our part, but there is more work involved between the mortgage rep and the client to have our instructions implemented.


Ed

I didn't actually ask the bank! And i'm using the person FrugalTrader from MDJ refers people to ;)

[edrempel]

Thanks Ed for the details. Would you think that in a case like Quebec, where you can deduct only investment interest from investment income, dividend income could outperform the capital realisation strategy?

Hi Hemos,

I ran the same scenario with Quebec as the province and had similar results, but I don't think our software takes into account the different rules in Quebec - just the tax rates. That would make a difference, but depending on the scenario, may or may not change the result.

If the tax-efficient growth investor could not deduct the interest, while the dividend investor was able to off-set the tax on the dividends, then the "tax bleed" would be gone. However, it would depend on the dividend and interest rates. We can get a 6% fixed dividend, while we can borrow to invest at 3.5% today. Therefore, nearly half the dividend would still be taxed. Therefore, there would still be a "tax bleed" on the dividends.

The deciding factor is the tax on the dividends. We did find that the dividends worked for low income investors (less than $41K). This is because the low tax bracket actually has negative tax on dividends. However, that negative tax is being eliminated by 2012.





Ed

[edrempel]

I will ponder this a bit more later, but my off the cuff reaction is that you may be comparing slightly different animals. Doesn't the version with dividends result in a comparatively lower amount of debt over time and so there's slightly less risk involved? (i.e. my understanding is that for the same net worth, having lower debt is less risky. eg. risk profile of someone with 100K assets and 90K debt is higher than someone with 10K assets and 0K debt)

Hi Icedawn,

Actually, the amount of debt and the amount of investments is the same in both cases. Any amount paid onto the mortgage is immediately reborrowed to invest. So, the amount of debt, and therefore the leverage risk, is identical in both scenarios. The only difference is how much of it is tax deductible and how much is not.

With the dividend strategy, you convert your mortgage to tax deductible more quickly, so the mortgage is smaller and the tax deductible credit line is larger. However, the tax refunds are much smaller, since the tax-efficient growth investor gets to claim nearly the full interest as a tax deduction each year, while the dividend investor has most or all of the interest deduction wiped out by the tax on the dividend.

The tax-efficient growth investor ends up with a quite a bit larger portfolio because they can reinvest the much larger tax refund every year.



Ed

[edrempel]

Yes, but the dividends make me happy. :) And made me keep going.

I would not recommend this strategy today because interest rates are rising and I expect them to keep rising. I am now winding down this strategy as it does not make sense anymore.

Debt free and TFSAs seem to be the better option today.

Hi Brampton,

Yes, your strategy of ordinary leverage with dividends paying the interest won't work with rising interest rates. The Smith Manoeuvre is a completely different strategy that would work fine in higher interest rates. Since the interest is capitalized, it does not use any cash flow even if rates rise.

The breakeven point over time is about 2/3 of the interest rates, so even if prime rises to 5%, our investments only need to make about 3.5%/year after tax in the long run to be ahead - which quite a low hurdle. Without the dividend tax, the SM gives you a nice refund nearly every year.

The SM needs to be a long term strategy, though, since that is what keeps the risk down. The surprisingly large expected profits (typically double your current mortgage over 25 years) result from the long term compounding growth. Short term strategies that involve constantly using investment cash flows have comparatively tiny benefits.

Ed

[edrempel]

Yes, but the dividends make me happy. :) And made me keep going.

I would not recommend this strategy today because interest rates are rising and I expect them to keep rising. I am now winding down this strategy as it does not make sense anymore.

Debt free and TFSAs seem to be the better option today.

Hi Brampton,

I've been around a while, so it still seems funny to me to have dividends become the fad. I cant' remember any other time when dividend stocks were loved by investors under age 65!

Every time period has popular sectors. Right now, defensive strategies are popular because we just had the largest crash in 80 years in 2008 and the only 10-year period of no growth ever (outside of the 1930s). Since many investors have forgotten how much the market grows long term, the focus has shifted to "getting paid while we wait".

Dividends are popular today partly because they are defensive and partly because dividend stocks like the banks have been the recent market darlings.

This will, of course, all change in the next bull market. I can still remember the late 90s when any stock that paid a dividend at all was dumped! Many stocks and mutual funds were up 80-100% or more. The 10-15% return of dividend stocks was boring.

The attitude then was that there are 2 kinds of companies - growth companies that reinvested their profits in their fast-growing company and dividend companies that are no longer growing so they just pay out cash. If your stock pays a dividend at all, it can't possibly give you a large gain.

Of course, that was the tech bubble and the market darlings of that period ended up crashing.

Dividend investing is one of the most successful long term strategies. Jeremy Siegel's classic "Stocks for the Long Run" published in the late 1990s showed that growth stocks are the best long term investments, but his latest version after the 2000-2 crash showed that value stocks are the best long term investments - because you can reinvest the dividends and often buy more shares when the stocks are out of favour.

My point, though, is that, while dividend investing is one of the best long term strategies, it is currently a fad and many of the dividend investors of today will abandon dividend stocks the next time the inevitably become out of favour again.

Most dividend stocks are cyclical. Banks and resource companies are cyclical companies that are affected a lot by the normal business cycle. Meanwhile, new ideas, companies and products will mean the market darlings will constantly change. So, there is no doubt that dividend stocks will stop being the market darlings.

Since you are a dividend investor, we would recommend 2 choices:

1. Commit yourself now to be a dividend investor for your entire life. The next time dividend stocks are HATED by the market and performance is far below many other stocks, you must stick with dividend investing forever.
2. If you will change strategies in the future, it is always best to exit when a strategy is on top. Most investors wait until their investments are down or underperforming before they sell and change strategies. If you will change strategies in the next inevitable time when something else is popular instead of dividends, then this is probably a good time to exit now. Markets are still relatively low and gearing up for the next bull market. We are clearly past the low in the business cycle, so the return of less conservative equity strategies is inevitable.

Either of these strategies are better than what most investors will clearly do - continue with dividend investing until it underperforms, and then sell at a low.

Ed

[Icedawn]

Hi Icedawn,

Actually, the amount of debt and the amount of investments is the same in both cases. Any amount paid onto the mortgage is immediately reborrowed to invest. So, the amount of debt, and therefore the leverage risk, is identical in both scenarios. The only difference is how much of it is tax deductible and how much is not.

With the dividend strategy, you convert your mortgage to tax deductible more quickly, so the mortgage is smaller and the tax deductible credit line is larger. However, the tax refunds are much smaller, since the tax-efficient growth investor gets to claim nearly the full interest as a tax deduction each year, while the dividend investor has most or all of the interest deduction wiped out by the tax on the dividend.

The tax-efficient growth investor ends up with a quite a bit larger portfolio because they can reinvest the much larger tax refund every year.



Ed

Thanks for the clarification, I had omitted considering that aspect of the SM.

[nafrelioob]

(I am sorry if this has already been asked - I spent some time searching and didn't come up with anything.) I am new to the SM and a rookie investor. I need help wrapping my mind around the possibility of following scenario:

I am currently living in Winnipeg and have had the SM with a dividend strategy for almost a year with Firstline. I own about 50% of my home's value ($400,000ish) but I am considering moving to the Vancouver area, if I can find a way to afford it. Hypothetically, if I bought a $600,000 house there but rented out the basement, how can I set up my Smith manoeuvre? (I realize this might be a question that could be asked in another thread on rental property but I wanted to check it out from the SM angle first).

Would I have to cash in all my investments (about $60,000) so I could "reinvest"? Is there a way to separate the principle invested in the "rental" portion of the home so I could keep track of the interest paid there? Or could I "buy the rental property" from myself and have a second mortgage on the home, thereby increasing my "equity" and separating the mortgages to determine the investment interest?

Would that be too much risk equity to mortgage ratio? $200,000/$600,000 or does that matter?

I don't know what the tax rates would be on rental income vs dividends as I have now. Would the difference make this a poor strategy?

Any help is appreciated. Thanks in advance!

[florch]

Hi Florch,

Manulife One has never been the best, since their fixed rates have always been quite a bit higher than most of the other banks. It only works for people with little or no mortgage.

National works well, as do a few other banks. You can save more money by avoiding the "5-Year Fixed Mortgage Trap" and sticking with 1-year fixed or variable mortgages. The rates are then quite a bit lower than the 3-4% rates you were quoted.

If you want to make sure you have the best mortgage and rate for the SM, we have a free, no obligation, SM mortgage referral service (http://www.edrempel.com/mortgage_referral.php ).

We have contacts with all 7 Smith Manoeuvre mortgages, know the pros and cons for each with the SM, and try to always have the very best rates. Today, we are recommending 1-year fixed mortgages. Variable rates are similar, but will likely float up over the next year and we are expecting deeper discounts on variable by a year from now.



Ed

Hi Ed - just sent you a PM

[Jungle]

Hey Ed: (or anyone)

What do you think of the new Horizon's Betapro etf? It's based on 60 of biggest companies traded on the TSX (by market cap) and has a MER of .07% (.08% total with HST.)

What's interesting about this fund, is they are marketing it as being very tax efficient; the overall return is based on the TSX 60 composite, plus dividends being re-invested.

However, since this fund works as a total return swap, there is no tax liability on the dividend, since the counterparty agrees to just give this return of the TSX60+dividend, without holding the stock. Essentially deferreed capital gain, if you cash out. This could have a very positive compounding effect in a non-reg account. It's well explained here: http://wheredoesallmymoneygo.com/is-hxt-really-that-complex-and-risky/

I am looking at adding some ETF equity exposure to my SM, for some long term growth. However, with this being a non-reg account, I am concerned that other ETFs, such as domestic or international, will have negative effects with their witholding tax and income liabilities.

Thoughts?

[redwings_patriots]

"Use the HELOC portion of your mortgage to invest in income producing entities like dividend paying stocks or rental property"

So as the HELOC portion of the mortgage increases, how do I use it to invest in rental property? Can I use it to pay down my mortgage on the rental property?

[sslinn]

"Use the HELOC portion of your mortgage to invest in income producing entities like dividend paying stocks or rental property"

So as the HELOC portion of the mortgage increases, how do I use it to invest in rental property? Can I use it to pay down my mortgage on the rental property?

Do not use it to pay down the mortgage on the rental property. That is counter productive.

Read more and see a financial planner.

[Jungle]

"Use the HELOC portion of your mortgage to invest in income producing entities like dividend paying stocks or rental property"

So as the HELOC portion of the mortgage increases, how do I use it to invest in rental property? Can I use it to pay down my mortgage on the rental property?

Ideally, as your HELOC portion increase, you would use it to purchase new or more stocks. With a rental property, you can't really buy more or new rental property every time..

In addition, the CRA has it's own tax deductions, just for rental properties: (much better and more efficient)

http://www.cra-arc.gc.ca/E/pub/tg/t4036/t4036-09e.pdf

[rkrk]

Did anyone get a better rate than Prime + 0.5 from National Bank for their All In One product and who is not part of their professional designations like engineers?? Engineers are supposedly getting Prime!

[Jungle]

Ed:

Would it be acceptable to the CRA have two brokerage accounts to use for the SM? For example, my wife has a marginal tax rate of 24.15 %. We could use her brokerage account for a "dividend SM", since dividend tax is almost netural. (slightly negative right now)

Then I could set up a brokerage account (my marginal tax rate is 31%) and use capital gain ETF like HXT with no divided tax?

[Germack]

I am curious at which interest rate people can borrow at the moment for the SM and what would be the best way to do so?

If a person does not own a home, but has a portfolio of e.g. 300K would his interest rate for the SM be higher as compared to person owning a home valued at 300K?

[sslinn]

The best would be a secured LOC so you need a house.

Yes the rate would be higher as you are comparing unsecured to secured. More risk on the lender for unsecured so the rate is higher to offset the risk.

[edrempel]

(I am sorry if this has already been asked - I spent some time searching and didn't come up with anything.) I am new to the SM and a rookie investor. I need help wrapping my mind around the possibility of following scenario:

I am currently living in Winnipeg and have had the SM with a dividend strategy for almost a year with Firstline. I own about 50% of my home's value ($400,000ish) but I am considering moving to the Vancouver area, if I can find a way to afford it. Hypothetically, if I bought a $600,000 house there but rented out the basement, how can I set up my Smith manoeuvre? (I realize this might be a question that could be asked in another thread on rental property but I wanted to check it out from the SM angle first).

Would I have to cash in all my investments (about $60,000) so I could "reinvest"? Is there a way to separate the principle invested in the "rental" portion of the home so I could keep track of the interest paid there? Or could I "buy the rental property" from myself and have a second mortgage on the home, thereby increasing my "equity" and separating the mortgages to determine the investment interest?

Would that be too much risk equity to mortgage ratio? $200,000/$600,000 or does that matter?

I don't know what the tax rates would be on rental income vs dividends as I have now. Would the difference make this a poor strategy?

Any help is appreciated. Thanks in advance!

Hi Nafrelioob,

Having grown up in Winnipeg and moving to Toronto, I understand it will be a challenge for you to move to Vancouver. You have a lot of questions:

- You can transfer your existing SM. Just make sure you start with the same tax deductible credit line balance with your new home that you end with on your existing home. If you do it this way, then you don't have to sell your investments.
- Whether or not your rent out part of your home is irrelevant to the SM. The only part your home plays with the SM is to provide collateral for the investment loan.
- You need to be careful how you structure things, since it is important to keep your home as your principal residence. You can rent part of your home and maintain the principal residence status, as long as the portion rented is "ancillary" to the main use of your home (for you to live in). For example, you can deduct mortgage interest based on the proportion of your home that you rent, but you shouldn't separately buy a portion of the home that is the basement you are renting.
- You cannot buy anything from yourself. That would not be a valid transaction. Creativity is a good, but understanding tax rules would help you more. :)
- The equity/mortgage ratio relates to how you buy a home and whether it is affordable. It is not related to the SM. With the SM, you are borrowing to invest. Normally, you use available equity in your home, but depending on your risk tolerance and how much you are comfortable leveraging, you can use the investments as collateral with an investment loan as well. In your case, if your home is worth $400K, the bank will lend you up to 80%, or $320K. If your mortgage is $200K, then you have $120K that you could invest. However, you only invested $60K (unless you invested $120K and lost half), so you are only investing about half of your available equity. You may be restricting the amount you invest because you are "new to SM", but $60K is not a particularly large figure. I don't know your situation or what makes sens for you, but it looks like you are more likely missing opportunities by under-investing than risking too much by over-investing.
- Rent income is fully taxed, while dividends and capital gains are taxed at much lower rates. This is not relevant for you, however, since the whether or not you rent your basement and how you structure your SM are completely unrelated decisions. You can do both or either.
- Both dividends and rent are taxed. You can reduce the tax with the SM by investing for deferred capital gains, instead of paying tax on the dividends every year.


Ed

[edrempel]

Hey Ed: (or anyone)

What do you think of the new Horizon's Betapro etf? It's based on 60 of biggest companies traded on the TSX (by market cap) and has a MER of .07% (.08% total with HST.)

What's interesting about this fund, is they are marketing it as being very tax efficient; the overall return is based on the TSX 60 composite, plus dividends being re-invested.

However, since this fund works as a total return swap, there is no tax liability on the dividend, since the counterparty agrees to just give this return of the TSX60+dividend, without holding the stock. Essentially deferreed capital gain, if you cash out. This could have a very positive compounding effect in a non-reg account. It's well explained here: http://wheredoesallmymoneygo.com/is-hxt-really-that-complex-and-risky/

I am looking at adding some ETF equity exposure to my SM, for some long term growth. However, with this being a non-reg account, I am concerned that other ETFs, such as domestic or international, will have negative effects with their witholding tax and income liabilities.

Thoughts?

Hi Jungle,

I am not an expert in ETFs, since our investing focus is finding the fund managers that we are confident will beat the index over time with similar risk, or match the index with less risk

However, this structure providing deferred capital gains instead of dividends is generally helpful for the SM. Receiving dividends means you pay tax every year, which you can generally avoid by investing for deferred gains instead. Dividends are only useful for people under age 65 in the lowest tax bracket, most of which should not be doing the SM anyway.

Investing for deferred capital gains with a proper equity investment should not affect the deductibility of the interest with the SM either.


Ed

[edrempel]

Ideally, as your HELOC portion increase, you would use it to purchase new or more stocks. With a rental property, you can't really buy more or new rental property every time..

In addition, the CRA has it's own tax deductions, just for rental properties: (much better and more efficient)

http://www.cra-arc.gc.ca/E/pub/tg/t4036/t4036-09e.pdf

Hi Jungle,

The SM generally is better for tax savings than rentals.

With rentals, about the most you can hope for is to avoid tax on the rent income, but the SM can generally give you tax REFUNDS most years.

Rentals provide a wider variety of expenses (utilities, property tax, repairs, etc.), but generally it is difficult to deduct more than the rent for any length of time. If you show rental losses for several years in a row, CRA may question whether you are really trying to make a profit and could disallow all the losses. And as you pay your mortgage down, you start showing rental profits that are fully taxed (like salary or interest).

With the SM, you can normally get a REFUND most years, even far down the road when you take income from it. This is especially true if your main focus is investing for deferred capital gains.

For example, if you borrow at 4%, you can deduct the entire 4%. if your investment grows by 10%, you can normally have most of the gain deferred to future years. Only half the gain is taxable. Therefore, if anything less than 8% of the gain is triggered in a year, then the taxable half is less than the 4% interest, so you would get a refund.

Typically, only 0-2% capital gains would be taxed each year. With half being taxable, then 0-1% is added to your income. This is why the SM tends to have significant tax refunds even when the investments have grown a lot and are much more than the investment credit line.

Of course, the SM with dividends results in much smaller refunds or even paying tax. It is less tax-efficient compared to the SM with deferred capital gains (unless you are under 65 and in the lowest tax bracket).

There are a variety of tax-efficient ways to take income from the SM after you retire. Depending on your tax situation, you can structure the income to be mostly tax-deferred capital gains, taxable capital gains, or dividends. However, rental properties tend to eventually have a small mortgage, so the rent is then fully taxed. The tax-efficiency of rental properties disappears over time.

Most of our retired clients that are still doing the SM are still getting tax refunds - while getting income from the SM. The cash received can be quite a bit more than the interest paid, but is taxed at preferred rates to still allow a refund.



Ed

[edrempel]

Did anyone get a better rate than Prime + 0.5 from National Bank for their All In One product and who is not part of their professional designations like engineers?? Engineers are supposedly getting Prime!

Hi rkrk,

Prime +.5% is the best rate we have seen recently on the credit line portion of an SM mortgage. Of course, the mortgage portion has much lower rates. (We are recommending 1-year fixed today and getting between 2.15-2.44%, depending on the situation.)

We have quite a few engineers as clients (we seem to attract more technical people) and none have mentioned a preferred credit line rates. I am also an accountant (CMA) and get offers for all CMAs, but have not yet had any as good as I can get on my own. These are usually insurance/benefit and occasionally investment, but rarely mortgage type offers.

Our experience is that professional/industry groups rarely get anything you can't get your self by effective negotiation.


Ed

[edrempel]

Ed:

Would it be acceptable to the CRA have two brokerage accounts to use for the SM? For example, my wife has a marginal tax rate of 24.15 %. We could use her brokerage account for a "dividend SM", since dividend tax is almost netural. (slightly negative right now)

Then I could set up a brokerage account (my marginal tax rate is 31%) and use capital gain ETF like HXT with no divided tax?

Hi Jungle,

No problem. You and your wife can separately do the SM in different ways. Just make sure you keep them separate.


Ed

[edrempel]

I am curious at which interest rate people can borrow at the moment for the SM and what would be the best way to do so?

If a person does not own a home, but has a portfolio of e.g. 300K would his interest rate for the SM be higher as compared to person owning a home valued at 300K?

Hi Germack,

With the SM, you normally are borrowing with a secured credit line, which you can get at prime +.5% today. That is 3.5%.

That is quite low. If you are in a 40% tax bracket, the cost is only 2.1% after tax. To be profitable, we only need to find an investment that averages more than 2.1% after tax over time - which is a very low hurdle.

Depending on how you structure the SM, you could also use the investments as collateral. This is generally in more aggressive versions of the SM for people that want to build wealth faster. Investment loans on mutual funds can be up to 100% of the investment and are at prime +.5% to prime +2% today (3.5-5.0%), depending on the type and size of loan.




Ed

[Jungle]

Of course, the SM with dividends results in much smaller refunds or even paying tax. It is less tax-efficient compared to the SM with deferred capital gains (unless you are under 65 and in the lowest tax bracket).Ed



I wonder if paying the divided tax in some cases would be ok, so long as you are putting the divideds on the mortgage, reducing compound interest. Thoughts?

[rkrk]

Need help with the following scenario:
House price 485K
Have margin account with interactive brokers which I used to buy US stocks (200K). They are charging over 5% interest. This is tax deductible. My collateral for tht margin account is 175K earning no interest.
I have roughly 300K in my company account which I can take out as a loan. I also have another 100K to put towards downpayment if needed.

I got an offer for a readvanceable mortgage for 3.49 fixed and LOC portion is Prime + 0.5

One option I read is sell the stock, put it towards mortgage down payment and buy it back again. I do not want to go this route as I may have to wait 30 days before I buy.

I would like to loan money from my company (300K), put it as downpayment then take out money from the LOC portion (200K) and pay off my investment loan with interactive brokers. I am hoping I should be able to do this as I am technically getting a cheaper loan to pay off a higher interest loan.

Would this work? How do you think I should proceed in this scenario?

Thanks a bunch for all your help!!

[Germack]

Hi Germack,

With the SM, you normally are borrowing with a secured credit line, which you can get at prime +.5% today. That is 3.5%.

That is quite low. If you are in a 40% tax bracket, the cost is only 2.1% after tax. To be profitable, we only need to find an investment that averages more than 2.1% after tax over time - which is a very low hurdle.

Depending on how you structure the SM, you could also use the investments as collateral. This is generally in more aggressive versions of the SM for people that want to build wealth faster. Investment loans on mutual funds can be up to 100% of the investment and are at prime +.5% to prime +2% today (3.5-5.0%), depending on the type and size of loan.




Ed

Thanks ED.

What would be the best type of loan for someone with no house as colloteral? A fixed rate for 1 to 2 years or just a variable rate where you just pay the interests?

[rkrk]

Need help with the following scenario:

House price 485K
Have margin account with interactive brokers which I used to buy US stocks (200K). They are charging over 5% interest. This is tax deductible. My collateral for tht margin account is 175K earning no interest.
I have roughly 300K in my company account which I can take out as a loan. I also have another 100K to put towards downpayment if needed.

I got an offer for a readvanceable mortgage for 3.49 fixed and LOC portion is Prime + 0.5

One option I read is sell the stock, put it towards mortgage down payment and buy it back again. I do not want to go this route as I may have to wait 30 days before I buy.

I would like to loan money from my company (300K), put it as downpayment then take out money from the LOC portion (200K) and pay off my investment loan with interactive brokers. I am hoping I should be able to do this as I am technically getting a cheaper loan to pay off a higher interest loan.

Would this work? How do you think I should proceed in this scenario?

Thanks a bunch for all your help!!

[riffr aff]

why the spam re-post? When someone knows the answer they will reply. jeesh.


Need help with the following scenario:

House price 485K
Have margin account with interactive brokers which I used to buy US stocks (200K). They are charging over 5% interest. This is tax deductible. My collateral for tht margin account is 175K earning no interest.
I have roughly 300K in my company account which I can take out as a loan. I also have another 100K to put towards downpayment if needed.

I got an offer for a readvanceable mortgage for 3.49 fixed and LOC portion is Prime + 0.5

One option I read is sell the stock, put it towards mortgage down payment and buy it back again. I do not want to go this route as I may have to wait 30 days before I buy.

I would like to loan money from my company (300K), put it as downpayment then take out money from the LOC portion (200K) and pay off my investment loan with interactive brokers. I am hoping I should be able to do this as I am technically getting a cheaper loan to pay off a higher interest loan.

Would this work? How do you think I should proceed in this scenario?

Thanks a bunch for all your help!!

[rkrk]

Sorry. My mistake. Thought I was posting onto a different thread.

[edrempel]

I wonder if paying the divided tax in some cases would be ok, so long as you are putting the divideds on the mortgage, reducing compound interest. Thoughts?

Hi Jungle,

We have SM software and have ran multiple projections on exactly that scenario. We showed a 6% eligible dividend plus 2% growth vs. 8% growth, and used the 6% dividend to pay down the mortgage more quickly and reborrow.

The result is that you need to make about 1% higher return to compensate for the "tax bleed" on the dividends each year.

The growth strategy provided a significantly larger tax refund each year and the compound growth of reinvesting the larger tax refund was the main factor.

The dividends did convert the mortgage to tax deductible more quickly, but the tax savings from that was much less than the tax on the dividends.

There is a bit of an offsetting factor as well, since the mortgage rate is normally lower than the credit line rate. We assumed the credit line was prime and the mortgage at prime -.85%, which is what we were getting for quite a few years. Therefore, paying the mortgage down more quickly resulted in reborrowing at a higher rate (although lower after the tax savings).

What we consistently find with the Smith Manoeuvre is that the main benefit is the compound growth of the investments over time. Many people start it thinking of it as mainly a way to pay off the mortgage more quickly or mainly as a tax strategy, but whenever you focus on one of these 2, the projected long term gain is lower than when you focus on the compound growth.

It is the compound growth over long periods of time that provides the large long term benefits.

The main reason people should consider the SM is because of the financial security it can provide in the future by building a large nest egg over time without using your cash flow - not paying off the mortgage more quickly or the tax savings.




Ed

[max88]

Ed:

Would it be acceptable to the CRA have two brokerage accounts to use for the SM? For example, my wife has a marginal tax rate of 24.15 %. We could use her brokerage account for a "dividend SM", since dividend tax is almost netural. (slightly negative right now)

Then I could set up a brokerage account (my marginal tax rate is 31%) and use capital gain ETF like HXT with no divided tax?

Hi Jungle,

No problem. You and your wife can separately do the SM in different ways. Just make sure you keep them separate.


Ed

Be careful with ETFs or stocks (and options) that produce only capital gain.

http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/ncm-tx/rtrn/cmpltng/ddctns/lns206-236/221/menu-eng.html

From CRA website


..most interest you pay on money you borrow for investment purposes, but generally only as long as you use it to try to earn investment income, including interest and dividends. However, if the only earnings your investment can produce are capital gains, you cannot claim the interest you paid. For more information, contact us;

[edrempel]

Thanks ED.

What would be the best type of loan for someone with no house as colloteral? A fixed rate for 1 to 2 years or just a variable rate where you just pay the interests?

Hi Germack,

That depends on your goal and whether you are trying to pay it off over time or keep it forever (as we normally do with the SM).

I assume you are referring to a P+I loan payment, not just a call on whether fixed or variable rates will be lower in the next year or 2?

Most of the time, we pay interest only. This is because the investments are expected to make far more than the interest cost after tax, so it is most efficient to maintain the investment loan forever.

In fact, most of the time we capitalize the interest (borrow money to pay the interest) as long as you have other debt. Since the interest on tax-deductible interest is also tax deductible, it is usually most effective to use any of your cash flow to pay down your mortgage or other debt, instead of using your cash flow to pay tax deductible interest.

In your case, are you saving up to buy a home on which to do the SM? If so, then you want to consider having a credit line pay all the interest on an investment loan so you can you all your cash flow (plus any profit on the investments) for your down payment.



Ed

[edrempel]

Be careful with ETFs or stocks (and options) that produce only capital gain.

http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/ncm-tx/rtrn/cmpltng/ddctns/lns206-236/221/menu-eng.html

From CRA website

Hi Max88,

CRA clarifies their intent in interpretation bulletins. Their position is that interest on stocks and mutual funds are generally deductible as long as the investment COULD pay a dividend some day and is not prevented in it's prospectus from even paying a dividend.

Even if they never pay a distribution and have an objective of being very tax efficient (such as capital class mutual funds), it is reasonable to expect that they could pay a dividend in the future and the prospectus does not prevent paying dividend, so they are fine.

Options could be an issue, but you can elect to consider all option profits as income, which is probably a good idea if it is borrowed money.

This is the key section of IT-533:

"BORROWING FOR INVESTMENTS INCLUDING COMMON SHARES

¶ 31. Where an investment (e.g., interest-bearing instrument or preferred shares) carries a stated interest or dividend rate, the purpose of earning income test will be met "absent a sham or window dressing or similar vitiating circumstances" (Ludco). Further, assuming all of the other requisite tests are met, interest will neither be denied in full nor restricted to the amount of income from the investment where the income does not exceed the interest expense, given the meaning of the term income as discussed in ¶ 10.

Where an investment does not carry a stated interest or dividend rate such as some common shares, the determination of the reasonable expectation of income at the time the investment is made is less clear. Normally, however, the CCRA considers interest costs in respect of funds borrowed to purchase common shares to be deductible on the basis that there is a reasonable expectation, at the time the shares are acquired, that the common shareholder will receive dividends. Nonetheless, each situation must be dealt with on the basis of the particular facts involved.

These comments are also generally applicable to investments in mutual fund trusts and mutual fund corporations.

Example 8

R Corp. is an investment vehicle designed to provide a capital return only to the investors in its common shares. The corporate policy with respect to R Corp. is that dividends will not be paid, that corporate earnings will be reinvested to increase the value of the shares and that shareholders are required to sell their shares to a third-party purchaser in a fixed number of years in order to realize their value. In this situation, it is not reasonable to expect income from such shareholdings and any interest expense on money borrowed to acquire R Corp. shares would not be deductible.

Example 9

S Corp. is raising capital by selling common shares. Its business plans indicate that its cash flow will be required to be reinvested for the foreseeable future and S Corp. discloses to shareholders that dividends will only be paid when operational circumstances permit (i.e., when cash flow exceeds requirements) or when it believes that shareholders could make better use of the cash. In this situation, the purpose of earning income test will generally be met and any interest on borrowed money to acquired S Corp. shares would be deductible."




Ed

[superskid]

I currently have about 100K in investments, and about 150K available to take out in equity on my house that I think I will take out at prime -0.8 and still be below CMHC LTV.

From what I understand though, I need to sell my investments and then buy them back directly with the equity I take out. I have some pretty volatile stocks and am concerned about how to time this.

[wookie]

I am currently reading the book for a second time as I wasnt at the right point in life to do anything when I read it the first time. However my question is do you have to have a certain % of your mortgage paid off in order to implement the Smith Manoeuvre; if I am currently in a mortgage (still 3+years I think) would I have to break that mortgage and go through the approval process etc all over again to implement the Smith Manouevre?

[Mark77]

From what I understand though, I need to sell my investments and then buy them back directly with the equity I take out. I have some pretty volatile stocks and am concerned about how to time this.

You don't need to conduct your sales/purchases on a stock exchange. You could sell the investments to a friend or family member, and then immediately buy them back, for instance, at the same price, thus avoiding the cost of an on-exchange transaction.

There's no law saying that a stock exchange is the only venue that you can buy or sell interests in businesses or debt.

[edrempel]

I currently have about 100K in investments, and about 150K available to take out in equity on my house that I think I will take out at prime -0.8 and still be below CMHC LTV.

From what I understand though, I need to sell my investments and then buy them back directly with the equity I take out. I have some pretty volatile stocks and am concerned about how to time this.

Hi Superskid,

Selling your existing investments and paying them down on the mortgage to reborrow is a related strategy that you can do in addition to the Smith Manoeuvre. It is called the Flintstone Flip or the Singleton Shuffle. Many people mistakenly think that is the Smith Manoeuvre.

You can do that at any time. There is no problem starting the Smith Manoeuvre now and then selling these investments to buy them back some time in the future. Whenever you do that, you will instantly convert $100K of your mortgage interest to tax deductible, with is a nice additional benefit.

Remember that is you sell them at a loss, you need to be out of them for at least 30 days or else you cannot claim the capital loss.


Ed

[edrempel]

I am currently reading the book for a second time as I wasnt at the right point in life to do anything when I read it the first time. However my question is do you have to have a certain % of your mortgage paid off in order to implement the Smith Manoeuvre; if I am currently in a mortgage (still 3+years I think) would I have to break that mortgage and go through the approval process etc all over again to implement the Smith Manouevre?

Hi Wookie,

You need a minimum of 20% down to do the SM, since all the readvanceable mortgages are not available with less than that.

If your mortgage is not a readvanceable, you will need to get one in order to do the SM fully. If you have 3 years left in your mortgage, is it still at a higher rate?

It is useful to learn to like the mortgage approval process. Keeping flexibility can save you a lot of money with mortgages. People often lose thousands by falling into the "5-Year Fixed Mortgage Trap" because they dislike the mortgage approval process. However, it can be your highest paid hour! Often it means you save $2,000 by spending one hour signing some forms.

You have 3 possible options:

1. Some banks allow you to covert to their SM mortgage for no fee.
2. It might be beneficial to pay the penalty to get out of your mortgage. You will pay a penalty, but you may get a lower rate today and there is a benefit of starting the SM now instead of 3 years from now. This can be a complicated calculation. We offer "Ed's Mortgage Breaking Calculation" from our web site as a free service if that is helpful.
3. If it is not worthwhile to break your mortgage and you have some equity, it is possible to get a 2nd readvaceable (or an unsecured credit line) and simulate that SM to get most of the benefit until your mortgage is due.


Ed

[goffeebeans]

You don't need to conduct your sales/purchases on a stock exchange. You could sell the investments to a friend or family member, and then immediately buy them back, for instance, at the same price, thus avoiding the cost of an on-exchange transaction.

There's no law saying that a stock exchange is the only venue that you can buy or sell interests in businesses or debt.

However I believe that in all situations you'll need to pay taxes. Assuming the stocks have gone up in value, as according to the CRA on Non arms length parties, they would have been deemed to be sold at fair market value. Anyone know of a particular way to avoid triggering capital gains?

[superskid]

Hi Superskid,

Selling your existing investments and paying them down on the mortgage to reborrow is a related strategy that you can do in addition to the Smith Manoeuvre. It is called the Flintstone Flip or the Singleton Shuffle. Many people mistakenly think that is the Smith Manoeuvre.

You can do that at any time. There is no problem starting the Smith Manoeuvre now and then selling these investments to buy them back some time in the future. Whenever you do that, you will instantly convert $100K of your mortgage interest to tax deductible, with is a nice additional benefit.

Remember that is you sell them at a loss, you need to be out of them for at least 30 days or else you cannot claim the capital loss.


Ed

This article seems to suggest that the singleton shuffle is not allowed by the CRA. Can anyone shed any light?

http://blog.danwhite.ca/2009/01/17/the-smith-manoeuvre-and-the-singleton-shuffle-bite-the-dust/

[edrempel]

This article seems to suggest that the singleton shuffle is not allowed by the CRA. Can anyone shed any light?

http://blog.danwhite.ca/2009/01/17/the-smith-manoeuvre-and-the-singleton-shuffle-bite-the-dust/

Hi Superskid,

Yes. Dan White is 100% wrong. As far as I can tell, he has no tax qualifications at all. He is flogging a ridiculous tax scheme involving creating a series of sham businesses and claiming losses on each. For a laugh, read Jamie Golombek's article called "Dumb Write-offs":

http://www.jamiegolombek.com/articledetail.php?article_id=916

The Singleton Shuffle, or plain vanilla debt swap, is fine and was approved by the tax court in the Singleton Case. The Lipson case was very different. It was a series of transactions, each of which was fine on its own, but all together was determined to be abusive of the tax rules and was disallowed under GAAR.

This is completely different from the Singleton Shuffle. In fact, the judge in the Lipson case referred to the plain debt swap as "unimpeachable". Here is Jamie Golombek's explanation. Skip to the bottom of the article for the conclusion if you want:

http://www.jamiegolombek.com/articledetail.php?article_id=939




Ed

[edrempel]

You don't need to conduct your sales/purchases on a stock exchange. You could sell the investments to a friend or family member, and then immediately buy them back, for instance, at the same price, thus avoiding the cost of an on-exchange transaction.

There's no law saying that a stock exchange is the only venue that you can buy or sell interests in businesses or debt.

Hi Mark77,

Selling your investment to a friend may avoid a transaction cost, but will still be taxed the same. It is a sale, so you need to claim the capital gain.

Also, if you sell and investment at a loss to a friend and immediately buy back, the loss is denied as a "superficial loss".

These tax rules are the same regardless of where you sell your investments. All that you might save is a transaction fee.


Ed

[Mark77]

Selling your investment to a friend may avoid a transaction cost, but will still be taxed the same. It is a sale, so you need to claim the capital gain.


Absolutely, and it must be done at fair market value. So no games in overvaluing or undervaluing the transaction.




Also, if you sell and investment at a loss to a friend and immediately buy back, the loss is denied as a "superficial loss".


True. Also, it is a superficial loss if you continue to have an interest in the investment, for instance, you enter into a repurchase agreement with your friend, in an effort to skirt the 30-day rule with respect to capital gains. Also, you're not allowed to accomplish the same by purchasing an options or future contract, for instance.



These tax rules are the same regardless of where you sell your investments. All that you might save is a transaction fee.


And bid/ask spreads.

[Jungle]

Not sure if this question should be asked in the mortgage section. I heard that on some HELOC products they can allow you to lock in certain rates. Maybe a fixed or variable rate, with a term attached.

To lower our interest costs, would it make sense to lock in a variable or fixed rate in the HELOC? Would you be able to capitalize on the interest with interest only payment, if it was converted this way?

[sslinn]

I think you could make it work with the right mortgage product.

[edrempel]

Not sure if this question should be asked in the mortgage section. I heard that on some HELOC products they can allow you to lock in certain rates. Maybe a fixed or variable rate, with a term attached.

To lower our interest costs, would it make sense to lock in a variable or fixed rate in the HELOC? Would you be able to capitalize on the interest with interest only payment, if it was converted this way?

Hi Jungle,

With most readvanceable mortgages, you can have multiple fixed (mortgage) and revolving (credit line) portions. With the Smith Manoeuvre, there is normally one fixed portion (the actual mortgage) and one credit line portion (used to borrow to invest). The mortgage portion usually has a lower rate, but has principal plus interest payments. The credit line portion normally has interest only payments.

It is possible to have the SM credit line converted to a mortgage. As long as you keep it separate from the actual mortgage and any other non-deductible debt, the interest would still be tax deductible. However, you would be making principal plus interest payments, so you would actually be paying down your tax deductible debt.

If you convert it to a fixed portion, than you cannot reborrow on it. Think of it as a mortgage portion. The amount is fixed until it comes due. You can only reborrow from a credit line portion - and there must always be at least one credit line portion in a readvanceable mortgage. You can capitalize the interest only on the credit line portion.




Ed

[sslinn]

Ed,

If it is readvancable it may be possible through a series or manual transactions and you would have access to the principle again.

[Diet Butcher]

Ed, thanks for your advice in this thread.

I know this isn't your strategy, but what is your opinion on using the SM to invest in a MIC providing 9-10% returns and letting the monthly dividend compound in the MIC, so no withdrawls.

[FrugalTrader]

@diet butcher, one thing to consider is that MIC's distribute interest, which means that it's 100% taxable at your marginal rate as the SM portfolio is held in a non-reg account.

[Jungle]

Hi Max88,

CRA clarifies their intent in interpretation bulletins. Their position is that interest on stocks and mutual funds are generally deductible as long as the investment COULD pay a dividend some day and is not prevented in it's prospectus from even paying a dividend.

Even if they never pay a distribution and have an objective of being very tax efficient (such as capital class mutual funds), it is reasonable to expect that they could pay a dividend in the future and the prospectus does not prevent paying dividend, so they are fine.

Options could be an issue, but you can elect to consider all option profits as income, which is probably a good idea if it is borrowed money.

This is the key section of IT-533:

"BORROWING FOR INVESTMENTS INCLUDING COMMON SHARES

¶ 31. Where an investment (e.g., interest-bearing instrument or preferred shares) carries a stated interest or dividend rate, the purpose of earning income test will be met "absent a sham or window dressing or similar vitiating circumstances" (Ludco). Further, assuming all of the other requisite tests are met, interest will neither be denied in full nor restricted to the amount of income from the investment where the income does not exceed the interest expense, given the meaning of the term income as discussed in ¶ 10.

Where an investment does not carry a stated interest or dividend rate such as some common shares, the determination of the reasonable expectation of income at the time the investment is made is less clear. Normally, however, the CCRA considers interest costs in respect of funds borrowed to purchase common shares to be deductible on the basis that there is a reasonable expectation, at the time the shares are acquired, that the common shareholder will receive dividends. Nonetheless, each situation must be dealt with on the basis of the particular facts involved.

These comments are also generally applicable to investments in mutual fund trusts and mutual fund corporations.

Example 8

R Corp. is an investment vehicle designed to provide a capital return only to the investors in its common shares. The corporate policy with respect to R Corp. is that dividends will not be paid, that corporate earnings will be reinvested to increase the value of the shares and that shareholders are required to sell their shares to a third-party purchaser in a fixed number of years in order to realize their value. In this situation, it is not reasonable to expect income from such shareholdings and any interest expense on money borrowed to acquire R Corp. shares would not be deductible.

Example 9

S Corp. is raising capital by selling common shares. Its business plans indicate that its cash flow will be required to be reinvested for the foreseeable future and S Corp. discloses to shareholders that dividends will only be paid when operational circumstances permit (i.e., when cash flow exceeds requirements) or when it believes that shareholders could make better use of the cash. In this situation, the purpose of earning income test will generally be met and any interest on borrowed money to acquired S Corp. shares would be deductible."




Ed


Ed or anyone. I was starting to read about HXT. I believe it would be an excellent ETF for the SM, despite country party default risk. However, it does not really produce income and according to what Ed posted, it doesn't look like they intend to pay income in the future.

"HXT will not pay any quarterly dividend distributions.

HXT, utilizing a total return swap (“TRS”), will provide the returns of the S&P/TSX 60™ Index (Total Return) where the value of any distributions paid out by constituent issuers are reflected in the total return of the index and are therefore reflected in the net asset value of HXT.

The Manager does not anticipate any income distributions from HXT for unitholders who buy and sell their units through normal market facilities (i.e. the Toronto Stock Exchange). It is expected that any interest income that HXT earns in any year will be offset by expenses that are deductible during that year and therefore HXT should not have any net income to distribute to its unitholders at any year end.

Although the initial TRS matures in 5 years, the Manager expects to extend the TRS for further 5 year periods and therefore HXT should only realize income if the TRS has to be partially settled, generally as a result of a redemption request placed directly through the Manager. If there is income realized from a partial settlement of the TRS, then the Manager intends, on behalf of HXT, to allocate this income to the applicable CDS participant (i.e. a broker dealer) redeeming HXT units directly through the Manager. Provided an HXT unitholder does not submit a request to redeem their units directly through the Manager, the Manager does not expect the unitholder will receive any allocation of income for tax purposes."

Source: http://www.hbpetfs.com/pub/en/etfs/?etf=HXT&r=o

Thought for SM? I don't think this one is deductible.. it would be a really suitable, for the middle or higher tax bracket people.

[max88]

Source: http://www.hbpetfs.com/pub/en/etfs/?etf=HXT&r=o

Thought for SM? I don't think this one is deductible.. it would be a really suitable, for the middle or higher tax bracket people.

This is the point I was trying to make. Ed gave a much better and thorough explanation on interest deductibility. Base on what I have read, HXT is not suitable for SM.

As an aside, BRK.a/BRK.b is the only individual stock that is known to not pay a dividend.

[Mark77]

Thought for SM? I don't think this one is deductible.. it would be a really suitable, for the middle or higher tax bracket people.

Not a good idea, not only for the counterparty risk issues (documented in other threads), but because the cashflow of a ETF trust that holds shares directly is quite valuable in terms of being able to accelerate the swap of debt from non-deductible to deductible. Plus the cashflow from an ETF (ie: XIU) facilitates a longer-term exit strategy from the SM, ie: paying off the (deductible) debt.

[Mark77]

As an aside, BRK.a/BRK.b is the only individual stock that is known to not pay a dividend.

??? BRKa/BRKb would be perfectly eligible investment-wise for the SM, as they are interests in actively functioning businesses, with the capability to pay a dividend in the future.

The test is not whether the company has paid a dividend in the past, or will pay a dividend in the future, rather, the test is whether or not there is an actual interest in a debt or equity obligation of an actual business beneath the trust.

This is why, for instance, an investment in the GLD ETF would not quality -- since there is not a business, and a bar of gold can never pay a dividend. While an investment in, say, Manitoba-based San Gold (SGR.V), a gold miner that doesn't pay a dividend, is perfectly eligible.

[Jungle]

The only thing I don't like about XIU for the SM is the "other income and ROC" that it produces. A bit of tax bleed as Ed would say. However I do like the idea of a index ETF for part of the SM, you don't really need to worry about a one company going bankrupt or in the dumps. (IE MFC lol)

[edrempel]

Not a good idea, not only for the counterparty risk issues (documented in other threads), but because the cashflow of a ETF trust that holds shares directly is quite valuable in terms of being able to accelerate the swap of debt from non-deductible to deductible. Plus the cashflow from an ETF (ie: XIU) facilitates a longer-term exit strategy from the SM, ie: paying off the (deductible) debt.

Hi Mark,

Actually, the cashflow from the investment is a relatively minor detail. In fact, total tax savings are generally only 5-15% of the benefit of the Smith Manoeuvre.

In addition, the cashflow REDUCES the benefit because of the tax bleed it causes. Jungle is on the right track in looking for a 100% tax-efficient investment.

Focusing on the tax benefit is thinking too small and misses the main point. The main benefit of the Smith Manoeuvre is the compound growth of the leveraged investment over time.

Many people think of the SM as primarily a tax strategy to convert your mortgage to tax deductible interest over time and therefore focus on how fast the mortgage is converted. However, the investment benefit is 85-95% of the benefit.

For example, in a 25-year amortization of a $400,000 mortgage for someone in the highest tax bracket with a 10% investment return and 4% mortgage, the expected benefit of the Smith Manoeuvre over 25 years is $716,734. Of this amount, $100,375 is the total tax benefit, while the investment benefit is $616,359.

If you can increase your cash flow by having a 4% dividend and 6% growth (instead of 10% growth), the expected benefit drops to $633,598. The dividend converts the mortgage in 17.5 years (instead of 21.4 years with the tax-deferred compound growth), but the total benefit is $83,136 less.

Focusing on the tax refund is why so many people fell for the Smith/Snyder strategy, instead of the real Smith Manoeuvre.

The Smith Manoeuvre is a far bigger idea than just a tax strategy. Once you realize that the main benefit is the compound growth of the investment, then you can start to maximize the benefits.

Remember that the SM is primarily a leveraged investment strategy. The leverage makes it a riskier strategy, which makes the quality of the investments key to maximizing the benefits and minimizing the risk.



Ed

[edrempel]

Ed, thanks for your advice in this thread.

I know this isn't your strategy, but what is your opinion on using the SM to invest in a MIC providing 9-10% returns and letting the monthly dividend compound in the MIC, so no withdrawls.

Hi Diet Butcher,

FrugalTrader is right that you will lose all the tax benefits and will probably pay tax every year, instead of getting tax refunds. Also, if a mortgage-type investment is paying 9-10% interest, it must be a high-risk investment.

The comments in my last post to Mark77 also apply. You are thinking far too small by focusing on how fast the mortgage is converted. Most versions of the SM that speed up the conversion actually REDUCE the expected benefit of the SM because of the tax bleed.

We would suggest to focus on the quality of the investment - not how fast you convert the mortgage.


Ed

[Mark77]

Actually, the cashflow from the investment is a relatively minor detail. In fact, total tax savings are generally only 5-15% of the benefit of the Smith Manoeuvre.


And how do you figure this out? The equity premium in Canada has been fairly minimal, so the benefit of buying equity with a short position in fixed income is significantly related to the tax arbitrage angle of things. We're talking 30-40% here, not 5-15%.



In addition, the cashflow REDUCES the benefit because of the tax bleed it causes. Jungle is on the right track in looking for a 100% tax-efficient investment.


"tax bleed"? Having the cashflow facilitates swapping the debt into the SM more expeditiously. And for many people who do the SM, the dividends received under the SM essentially have a zero incremental impact, whereas capital gains have a significant associated tax load. The risk of using that particular ETF is that, at some point, maybe unexpectedely, it will puke up a large amount of capital gains and/or income. Nevermind the risk of an adverse tax ruling because of its, ahem, "unique" structure.




Focusing on the tax benefit is thinking too small and misses the main point. The main benefit of the Smith Manoeuvre is the compound growth of the leveraged investment over time.


The SM is all about tax arbitrage. Without the tax arbitrage angle, there is little reason, historically, in Canada, to execute the SM.



Many people think of the SM as primarily a tax strategy to convert your mortgage to tax deductible interest over time and therefore focus on how fast the mortgage is converted. However, the investment benefit is 85-95% of the benefit.


Again, what are your numbers? What's the equity premium in Canada over the past 50 years? Hint: its fairly close to zero. Please don't just toss out random numbers because that's not really helpful.



For example, in a 25-year amortization of a $400,000 mortgage for someone in the highest tax bracket with a 10% investment return and 4% mortgage, the expected benefit of the Smith Manoeuvre over 25 years is $716,734. Of this amount, $100,375 is the total tax benefit, while the investment benefit is $616,359.


A 6% spread between equity returns and debt returns (ie: the cost of a mortgage, marked to market) is very atypical in Canada and certainly doesn't stand up to scrutiny over a 30-40-year cycle.





Remember that the SM is primarily a leveraged investment strategy. The leverage makes it a riskier strategy, which makes the quality of the investments key to maximizing the benefits and minimizing the risk.


No, its a tax arbitrage strategy. The leverage adds very little over the long term, or at least that's been the Canadian experience. Most, if not all of the benefit of the SM accrues from the tax benefit that is provided by the SM.

Now, you can come to your conclusion if you use a completely (empirically) unrealistic equity risk premium (versus fixed income), but that's not something that's been experienced in Canada over the past 2 or 3 decades.

Source: http://www.ndir.com/cgi-bin/downside_adv.cgi

Type in 100% for All Canadian bonds since 1970 -- ROI = 12.771%
Type in 100% for TSX Composite since 1970 -- ROI = 10.106%

Equity risk premium = -2.66%

See the problem? Your borrow at 4%, invest at 10% for the long term scenario isn't realistic if the past 40 years in Canada is any indication. You need the tax arbitrage to create a positive carry out of the situation.

edit: even if you change it and use "Short Canadian bonds" (which are like rolling 5-year mortgages), the ROI = 10%, so the equity risk premium = 0%. Still not the 6% you claim above. Nowhere near it.

edit: as usual, the numbers given for the TSX Composite are exclusive of fees that one would incur to actually invest in the index, but the impact of fees and the almost long-term impossibility of being successful with the SM if done through a traditionally compensated 'advisor' is a topic that has already been discussed here at length by other posters.

[edrempel]

And how do you figure this out? The equity premium in Canada has been fairly minimal, so the benefit of buying equity with a short position in fixed income is significantly related to the tax arbitrage angle of things. We're talking 30-40% here, not 5-15%.

"tax bleed"? Having the cashflow facilitates swapping the debt into the SM more expeditiously. And for many people who do the SM, the dividends received under the SM essentially have a zero incremental impact, whereas capital gains have a significant associated tax load. The risk of using that particular ETF is that, at some point, maybe unexpectedely, it will puke up a large amount of capital gains and/or income. Nevermind the risk of an adverse tax ruling because of its, ahem, "unique" structure.

The SM is all about tax arbitrage. Without the tax arbitrage angle, there is little reason, historically, in Canada, to execute the SM.

Again, what are your numbers? What's the equity premium in Canada over the past 50 years? Hint: its fairly close to zero. Please don't just toss out random numbers because that's not really helpful.

A 6% spread between equity returns and debt returns (ie: the cost of a mortgage, marked to market) is very atypical in Canada and certainly doesn't stand up to scrutiny over a 30-40-year cycle.

No, its a tax arbitrage strategy. The leverage adds very little over the long term, or at least that's been the Canadian experience. Most, if not all of the benefit of the SM accrues from the tax benefit that is provided by the SM.

Now, you can come to your conclusion if you use a completely (empirically) unrealistic equity risk premium (versus fixed income), but that's not something that's been experienced in Canada over the past 2 or 3 decades.

Source: http://www.ndir.com/cgi-bin/downside_adv.cgi

Type in 100% for All Canadian bonds since 1970 -- ROI = 12.771%
Type in 100% for TSX Composite since 1970 -- ROI = 10.106%

Equity risk premium = -2.66%

See the problem? Your borrow at 4%, invest at 10% for the long term scenario isn't realistic if the past 40 years in Canada is any indication. You need the tax arbitrage to create a positive carry out of the situation.

edit: even if you change it and use "Short Canadian bonds" (which are like rolling 5-year mortgages), the ROI = 10%, so the equity risk premium = 0%. Still not the 6% you claim above. Nowhere near it.

edit: as usual, the numbers given for the TSX Composite are exclusive of fees that one would incur to actually invest in the index, but the impact of fees and the almost long-term impossibility of being successful with the SM if done through a traditionally compensated 'advisor' is a topic that has already been discussed here at length by other posters.

Hi Mark77,

If you will permit me to put a little perspective on this, I think that looking at the equity risk premium stats may end up in a less than optimal implementation of the Smith Manoeuvre.

That stat hides the long term out-performance of stocks. By focusing on it, you change your strategy to try to get income, which can mean you pay much more tax and miss the main benefit of the Smith Manoeuvre - which is the long term compound return of the investments.


By way of evidence, first let me say that the expected benefit figures I quoted are all from our Smith Manoeuvre calculator. They show that tax savings in total are only 5-15% of the expected benefit of the SM (with our assumptions). So, 85-95% of the benefit is from the long term compound growth of the investments.

That is why an optimal implementation of the Smith Manoeuvre needs to focus on the investments.

Secondly, the recent past returns are not representative of normal returns or expected future returns. The last 10 years have been the worst in 80 years for stocks, while the last 30 years have been artificially high for bonds because that is the great period of interest rate declines.

I was an accountant of a savings and mortgage company in 1982. Our 5-year mortgage rates at the time were 22.75% and people were taking them because the belief was that they were on their way to 30-40%. Now, 5-year mortgages are about 3.4% and we are recommending 1-year mortgages at 2.2%.

The period from 1982 until now may seem like a long time, but this is the period of the great decline in interest rates, which have declined nearly every year. This has meant far higher returns for bonds than normal, since bonds have a capital gain when interest rates decline. However, it appears that the decline in interest rates is probably done.

For this reason, bond returns for the last 30 years are not representative of normal bond returns or the returns we could reasonably expect from bonds from now on.

If we take long term stats from 1900-2006, the return of equity risk premium in Canada was about 6.2% and the US about 6.6%(Stocks for the Long Run).

My point is that expected returns from equities normally are much higher than bonds.

Thirdly, with the SM, we are generally borrowing from a secured credit line at prime (or prime +.5% today), not at 10-year rates or longer like bonds average. So, the equity risk premium does not really provide relevant figures.


Now we can go back to looking at an optimal implementation of the SM. The expected returns in our SM calculator always come out higher the less tax you pay on your investments. Therefore, in general, income investments that produce taxable income REDUCE the benefits of the SM - even though they can convert the mortgage to tax deductible more quickly.

This is because you get a smaller refund each year. Remember that you pay tax on the investment income, while the tax savings on converting the mortgage are only on the interest. For example, if you receive $1,000 of investment income, you pay tax on it and use it to to convert $1,000 of your mortgage to tax deductible. This gives you $1,000 of investment income to pay tax on, but the future extra tax deduction is only say $40/year (if the credit line is at 4%).

There are off-setting factors as well. The mortgage is usually at a lower rate than the credit line. When you convert your mortgage to tax deductible, you may pay down your 3% mortgage and convert it to a 4% tax deductible credit line. There is still a savings, but the higher interest rate eats up some of your tax savings.


If you focus on the investment growth and how to get it, instead of the debt conversion and how to get it, you can have a far more effective SM implementation.



Ed

[wasserware]

All these talks seems nice and dandy about tax savings, paying off your mortgage blah blah but I am sure there are people out there who got burned by this "creative" techniques. Care to share those?

[edrempel]

as usual, the numbers given for the TSX Composite are exclusive of fees that one would incur to actually invest in the index, but the impact of fees and the almost long-term impossibility of being successful with the SM if done through a traditionally compensated 'advisor' is a topic that has already been discussed here at length by other posters.

Hi Mark77,

There are sold reasons why the SM is best implemented with professional advice for most people.

1. An advisor can help you focus on the key factors. Focusing on income and how fast you convert the mortgage is far less effective than focusing on having the most effective investments based on risk/return. For example, if you buy investments mainly because they pay interest or a dividend or because they are income trusts instead of investing in the equities with the best expected future total return, you can end up with a far lower long term return and higher tax.
2. An advisor can help you setup the optimal implementation. How should all your debts be structured? How does the SM fit into your Retirement Plan? Is it priority over RRSP and/or TFSA in your situation? Our experience is that implementing the SM as part of a written financial plan and including it in your retirement plan makes it far more effective.
3. The optimal amount of leverage is key with the SM. Since it is primarily a leverage strategy, you need to understand the risk and figure out how much leverage is appropriate for you. With a good advisor holding your hand and a solid investment strategy, you may be comfortable with more leverage.
4. An advisor can help you invest effectively by diversifying properly. Keeping your money all in Canada may have worked relatively well the last few years with rising commodities, but it the TSX is not well diversified (80% in 3 sectors) and is only large cap. Most investment opportunities are outside of Canada and many are in mid-caps and small-caps.
5. An advisor can help you invest effectively and pay for himself by identifying the fund managers that do beat the index. They do exist. (http://www.milliondollarjourney.com/truly-acitve-managers-outperform-being-different-is-key.htm ). We focus on identifying them and only use investments that we are confident will beat their index (either actual or risk/return, depending on the client). It takes a lot of research to figure which fund managers have beaten the index because of real skill. We call them "All Star Fund Managers". Most large cap fund managers in Canada are "closet indexers", so the "All Star Fund Managers" mostly manage outside of Canada or small/mid-cap funds.


Here is an example to illustrate:

Couple A: They implemented an income-focused Smith Manoeuvre by buying an income ETF from their equity and focus on converting the mortgage. They start with $0 and invest $1,000/month into an income ETF, then take the income from it to pay down their mortgage and convert it to tax deductible as quickly as possible. The ETF paid dividends of 4% on which they paid a low 6% income tax.

Couple B: They implemented a growth-focused Smith Manoeuvre by figuring the optimal leverage and take out a $200,000 investment loan. They invest it in 3 tax-efficient global and 1 Canadian small cap mutual funds with "All-Star Fund Managers" that have all beaten their indexes for the last 10-30 years (after the MER) with lower risk, and had minimal taxable distributions. They implemented the Smith Manoeuvre and used part of the mortgage principal to make the investment loan payments, and invested the rest each month. They took no distributions from the mutual funds and allowed the growth to compound.

In addition, Couple B work with a financial planner that created a custom, written comprehensive financial plan for them. They realized they needed to invest more to have the retirement they wanted. Part of the reason for the $200,000 investment loan was to invest without using their cash flow. They also took a $30,000 RRSP loan and rolled it, their credit line balance and their car loan all into their mortgage, making their new mortgage payment equal to the total they were paying. This allowed them to SM all their debt and saved them $2,000/year in interest. They also found that after this year, $10,000/year RRSP was optimal based on their tax bracket (instead of the $15,000 they had been doing) and that the SM was more effective for them than TFSA, so they further increased their mortgage payment by $10,000/year (from $5,000 reduced RRSP and $5,000 reduced TFSA contributions). They saved $2,300 by paying the penalty to get out of their 5-year fixed mortgage and refinancing it into a 1-year fixed at 2.2%. Using their new much higher mortgage payment, they reduced their amortization from 25 years to 12. They also stopped their RESP monthly contributions of $200/month and added this to their mortgage payment. They would use $5,000 from their tax refund each year to make the RESP contribution (instead of paying it onto the mortgage), which also would provide the amount they wanted for their kids' education (plus $1,000 grant). The tax refunds will be larger because of the Smith Manoeuvre and optimizing their deductions based on their tax brackets.

Their advisor did not charge them for the plan, the SM implementation or for doing their tax returns. All of this did not affect their cash flow but put them on track for their retirement, education and debt goals.

1. Which one do you think will do better, Couple A or Couple B?

2. Which factors made the biggest difference? Was it the plan, the way the SM strategy was implemented, the investment, or the rate at which the mortgage was converted?






Ed

[Mark77]

If you will permit me to put a little perspective on this, I think that looking at the equity risk premium stats may end up in a less than optimal implementation of the Smith Manoeuvre.

That stat hides the long term out-performance of stocks. By focusing on it, you change your strategy to try to get income, which can mean you pay much more tax and miss the main benefit of the Smith Manoeuvre - which is the long term compound return of the investments.


"long-term outperformance of stocks" is embodied by the equity risk premium. How can you ignore it? The past 40 years worth of numbers have shown that there is no excess return provided by stocks, versus bonds. The SM, at its heart, essentially taking a long position in a stock portfolio, and a short position in a fixed income portfolio. The gains expected in the SM under such an environment without an equity risk premium are entirely due to tax arbitrage, ie: that you're swapping a tax deferred and tax-preferred stream of 'income' (ie: the stock gains, dividends, etc.) against financing with fully deductible debt (ie: bond) instruments.

I sure hope you're correct about the equity risk premium being abnormally low over the past 40 years relative to the long-term historical perspective. Present conditions imply that fixed income (ie: bonds, debt) is massively overvalued, while equity is massively undervalued. But 1970-2009 did not deliver an equity risk premium and all of the expected gains from the SM, ie: the profit, came from the tax arbitrage angle of things.




By way of evidence, first let me say that the expected benefit figures I quoted are all from our Smith Manoeuvre calculator. They show that tax savings in total are only 5-15% of the expected benefit of the SM (with our assumptions). So, 85-95% of the benefit is from the long term compound growth of the investments.


Sure, your 'calculator' churns through the 'numbers', but are the inputs accurate over the long term? Is the SM a short-term strategy, ie: 5-10 years, or is it a 30-50 year strategy? If you put 4% financing against 10% returns into any sort of calculator, you will get a positive return that is very lucrative. But the past 40 years has embodied roughly 10% financing (on average) against 10% returns (on average), which, in your calculator, if repeated, would obviously lead to some quite different results.



Secondly, the recent past returns are not representative of normal returns or expected future returns. The last 10 years have been the worst in 80 years for stocks, while the last 30 years have been artificially high for bonds because that is the great period of interest rate declines.


40 years should cover pretty much an entire economic cycle, shouldn't it though? In order to get to 6% from 1970-2011, the TSX would need to rise approximately 10X immediately (ie: 1.06^40) to deliver the 6% equity premium over that interval. I think we can agree that the likelyhood is slim to none that the TSX will be 100,000 next year, or even in the next 5 years more than likely :). Hence, 6% is not realistic (but 1-2% might be), and most of the gains in the SM come from tax, not from raw pre-tax investment returns.



I was an accountant of a savings and mortgage company in 1982. Our 5-year mortgage rates at the time were 22.75% and people were taking them because the belief was that they were on their way to 30-40%. Now, 5-year mortgages are about 3.4% and we are recommending 1-year mortgages at 2.2%.


Absolutely! And if you did the SM in 1982 and put the proceeds into the TSX composite, you lost money because the TSX composite did not return 22.75%/annum over the next 5 years. Only being able to deduct your mortgage payments @ 22.75% interest saved your bacon!




If we take long term stats from 1900-2006, the return of equity risk premium in Canada was about 6.2% and the US about 6.6%(Stocks for the Long Run).
My point is that expected returns from equities normally are much higher than bonds.

Thirdly, with the SM, we are generally borrowing from a secured credit line at prime (or prime +.5% today), not at 10-year rates or longer like bonds average. So, the equity risk premium does not really provide relevant figures.


Okay, go back to that calculator, and use the 3-month T-bill rate + 200bp (which is typical of "prime"). Its still in the 9-10% range, against the TSX which returns 10%. Again, you're back to relying upon tax arbitrage to make the business case for doing the SM, if you were able to make business decisions in hindsight.

Sure hope you're correct about the bond returns versus stock returns. Canada is quite abnormal that way, with our chronically underperforming equity markets, and relatively illiquid and expensive debt markets. The 1970s, 80s, and 90s, with strongly spend-happy, socialist governments, were most certainly not kind to the Canadian economy. But the numbers definitely re-inforce my belief, which I have supported, in that, the SM's success is intrinsically tied to taking advantage of the tax system, and not of taking advantage of higher equity returns.

[kerdon]

Hi Mark77,

There are sold reasons why the SM is best implemented with professional advice for most people.

1. An advisor can help you focus on the key factors. Focusing on income and how fast you convert the mortgage is far less effective than focusing on having the most effective investments based on risk/return. For example, if you buy investments mainly because they pay interest or a dividend or because they are income trusts instead of investing in the equities with the best expected future total return, you can end up with a far lower long term return and higher tax.
2. An advisor can help you setup the optimal implementation. How should all your debts be structured? How does the SM fit into your Retirement Plan? Is it priority over RRSP and/or TFSA in your situation? Our experience is that implementing the SM as part of a written financial plan and including it in your retirement plan makes it far more effective.
3. The optimal amount of leverage is key with the SM. Since it is primarily a leverage strategy, you need to understand the risk and figure out how much leverage is appropriate for you. With a good advisor holding your hand and a solid investment strategy, you may be comfortable with more leverage.
4. An advisor can help you invest effectively by diversifying properly. Keeping your money all in Canada may have worked relatively well the last few years with rising commodities, but it the TSX is not well diversified (80% in 3 sectors) and is only large cap. Most investment opportunities are outside of Canada and many are in mid-caps and small-caps.
5. An advisor can help you invest effectively and pay for himself by identifying the fund managers that do beat the index. They do exist. (http://www.milliondollarjourney.com/truly-acitve-managers-outperform-being-different-is-key.htm ). We focus on identifying them and only use investments that we are confident will beat their index (either actual or risk/return, depending on the client). It takes a lot of research to figure which fund managers have beaten the index because of real skill. We call them "All Star Fund Managers". Most large cap fund managers in Canada are "closet indexers", so the "All Star Fund Managers" mostly manage outside of Canada or small/mid-cap funds.


Here is an example to illustrate:

Couple A: They implemented an income-focused Smith Manoeuvre by buying an income ETF from their equity and focus on converting the mortgage. They start with $0 and invest $1,000/month into an income ETF, then take the income from it to pay down their mortgage and convert it to tax deductible as quickly as possible. The ETF paid dividends of 4% on which they paid a low 6% income tax.

Couple B: They implemented a growth-focused Smith Manoeuvre by figuring the optimal leverage and take out a $200,000 investment loan. They invest it in 3 tax-efficient global and 1 Canadian small cap mutual funds with "All-Star Fund Managers" that have all beaten their indexes for the last 10-30 years (after the MER) with lower risk, and had minimal taxable distributions. They implemented the Smith Manoeuvre and used part of the mortgage principal to make the investment loan payments, and invested the rest each month. They took no distributions from the mutual funds and allowed the growth to compound.

In addition, Couple B work with a financial planner that created a custom, written comprehensive financial plan for them. They realized they needed to invest more to have the retirement they wanted. Part of the reason for the $200,000 investment loan was to invest without using their cash flow. They also took a $30,000 RRSP loan and rolled it, their credit line balance and their car loan all into their mortgage, making their new mortgage payment equal to the total they were paying. This allowed them to SM all their debt and saved them $2,000/year in interest. They also found that after this year, $10,000/year RRSP was optimal based on their tax bracket (instead of the $15,000 they had been doing) and that the SM was more effective for them than TFSA, so they further increased their mortgage payment by $10,000/year (from $5,000 reduced RRSP and $5,000 reduced TFSA contributions). They saved $2,300 by paying the penalty to get out of their 5-year fixed mortgage and refinancing it into a 1-year fixed at 2.2%. Using their new much higher mortgage payment, they reduced their amortization from 25 years to 12. They also stopped their RESP monthly contributions of $200/month and added this to their mortgage payment. They would use $5,000 from their tax refund each year to make the RESP contribution (instead of paying it onto the mortgage), which also would provide the amount they wanted for their kids' education (plus $1,000 grant). The tax refunds will be larger because of the Smith Manoeuvre and optimizing their deductions based on their tax brackets.

Their advisor did not charge them for the plan, the SM implementation or for doing their tax returns. All of this did not affect their cash flow but put them on track for their retirement, education and debt goals.

1. Which one do you think will do better, Couple A or Couple B?

2. Which factors made the biggest difference? Was it the plan, the way the SM strategy was implemented, the investment, or the rate at which the mortgage was converted?






Ed

Which one pays the advisor more? lol

[Mark77]

Couple B: They implemented a growth-focused Smith Manoeuvre by figuring the optimal leverage and take out a $200,000 investment loan. They invest it in 3 tax-efficient global and 1 Canadian small cap mutual funds with "All-Star Fund Managers" that have all beaten their indexes for the last 10-30 years (after the MER) with lower risk, and had minimal taxable distributions. They implemented the Smith Manoeuvre and used part of the mortgage principal to make the investment loan payments, and invested the rest each month. They took no distributions from the mutual funds and allowed the growth to compound.


Oh boy, the bolded part, where do I start:

1) The majority of managers do not beat the index. Some studies have shown that >90% of managers actually underperform the index. How realistic is it to suggest that a manager will be able to consistently beat the index for the next 20 years, based on the performance of the prior 20 years? Not very. An advisor that leads a client down that path probably is doing their client a disservice as it just isn't realistic.

2) The managers that are able to outperform, definitely would be doing so by applying some sort of proprietary advantage through trading, hence, generating significant taxable distributions. Otherwise, they are just a closet indexxer, and will have performance similar to that of a closet indexxer, ie: on average, the index's performance, minus the MER.

You're asking me to believe that a manager can be all three of a) market outperforming, and b) tax efficient, and c) do both over the long term. I simply do not believe such is realistic.

On your last point, you've intermixed a number of issues, all of which, financial education, or the assistance of a FA, can add value. But that's value that largely should be attributed to the financial planner, and not to the SM. As in my previous reply, the SM itself hasn't, in the past 40 years, provide a positive pre-tax return for Canadian investors in the TSE/TSX Composite Index, borrowing Canadian dollars. Any returns have been entirely due to tax arbitrage, which, even at the best of times, only runs 20-30% (spread between the taxable rate on deferred capital gains or dividends, and tax deductions on current interest payments). A 2-3% MER under such circumstances, typically charged by a FA for managed mutual funds (which, on average, match the index pre-MER) eliminates the positive rate of carry on an after-tax basis.

[Mark77]

Which one pays the advisor more? lol

The SM can make a ton of money for FA's, which is why they might feel incented to promote it even though, historically, it has added little value for clients after all management fees are paid.

Every so often a FA hits the jackpot and gets his clients into certain hot stocks or hot investments. But that is definitely not the average case.

The reason the wealth gap in Canada is relatively smaller than the USA is because strategies like the SM haven't been overly successful, historically. If you want to get rich in Canada, you need to earn money the old fashioned way, by working, by building a business, just plain stealing it or leeching it off taxpayers as a civil servant.

[wasserware]

The SM can make a ton of money for FA's, which is why they might feel incented to promote it even though, historically, it has added little value for clients after all management fees are paid.

Every so often a FA hits the jackpot and gets his clients into certain hot stocks or hot investments. But that is definitely not the average case.

The reason the wealth gap in Canada is relatively smaller than the USA is because strategies like the SM haven't been overly successful, historically. If you want to get rich in Canada, you need to earn money the old fashioned way, by working, by building a business, just plain stealing it or leeching it off taxpayers as a civil servant.

Exactly and many people want the "easy way out" for their mortgage or some are taking on mortgage that they cannot handle and is hoping that the so called SM is a miracle cure for their ailment.

What happened to the working hard, getting a better job/education that leads to better pay and paying off the mortgage faster rather than using such "creative accounting" tricks? Is there any licensed CAs and CFAS doing the SM trick?

Plus, who is this guy who invented the SM trick? If a nobel laureate came up with this then it will have my ears.

[Mark77]

Exactly and many people want the "easy way out" for their mortgage or some are taking on mortgage that they cannot handle and is hoping that the so called SM is a miracle cure for their ailment.

It can be the miracle cure, if executed in a precision manner, keeping costs to an absolute minimum, and making appropriate decisions (ie: don't invest in mortgages if you are financing the SM with a mortgage, for instance!).

Mr. Rempel and I are only arguing over how the SM creates value, and the extent of the value that is created.

Doing the SM is no different than what your friendly neighbourhood banker does. Borrows at one rate, and lends at a higher rate.

Essentially, when you do the SM, you are running your own little mini-Royal Bank with your own personal finances.

There's nothing immoral about it, there's nothing lazy about it. There's nothing "creative accounting" about it. People who do the SM are performing a valuable function for society, by putting their financial a*ses on the line, to create additional investment and to allocate capital within the economy.



What happened to the working hard, getting a better job/education that leads to better pay and paying off the mortgage faster rather than using such "creative accounting" tricks? Is there any licensed CAs and CFAS doing the SM trick?


Many, if not most CAs and CFAs, I believe. Anyone who knows anything about portfolio allocation and diversification would understand that its not healthy to have the entirety of one's assets concentrated into one asset class, and the SM is an important tool to achieve diversification.



Plus, who is this guy who invented the SM trick? If a nobel laureate came up with this then it will have my ears.

Fraser Smith, a BC-based financial planner.

[kerdon]

It can be the miracle cure, if executed in a precision manner, keeping costs to an absolute minimum, and making appropriate decisions (ie: don't invest in mortgages if you are financing the SM with a mortgage, for instance!).

Mr. Rempel and I are only arguing over how the SM creates value, and the extent of the value that is created.

Doing the SM is no different than what your friendly neighbourhood banker does. Borrows at one rate, and lends at a higher rate.

Essentially, when you do the SM, you are running your own little mini-Royal Bank with your own personal finances.

There's nothing immoral about it, there's nothing lazy about it. There's nothing "creative accounting" about it. People who do the SM are performing a valuable function for society, by putting their financial a*ses on the line, to create additional investment and to allocate capital within the economy.



Many, if not most CAs and CFAs, I believe. Anyone who knows anything about portfolio allocation and diversification would understand that its not healthy to have the entirety of one's assets concentrated into one asset class, and the SM is an important tool to achieve diversification.




Fraser Smith, a BC-based financial planner.

Also remember that his book is self published.

[Jungle]

Fraser Smith just wrote the plan down and sold it as a book. His name has been attached to the strategy. However, people have been leverage investing since sliced bread was invented.

[Mark77]

Fraser Smith just wrote the plan down and sold it as a book. His name has been attached to the strategy. However, people have been leverage investing since sliced bread was invented.

Yeah no kidding, Canada needs far more people doing the SM than it has right now, especially if Canadians want to keep ownership of such national gems as POT, Alcan, Cameco, Inco, Falconbridge, Barrick, etc., in Canadian hands.

[Jungle]

Not to be off topic, but it looks like the GOV will decided who takes over some gems, such as potash. To make this on topic, I don't have enough leverage to save potash through a 38.6B+ SM buy out strategy. :razz:

[Mark77]

Not to be off topic, but it looks like the GOV will decided who takes over some gems, such as potash. To make this on topic, I don't have enough leverage to save potash through a 38.6B+ SM buy out strategy. :razz:

The POT bid was completely and innappropriately low, and wouldn't even cover the replacement cost of the assets (nevermind the value of the resource!), if a meteor hit POT's mines in Saskatchewan tomorrow and they had to be reconstructed from scratch.

Governments would have lost literally billions of dollars in capital gains and income tax revenue if those assets were sold at $39B, instead of at a more appropriate price.

Keeping it on-topic, the only reason that such absurdly low bids even see the "light of day" in Canada for our resources is that we don't cherish them, and we'd rather borrow insane amounts of money to bid up houses, instead of keeping assets appropriately valued.

[edrempel]

"long-term outperformance of stocks" is embodied by the equity risk premium. How can you ignore it? The past 40 years worth of numbers have shown that there is no excess return provided by stocks, versus bonds. The SM, at its heart, essentially taking a long position in a stock portfolio, and a short position in a fixed income portfolio. The gains expected in the SM under such an environment without an equity risk premium are entirely due to tax arbitrage, ie: that you're swapping a tax deferred and tax-preferred stream of 'income' (ie: the stock gains, dividends, etc.) against financing with fully deductible debt (ie: bond) instruments.

I sure hope you're correct about the equity risk premium being abnormally low over the past 40 years relative to the long-term historical perspective. Present conditions imply that fixed income (ie: bonds, debt) is massively overvalued, while equity is massively undervalued. But 1970-2009 did not deliver an equity risk premium and all of the expected gains from the SM, ie: the profit, came from the tax arbitrage angle of things.

Sure, your 'calculator' churns through the 'numbers', but are the inputs accurate over the long term? Is the SM a short-term strategy, ie: 5-10 years, or is it a 30-50 year strategy? If you put 4% financing against 10% returns into any sort of calculator, you will get a positive return that is very lucrative. But the past 40 years has embodied roughly 10% financing (on average) against 10% returns (on average), which, in your calculator, if repeated, would obviously lead to some quite different results.

40 years should cover pretty much an entire economic cycle, shouldn't it though? In order to get to 6% from 1970-2011, the TSX would need to rise approximately 10X immediately (ie: 1.06^40) to deliver the 6% equity premium over that interval. I think we can agree that the likelyhood is slim to none that the TSX will be 100,000 next year, or even in the next 5 years more than likely :). Hence, 6% is not realistic (but 1-2% might be), and most of the gains in the SM come from tax, not from raw pre-tax investment returns.

Absolutely! And if you did the SM in 1982 and put the proceeds into the TSX composite, you lost money because the TSX composite did not return 22.75%/annum over the next 5 years. Only being able to deduct your mortgage payments @ 22.75% interest saved your bacon!

Okay, go back to that calculator, and use the 3-month T-bill rate + 200bp (which is typical of "prime"). Its still in the 9-10% range, against the TSX which returns 10%. Again, you're back to relying upon tax arbitrage to make the business case for doing the SM, if you were able to make business decisions in hindsight.

Sure hope you're correct about the bond returns versus stock returns. Canada is quite abnormal that way, with our chronically underperforming equity markets, and relatively illiquid and expensive debt markets. The 1970s, 80s, and 90s, with strongly spend-happy, socialist governments, were most certainly not kind to the Canadian economy. But the numbers definitely re-inforce my belief, which I have supported, in that, the SM's success is intrinsically tied to taking advantage of the tax system, and not of taking advantage of higher equity returns.

Hi Mark77,

So, you actually believe that prime rate will average 10% in the next 10 or 20 years?

The reason that "equity risk premium" is irrelevant to the SM is that it is based on bond returns - not prime rate. Bond returns have included a large capital gain resulting from declining interest rates since 1982, but prime rate does not. Bond returns are also 10+ years, while prime rate is a monthly floating rate that is usually somewhere between 1-5 year bonds and T-Bills.

For example, rates were around 20% in 1982, but prime was down to 11% by 1983 and has been below 10% the entire time since 1992. It has averaged 4.77% since 2000. We think the average of the next decade will likely be a bit lower than the last decade.


We think that our assumptions of equity returns averaging 10% and prime averaging 4% are very reasonable. That is why the main benefit of the SM is the compound growth of the investments.

The secondary benefit is the tax savings, since the 4% is fully tax deductible and IF you invest tax-efficiently, you can pay very little tax on the 10%.

Then you usually have to SUBTRACT the extra tax that results from investing for income in order to convert your mortgage to tax deductible more quickly. This strategy does convert your mortgage more quickly, but REDUCES the profit from the SM.

This is the clear result from looking at various scenarios with our SM Calculator. My point is that many people misunderstand the SM and think it is primarily a mortgage conversion strategy - which is why they lose much of the benefit of the SM.

Once you realized that the SM is primarily a leveraged investment strategy, then you can understand why 85-95% of the benefit results from the compound growth of the investments.


Ed

[edrempel]

On your last point, you've intermixed a number of issues, all of which, financial education, or the assistance of a FA, can add value. But that's value that largely should be attributed to the financial planner, and not to the SM. As in my previous reply, the SM itself hasn't, in the past 40 years, provide a positive pre-tax return for Canadian investors in the TSE/TSX Composite Index, borrowing Canadian dollars. Any returns have been entirely due to tax arbitrage, which, even at the best of times, only runs 20-30% (spread between the taxable rate on deferred capital gains or dividends, and tax deductions on current interest payments). A 2-3% MER under such circumstances, typically charged by a FA for managed mutual funds (which, on average, match the index pre-MER) eliminates the positive rate of carry on an after-tax basis.

Hi again, Mark77,

Exactly. It is Couple B in my example that will likely be way ahead. But the reason has nothing to do with investment returns. The main determinants of the expected benefit of the SM were:

1. The implementation strategy - specifically that they invested $200,000 on day 1.
2. Having the Smith Manoeuvre as part of a comprehensive written plan, combining it with restructuring all debt, their RRSP contributions, and other cash flow strategies.
3. The compounding return of the investments.
4. The tax savings, including both SM & RRSP, and that Couple B had more tax efficient investments.

You said in an earlier post: "the almost long-term impossibility of being successful with the SM if done through a traditionally compensated 'advisor' is a topic that has already been discussed here at length by other posters." In actual fact, we have seen and talked to many people doing various versions of an amateur implementation of the Smith Manoeuvre, most of which miss out on the vast majority of the benefits.

Amateur SM implementations rarely start with a significant or optimized lump sum, rarely are part of a long term plan, rarely include restructuring all debt, debt payments and other cash flow issues (including RRSP contributions), and often miss much of the investment returns because they are focused on making taxable income, instead of maximizing investment growth for the risk level.





Ed

[Jungle]

Although this is not directly related to the current SM discussion between Mark77 and Ed Rampel, I thought I would share this article I just read in the Globe and Mail (it's about the SM)
http://www.theglobeandmail.com/globe-investor/personal-finance/preet-banerjee/deducting-mortgage-interest-takes-a-fortitude-many-lack/article1766530/

[Mark77]

So, you actually believe that prime rate will average 10% in the next 10 or 20 years?


No. I agree with you, in that, the SM is likely to be a successful strategy in the next 10 years, as governments attempt to reflate housing prices by keeping interest rates relatively low. My only argument is relating to the past 40 years of SM performance, the only returns for an average SM user being derived from the tax part of the SM strategy.



The reason that "equity risk premium" is irrelevant to the SM is that it is based on bond returns - not prime rate. Bond returns have included a large capital gain resulting from declining interest rates since 1982, but prime rate does not. Bond returns are also 10+ years, while prime rate is a monthly floating rate that is usually somewhere between 1-5 year bonds and T-Bills.


"Prime" approximates 3-month T-bills, plus a spread, typically 200bp, but sometimes more, sometimes slightly less. This is because 3-month T-bill yields generally reflect interest rate expectations on the part of the Bank of Canada's policy rate, and banks apply a spread above the 'risk-free' T-bill/BoC rate, to determine Prime. For instance, Prime is currently 200bp above the BoC policy target rate.

Hence, we can use 3-month T-bill returns + an average spread (ie: 200bps), to approximate the long-term average Prime rate.




For example, rates were around 20% in 1982, but prime was down to 11% by 1983 and has been below 10% the entire time since 1992. It has averaged 4.77% since 2000. We think the average of the next decade will likely be a bit lower than the last decade.


That's my view as well, unless the stock market overheats (but a SM investor would benefit very handsomely from the stock market becoming very high! -- so its pretty moot, overall). But a customer that started the SM in 1970, borrowing at Prime (or on 5-year mortgages), and investing the proceeds into the TSE/TSX Composite Index, would owe the entirety of his returns to tax arbitrage as the equity risk premium over that interval was simply non-existent.



Once you realized that the SM is primarily a leveraged investment strategy, then you can understand why 85-95% of the benefit results from the compound growth of the investments.


In the past decade, for instance, the TSX has had a return of only dividends (ie: index level remained flat), but the 4.77% interest on the debt has compounded annually, to the tune of 59%. An investor who did the SM a decade ago, for instance, has lost significant money. TSX dividends over the past decade have been, what, 1.75%/year? So ~20%. So 59% return on debt minus 20% return on equity = -39% return overall. Tax arbitrage closed the gap significantly though, because the dividends received were subject to, in most cases, almost no income tax, while the interest payments were fully deductible against income.

We both do agree though, that the equity risk premium cannot remain negative over the long term, right? So things should be better for SM users going forward!

[edrempel]

Oh boy, the bolded part, where do I start:

1) The majority of managers do not beat the index. Some studies have shown that >90% of managers actually underperform the index. How realistic is it to suggest that a manager will be able to consistently beat the index for the next 20 years, based on the performance of the prior 20 years? Not very. An advisor that leads a client down that path probably is doing their client a disservice as it just isn't realistic.

2) The managers that are able to outperform, definitely would be doing so by applying some sort of proprietary advantage through trading, hence, generating significant taxable distributions. Otherwise, they are just a closet indexxer, and will have performance similar to that of a closet indexxer, ie: on average, the index's performance, minus the MER.

You're asking me to believe that a manager can be all three of a) market outperforming, and b) tax efficient, and c) do both over the long term. I simply do not believe such is realistic.

Hi Mark77,

We have the same distaste for the "average mutual fund" that you do. The "average fund manager" does not have much actual skill. About 30% are "closet indexers" that try to be similar to the market, but have an MER similar to managers with actual skill.

Many are marketing vehicles primarily focused on "sales" (getting people to invest in it), so they try own whatever investment or strategy is currently popular. The fund managers working for large financial institutions usually have bosses that will fire them if they underperform when other funds are not, so the fund managers try to be similar to the index to protect their jobs. Their bosses often want them to "window dress" their top 10 holdings for the last day of the month to attract more money to their fund. The word is: "It is better to fail conventionally than succeed unconventionally."

Also, since most investors have trouble tolerating the volatility of the index, a lot of mutual funds are more conservative than the index. The TSX60 has a 3-year risk level (standard deviation) of 20.5%, but only 28% of domestic equity funds of any type are that high.

So, of course most mutual funds will underperform the index:
- 10% are index funds (100% of which underperform the index).
- 30% are "closet indexers", nearly all of which will underperform.
- 72% are more conservative than the index.
- Many are marketing vehicles or the fund managers have bosses.

Our opinion is that most mutual funds don't even try to beat the index.


However, I can assure you there are top fund managers that beat the index over the long term. Just like there are all star hockey players and all stars in every field, there are All Star Fund Managers. Our investment process is focused on evaluating fund managers. We study them and the qualities to look for.

We find that it is easy to eliminate the "bottom 90%" of fund managers. For example, most of the All Star Fund Managers:

- Have portfolios very different from the index. If a fund manager's top 10 have more than 2 of the top 10 of the index, they are probably in the "bottom 90%" (http://www.milliondollarjourney.com/truly-acitve-managers-outperform-being-different-is-key.htm ).
- Are stock pickers, not traders (contrary to your comment). In general, they have lower turnover. The best example is Warren Buffett, who has massacred the index partly because he has hardly ever sold a stock.
- Are much more likely to be value managers, rather than growth or any type of blend of styles.
- Can almost always tell you why they beat the market long term (what systematic inefficiency of the market they exploit ).
- Often underperform about 1/3 of the time, even though they beat the index by 1-13%/year compounded over the long term (after all fees).

There are many other qualities to look for in addition to all the stats, so it takes a lot of work to identify them. You can't just take fund managers that beat the index over the long term, since it could be just luck or that their style or favourite sector happened to have been in favour.

You have a valid point that identifying them ahead of time is the tough part. It takes a while to become convinced that a fund manager is truly skilled. However, All Star Fund Managers tend to remain all stars. The Yale study above confirmed this, as did the classic article by Warren Buffett (http://www.edrempel.com/pdfs/superinvestors.pdf ). He shows the returns of 9 guys that he met early in their career that he thought were skilled and were all value investors. All 9 massacred their index for the following decades.

Tax efficiency comes from low turnover in the fund and the structure of the fund (usually a corporate class structure). Any fund can be made into a tax-efficient fund, but not all are.


Investing in individual stocks or ETFs has its challenges as well. Studies show that the "average investor" in ETFs or stocks make far less than the index - and generally less than the "average mutual fund". Read Bogle's article, "Investors are getting killed in ETFs" (http://advisoranalyst.com/glablog/2010/06/13/bogle-investors-are-getting-killed-in-etfs/ ).

We could pick our own stocks or ETFs, but we think these All Star Fund Managers are much better investors than we are. In fact, since we (and nearly all financial planners and stock brokers) are not fund managers, a portfolio we pick would be an amateur portfolio.

We have seen a lot of amateur portfolios and find they usually have mostly the same holdings. The "herd mentality" is pervasive. There is a tendency to choose the currently popular stocks or ETFs, or the ones that did well last year. Stock portfolios tend to be almost entirely in Canada or the US, missing opportunities in the rest of the world.

For example, in the late 90s, everyone owned Nortel during the tech bubble until it flamed out. Then many switched to cash or bonds, before switching into dividend stocks and income trusts, just before the rules were changed to pop the income trust bubble. Then commodities became the rage during the oil bubble. The crash in 2008 made the remaining investors income-focused or defensive. Everyone has forgotten that the markets go up, so investors want to be "paid to wait". So, most amateurs are now into dividend or income stocks again - or gold which we think is the next bubble to pop.

Being a true stock picker takes a lot of work, so amateurs tend to fall back on simple methods like following the herd or looking at graphs, instead of doing the real research on their stocks. Amateur investors tend to know little about the stocks they own - just a few main, publicly available facts that you can get from the internet. They don't realize that publicly available information is almost always already built into stock prices, so the information is generally irrelevant to stock picking.

With ETF portfolios, there is a tendency of investors to trade a lot (which generally reduces returns) and to feel compelled to diversify among ETFs. For example, the most diversified equity ETF portfolio is probably to have 1 global ETF. Adding TSX or S&P ETF reduces returns, since they are subsets of the global market. But it seems inadequate to just have one global ETF, so investors tend to feel they need allocate (or market time). This often also results in reducing returns by having more fixed income (since equity ETFs can be volatile).

For example, investing with our fund managers gives us the confidence to invest 100% equities. A 100% equity mutual fund portfolio will likely beat an ETF index of 50% equity/50% bonds over time. This would likely be true even if the fund managers had no skill and didn't outperform their index.

We don't buy or own any ETFs because we are confident that our fund managers will beat their index over time - so why own an index investment that will underperform the index?

Wow, that was longer than I intended!

In short, we think the effort involved in identifying All Star Fund Managers is worth the effort and produces better returns for us and our clients than we could by choosing individual stocks or ETFs.



Ed

[edrempel]

The reason the wealth gap in Canada is relatively smaller than the USA is because strategies like the SM haven't been overly successful, historically. If you want to get rich in Canada, you need to earn money the old fashioned way, by working, by building a business, just plain stealing it or leeching it off taxpayers as a civil servant.

Very funny, Mark :)

You forgot marrying it...

One point though. I think you have it backwards on the wealth gap. We think one of the main reasons there are so many more wealthy people in the US than in Canada is because mortgages are already tax deductible there. We can create it over time in Canada, but in the US it is tax deductible from the beginning.

That sounds like just a tax rule, but we think it has a much more profound effect on people's lives than just the tax savings. Most Canadians spend the bulk of their working life focused on paying off their mortgage. In the US, from when they are young, they are focused on building wealth. The attitude is that you are much better off investing your money than paying it down on your mortgage since it is a low rate and deductible.

Canadians are focused on paying off debt, while Americans are focused on building wealth. That is the reason there are so many more wealthy people there.

This attitude contributed a lot to their recent real estate and debt bubbles popping, but we think it is still one of the main reasons there are so many more millionaires in the US than in Canada.



Ed

[xlfe]

that is an impressive fountain of knowledge....
interesting conclusion to focus on the manager more so than the actual investment product!

i have to ask though, what would be the best way to invest on an index?
in my mind i always thought it was etfs.

[kerdon]

that is an impressive fountain of knowledge....
interesting conclusion to focus on the manager more so than the actual investment product!

i have to ask though, what would be the best way to invest on an index?
in my mind i always thought it was etfs.


The manager is the one making the decisions in the fund. Hence why I am not a big believer in the Morning star ratings, a fund can still be a 5 star funds even if the manager has recently left.

[edrempel]

Although this is not directly related to the current SM discussion between Mark77 and Ed Rampel, I thought I would share this article I just read in the Globe and Mail (it's about the SM)
http://www.theglobeandmail.com/globe-investor/personal-finance/preet-banerjee/deducting-mortgage-interest-takes-a-fortitude-many-lack/article1766530/

Hi Jungle,

Thanks for pointing it out, Jungle. I missed that article on Friday. It was well written.


Ed

[edrempel]

that is an impressive fountain of knowledge....
interesting conclusion to focus on the manager more so than the actual investment product!

i have to ask though, what would be the best way to invest on an index?
in my mind i always thought it was etfs.

Hi xlfe,

If you want an index, then the only questions are which index and how low can the MER be (although there are often other feature to note). An ETF is probably the best - that is if you are satisfied with under-performing an index average return. :)

We would think that a better strategy would be to invest with an All Star Fund Manager that invests in the same area as that index. That does mean you would likely have very different holdings, since the top fund managers have holdings almost completely different from the index (usually less than 20% in common with the index). This is because most are looking for under-valued companies, which are often over-looked companies outside the index.

Remember that when you are picking and index, it is you making the choice. Therefore, it is amateur investing.

We usually try to choose a broader mandate and let the fund manager determine the allocation. That way, the amount in a specific country or sector is determined by the fund manager, which would make it a professional investment decision.

Most of the top fund managers don't specifically make an allocation decision at all. They do tons of research to identify the best companies to invest in and let the allocation be determined by where they find the best value or most growth potential. All Star Fund Managers are more likely bottom-up investors, rather than top-down investors.




Ed

[sTeViE26]

This post is mainly directed towards Ed:

What are the current rates on investment loans that you would utilize for the Rempel Maximum strategy (ie. prime +_)? Do you usually deal with the mutual fund companies themselves, or banks and trust companies for the loans?

As for the mortgage itself, who's offering the best rates on the LOC portion? I've heard prime +0.5 to +1.0 is the norm right now, but I heard FirstLine offers discounts on the LOC portion if you get a fixed rate mortgage - does anyone know what their dicount is? Prime?

Thanks.

[Jungle]

This post is mainly directed towards Ed:

What are the current rates on investment loans that you would utilize for the Rempel Maximum strategy (ie. prime +_)? Do you usually deal with the mutual fund companies themselves, or banks and trust companies for the loans?

As for the mortgage itself, who's offering the best rates on the LOC portion? I've heard prime +0.5 to +1.0 is the norm right now, but I heard FirstLine offers discounts on the LOC portion if you get a fixed rate mortgage - does anyone know what their dicount is? Prime?

Thanks.

From reading a few HELOC threads, prime + 0.5 is about the best you can get for HELOC right now. I have that rate and I had to complain and fight for it, all the way to head office. So it may not be easy. I have read of some rare exceptions of one guy posting prime + 0 . I don't know how he got that rate. (maybe a lot of $$ in investments?)

[edrempel]

This post is mainly directed towards Ed:

What are the current rates on investment loans that you would utilize for the Rempel Maximum strategy (ie. prime +_)? Do you usually deal with the mutual fund companies themselves, or banks and trust companies for the loans?

As for the mortgage itself, who's offering the best rates on the LOC portion? I've heard prime +0.5 to +1.0 is the norm right now, but I heard FirstLine offers discounts on the LOC portion if you get a fixed rate mortgage - does anyone know what their dicount is? Prime?

Thanks.

Hi Stevie,

The interest rates on investment loans vary, depending on the type of loan and the amount, but are generally between prime +.75% to Prime +1.5%. Rates can also be lower if you are willing to restrict your investment choices to a short list of companies, which we rarely do. There is some flexibility in the rates and we can often get a lower rate because of the volume we do. A very strong client can get a lower rate as well.

The mutual fund companies have essentially left the investment loan business (since AGF essentially blew up by taking too many Smith/Snyder loans) and the banks have too many restrictions on their loans, so we work mostly with a couple of trust companies - mainly B2B & MRS.

Jungle is right that generally prime +.5% is the best for the LOC portion of the mortgage. This rate varies between banks, with banks that have a higher LOC rate sometimes having a lower mortgage rate. The best overall package for each client depends on how large their mortgage vs. LOC portions are.

We have not been working with FirstLine, since they do not offer the 1-year or variable mortgages we recommend. We are hesitant to lock in for years at a higher rate and give up all our flexibility, even if it would give us a bit lower LOC rate. Studies consistently show that locking in longer term almost never works for the client. We believe that nearly all mortgage foreclosures are 5-year fixed mortgages and I think people would be surprised to hear how many people with 5-year fixed mortgages end up paying the penalty to get out.


Ed

[xlfe]

Hi xlfe,

If you want an index, then the only questions are which index and how low can the MER be (although there are often other feature to note). An ETF is probably the best - that is if you are satisfied with under-performing an index average return. :)

We would think that a better strategy would be to invest with an All Star Fund Manager that invests in the same area as that index. That does mean you would likely have very different holdings, since the top fund managers have holdings almost completely different from the index (usually less than 20% in common with the index). This is because most are looking for under-valued companies, which are often over-looked companies outside the index.

Remember that when you are picking and index, it is you making the choice. Therefore, it is amateur investing.

We usually try to choose a broader mandate and let the fund manager determine the allocation. That way, the amount in a specific country or sector is determined by the fund manager, which would make it a professional investment decision.

Most of the top fund managers don't specifically make an allocation decision at all. They do tons of research to identify the best companies to invest in and let the allocation be determined by where they find the best value or most growth potential. All Star Fund Managers are more likely bottom-up investors, rather than top-down investors.




Ed

hi

thanks for the reply, sorry for my tardiness in my reply!
woah didn't expect that.. 20% less in common.

with that said it wouldn't be fair to compare unless it was in a long time frame.

it's almost like rock paper scissors. there's the index, the all star fund which could possibly beat it but has mer and etfs with lower mers but can't hope to beat the index.

[edrempel]

hi

thanks for the reply, sorry for my tardiness in my reply!
woah didn't expect that.. 20% less in common.

with that said it wouldn't be fair to compare unless it was in a long time frame.

it's almost like rock paper scissors. there's the index, the all star fund which could possibly beat it but has mer and etfs with lower mers but can't hope to beat the index.

Hi xlfe,

"Rock, paper, scissors"? Does that mean you think the 3 are similar in potential?

The index is not really a comparison, since you cannot buy an index per se. You can only buy an ETF or index fund. That means you definitely make a bit less than the index.

Only the mutual fund could make more. The "average" mutual fund usually makes less than the index, so that would probably not be a good choice either, but there are always some funds that do beat the index. It is not as easy as picking last year's winners or buying "5-Star funds" (also recent hot performers). One study showed that, on average, 2-Star funds out-performed 5-Star funds going forward.

We think the key is not the fund, but the fund manager, so the best choice is to invest in mutual funds (or hedge funds) with All Star Fund Managers. In order to beat an index, a fund manager must invest much differently from the index. However, the Yale study showed that, of funds that had less than 20% of their holdings in common with the index, the average fund beat the index.

All of our fund managers have beaten the index over long periods of time (their career). Many people may be surprised by how much fund managers can sometimes beat the index. Two of our core global and Canadian fund managers have beaten the TSX and MSCI World indexes by 10%/year compounded for the last decade - which is a huge difference. Both have essentially no holdings in common with their index.

In short, we think the answer to "average" (fund under-performing) is not "amateur" (picking your own stocks) - it is "All Star".



Ed

[superping]

There is a flaw in "Choosing the Star Fund manager " strategy. The problem is that the investment links to the Fund company, not the fund manager.

The "Star" Fund Manager, are like everybody else. They move from one company to the other for better pay, compensation and promotion.

Most actively manage fund comes with high MER + DSC (defer sale charge penalty if you leave before 7 years). What happen if the "Star Fund Manager" moves to a new company?

Average investor are pretty much stuck with the same fund company (+ high MER + below index performance) for the remaining terms. :cry: OR pay 5% DSC penalty and follow the "Star" Fund Manager. In the meantime, the "advisor" makes another sale + more commission.

[Sanchez]

There is a flaw in "Choosing the Star Fund manager " strategy. The problem is that the investment links to the Fund company, not the fund manager.

The "Star" Fund Manager, are like everybody else. They move from one company to the other for better pay, compensation and promotion.

Most actively manage fund comes with high MER + DSC (defer sale charge penalty if you leave before 7 years). What happen if the "Star Fund Manager" moves to a new company?

Average investor are pretty much stuck with the same fund company (+ high MER + below index performance) for the remaining terms. :cry: OR pay 5% DSC penalty and follow the "Star" Fund Manager. In the meantime, the "advisor" makes another sale + more commission.

Well it seems like the solution to your "problem" is pretty simple then - invest in one of the hundreds or thousands of funds that don't charge a DSC, front-end or back-end load (not that I advocate investing in mutual funds at all).

[edrempel]

There is a flaw in "Choosing the Star Fund manager " strategy. The problem is that the investment links to the Fund company, not the fund manager.

The "Star" Fund Manager, are like everybody else. They move from one company to the other for better pay, compensation and promotion.

Most actively manage fund comes with high MER + DSC (defer sale charge penalty if you leave before 7 years). What happen if the "Star Fund Manager" moves to a new company?

Average investor are pretty much stuck with the same fund company (+ high MER + below index performance) for the remaining terms. :cry: OR pay 5% DSC penalty and follow the "Star" Fund Manager. In the meantime, the "advisor" makes another sale + more commission.

Hi Superping,

We have not really had much of an issue with at all. Top fund managers are rarely employees of someone else's corporation. They can make 10-100 times as much by setting up their own investment firm and getting contracts from fund companies. These contracts tend to remain, since the arrangement works well for both. The fund manager can usually also handle private money or get contracts with other fund companies. They won't quite their own company.

Also, if a fund manager moved and we thought it was best to follow him, we (and many advisors) would reimburse all the fees, so that the it costs our clients nothing to stick with the same fund manager.

We tell our clients that, as long as you follow your long term plan, you should never have to pay a DSC fee.


Ed

[Mark77]

Average investor are pretty much stuck with the same fund company (+ high MER + below index performance) for the remaining terms. :cry: OR pay 5% DSC penalty and follow the "Star" Fund Manager. In the meantime, the "advisor" makes another sale + more commission.

Yeah, and the research doesn't show that finding and maintaining 'star fund managers' is sustainable over the long term. Mr. Rempel might have gotten lucky throughout his career, but past performance is no prediction of future results.

[edrempel]

Yeah, and the research doesn't show that finding and maintaining 'star fund managers' is sustainable over the long term. Mr. Rempel might have gotten lucky throughout his career, but past performance is no prediction of future results.

Hey Mark,

What's with the formality? Haven't we debated long enough that you can call me Ed?

Actually, the in-depth research we've seen does support that the best fund managers tend to continue to out-perform. The most in-depth one I've seen by 2 Yale researchers (http://www.edrempel.com/pdfs/Active%20Share%20Study%20-%20How%20Active%20Is%20Your%20Fund%20Manager.pdf ).

Most of the studies of fund managers are extremely simplistic and just look at Morningstar ratings or the top performers over a certain time period. Identifying an All Star Fund Manager takes a ton of research, understanding how they pick stocks, why they think they beat the index, meeting them, analyzing the portfolio, etc. Of course, every top fund manager has periods of time when they under-perform because they tend to have portfolios very different from the index. That is part of what makes them a challenge to identify.

If you do enough research to really identify the superior stock pickers with superior skill, they tend to maintain it.




Ed

[GonePostal]

Hey Mark,

What's with the formality? Haven't we debated long enough that you can call me Ed?

Actually, the in-depth research we've seen does support that the best fund managers tend to continue to out-perform. The most in-depth one I've seen by 2 Yale researchers (http://www.edrempel.com/pdfs/Active%20Share%20Study%20-%20How%20Active%20Is%20Your%20Fund%20Manager.pdf ).

Most of the studies of fund managers are extremely simplistic and just look at Morningstar ratings or the top performers over a certain time period. Identifying an All Star Fund Manager takes a ton of research, understanding how they pick stocks, why they think they beat the index, meeting them, analyzing the portfolio, etc. Of course, every top fund manager has periods of time when they under-perform because they tend to have portfolios very different from the index. That is part of what makes them a challenge to identify.

If you do enough research to really identify the superior stock pickers with superior skill, they tend to maintain it.




Ed

Honest question.

Wouldn't it be easier and more profitable to put all that effort into learning to pick winning investments? I would imagine (since I have never actually tried) that evaluating a fund manager is as complex or more complex then evaluating an investment such as a stock.

[Germack]

I believe picking only Star Fund Managers sounds good on paper but does not really work in real life.

Looking back at historical data is just not useful to develop successful investment strategies. There is so much data available that you can basically prove what ever you want e.g. fund managers where the last name starts with Q will outperform the market.

People often confuse random events with causation. A good example of this was shown by a paper of David Leinweber called "Stupid Data Mining Tricks". He showed that the best predictor of the S&P 500 was the butter production in Bangladesh. I guess no one here would base there investment decision based on the butter production in Bangladesh.

[edrempel]

I believe picking only Star Fund Managers sounds good on paper but does not really work in real life.

Looking back at historical data is just not useful to develop successful investment strategies. There is so much data available that you can basically prove what ever you want e.g. fund managers where the last name starts with Q will outperform the market.

People often confuse random events with causation. A good example of this was shown by a paper of David Leinweber called "Stupid Data Mining Tricks". He showed that the best predictor of the S&P 500 was the butter production in Bangladesh. I guess no one here would base there investment decision based on the butter production in Bangladesh.

Hi Germack,

Thanks for the article. I had not read it before. You make a good point, but the "Stupid Data Miner Tricks" would apply more to analyzing ETFs and stocks, and somewhat less when it comes to analyzing fund managers.

It would apply if you only analyze data about the mutual fund, but evaluating a fund manager should involve a lot more analysis about the person. What is his unique edge, what is his style, does he try to create a fund that sells or focus just on performance, does he have a boss telling him what to do, is he ethical, does he suffer from style-drift, how smart and connected is he, how hard-working is he, etc.

The "Stupid Data Miner Tricks" does explain why the stock-selection screens used so commonly usually lead to under-performing investments. The same is true for technical analysis (charts).



Ed

[SustainablePF]

Hi Ed,

Do you have any thoughts on DF and DS (they seem to be MF in that there are fees included, but they are publicly traded)? Yield is fantastic but the fees are cloudy at best. For people employing the SM to use dividends to pay off the mortgage more quickly and free up more money to invest the yield of 10%+ is attractive.

Thanks,
Sustainable PF

[SustainablePF]

I just wanted to add that I do understand that you prefer growth stocks over dividend stocks, but if you would be so kind as to give an opinion on those holdings I would appreciate it Ed.

[edrempel]

Honest question.

Wouldn't it be easier and more profitable to put all that effort into learning to pick winning investments? I would imagine (since I have never actually tried) that evaluating a fund manager is as complex or more complex then evaluating an investment such as a stock.

Hi Gone Postal,

That's a great question. That would make a good article. Here is how we see it.

You are right that analyzing fund managers effectively is quite complex. However, we think it is worthwhile analyzing All Star Fund Managers, instead of individual stocks for a few reasons:

1. Quality of the investor - The stocks a top fund manager would pick would be far better than what I could find. I've been in the investment industry for 16 years and am also an accountant, so I know how to analyze stocks, but we talk with these fund managers regularly and I get to see how much more they know and do. They know so much more about the companies, management, competitors, industry, etc. Most of our fund managers are global, not just in Canada and the US, and often they will pick smaller caps or mid-caps.

For example, last week one our fund managers was telling us about a mid-cap company in Malaysia selling at a P/E of only 7, has zero debt, has been growing profits at 40%/year, a dynamic management and is in an industry with great long term growth potential. That looks like an awesome investment! How would I find a company like that?

2. Number of choices - You can have a well-diversified portfolio with 3-5 mutual funds, but you need at least 20-30 stocks to be properly diversified.

3. Less monitoring - Fund managers we identify as being superior stock pickers usually tend to maintain their skill. Most remain among our top choices for quite a few years. Individual stocks require constant monitoring.

4. Only need to be right once - With stocks, you need to decide when to buy and when to sell. With fund managers, we stick with them as long as we believe they are an All Star Fund Manager.

5. Measure risk & return - With a bunch of individual stocks, it is hard to understand the risk level. Any stock is far more volatile than a mutual fund, and you can reduce this with diversification, but measuring it is difficult. Most amateur portfolios I've seen are either several times the index risk (so a blow-up is inevitable) or quite a bit more conservative (so that the will likely underperform the index). With a mutual fund, there are all kinds of risk stats.

We do quite a bit of leverage so this is important. It is one thing if you are investing $5,000 or $50,000, but if you are investing $500,000 or $5 million, measuring risk is important. This is especially important if the $500,000 is borrowed.

6. Better chance to beat the index - When we invest with a fund manager that has beaten his index by a wide margin over his career and we believe it is because of skill, I have confidence that we have a good chance of out-performing. If I buy an ETF, I have zero chance to beat the index. If I pick individual stocks, can I beat the index other than by being more risky?

7. Peace of mind - I can go on vacation with complete confidence that my fund managers are on top of anything that happens. I've seen lots of amateur investors worried about their stocks while on vacation. So sad! Even if there is dramatic news, I can relax on my entire vacation.

In short, why would we try to play like Sidney Crosby when we could just hire him?





Ed

[TheCris]

Hi Ed,
From what you wrote here, you have great experience doing the SM and I would like to work with you, but your investment strategy a little blurry for me, can you explain it a little bit? The “All Star Managers”; 10% return sounds wonderful, but without being able to verify it, I am worried. If I become your client, will I be able to know the mutual fund(s) where my money goes to? Can I check the fund’s performance history? In other words; what will be my contribution and my rights in the investment part?

What is the exit strategy? And this applies to everybody doing the SM, investing in mutual funds.

Building your wealth is wonderful, but me for example, I want to do it to retire early. That means that at one point in time (15 to 25 years) I will stop contributing and will need a steady and secure income from my investment. How do you see this?
Keeping the investment and withdrawing from it is risky because the market can crash and you do not have time to recover.
Moving everything into GIC/Bonds/Money Market sounds safe but what do you do with taxes when you sell your portfolio and have let’s say 400k to 600k capital gain to pay taxes for?

Cris

[kerdon]

Hi Ed,
From what you wrote here, you have great experience doing the SM and I would like to work with you, but your investment strategy a little blurry for me, can you explain it a little bit? The “All Star Managers”; 10% return sounds wonderful, but without being able to verify it, I am worried. If I become your client, will I be able to know the mutual fund(s) where my money goes to? Can I check the fund’s performance history? In other words; what will be my contribution and my rights in the investment part?

What is the exit strategy? And this applies to everybody doing the SM, investing in mutual funds.

Building your wealth is wonderful, but me for example, I want to do it to retire early. That means that at one point in time (15 to 25 years) I will stop contributing and will need a steady and secure income from my investment. How do you see this?
Keeping the investment and withdrawing from it is risky because the market can crash and you do not have time to recover.
Moving everything into GIC/Bonds/Money Market sounds safe but what do you do with taxes when you sell your portfolio and have let’s say 400k to 600k capital gain to pay taxes for?

Cris

He'll get you 10% which will include ROC(return of capital), you will get a 10% payout, some of this will be your own money getting paid back to you. This will bring down your ACB(adjusted cost base), and yes you will have a capital gain to pay in the end on the investment.
Take this one:

http://www.iaclarington.com/en/products/mutual-funds/corporate-class-funds/dividend-growth-class-t10.aspx

It started as a T10 class, but is now paying out approx 8.3c/unit/month, the NAVPU is 12.33 = 8% payout approx.

Look at the fund details and you will see that it is mostly ROC, and the underlying holdings are mainly banks yielding approx 4% through dividends.

The advisor will likely DSC the fund also, collect the 5% commission up front, and tell you its a long term strategy and you don't have to pay anything, each year he will redeem 10% of the fund and roll it into a 0% commission front end same fund and collect a 1% trailer.

Just FYI.

[Anonymouse]

Does TD still offer the kind of HELOC that has the feature that as you pay down the mortgage, the available credit on your HELOC goes up concomitantly? My TD advisor didn't seem to think so, but this conflicts with information I've read elsewhere.

[Mark77]

What is the exit strategy? And this applies to everybody doing the SM, investing in mutual funds.


The dividend stream on one's investments should over time grow at a rate that is adequate to make the mortgage payments, and ultimately, extinguish all debt arising from the SM. If you're not investing in stuff that pays a dividend, or will eventually pay a dividend, then you're not doing the SM correctly (and you will have a hard time deducting the interest on money borrowed to invest if the CRA catches up with you!).

[netriones]

People need to understand the risk of borrow to invest. It increase both profit and loss. It's same for business. The business that borrows more in terms of it's net worth is perceived as more risky.

[edrempel]

Hi Ed,
From what you wrote here, you have great experience doing the SM and I would like to work with you, but your investment strategy a little blurry for me, can you explain it a little bit? The “All Star Managers”; 10% return sounds wonderful, but without being able to verify it, I am worried. If I become your client, will I be able to know the mutual fund(s) where my money goes to? Can I check the fund’s performance history? In other words; what will be my contribution and my rights in the investment part?

What is the exit strategy? And this applies to everybody doing the SM, investing in mutual funds.

Building your wealth is wonderful, but me for example, I want to do it to retire early. That means that at one point in time (15 to 25 years) I will stop contributing and will need a steady and secure income from my investment. How do you see this?
Keeping the investment and withdrawing from it is risky because the market can crash and you do not have time to recover.
Moving everything into GIC/Bonds/Money Market sounds safe but what do you do with taxes when you sell your portfolio and have let’s say 400k to 600k capital gain to pay taxes for?

Cris

Hi Cris,

Thanks for your comments.

If you want to work with us, the main reason should be for our financial planning expertise, not just to do the Smith Manoeuvre. We are a boutique financial planning firm that focuses on planning. We prepare a professional, comprehensive written financial plan for every client for no charge, but we are selective on who we work with and are looking for clients that want to work 100% with us. We find this gives our clients the best chance of achieving their life goals. I can explain this if you like.

We believe leverage done right is an effective strategy and have quite a few clients doing the Smith Manoeuvre, but we only do it as part of a financial plan. We find that the plan is what most people need most in order to have the life they want and that the Smith Manoeuvre fits in very well in quite a few cases.

Our investment strategy, in short, is that we focus on analyzing fund managers to try to identify what we call "All Star Fund Managers". They are fund managers that have beaten their index over long periods of time (usually at least 10 years or over their career), have superior stock picking skill, and that we believe should continue to outperform their index and peers (based on their risk level) over time.

The average fund makes less than the index, but like in any other field, there are fund managers with superior skill. Identifying them is a long, in-depth process. Post #1172 has more detail about it.

The key point is that we are focused on the fund manager, not the fund. So, it is not us trying to figure out the allocation or choose a sector or region by choosing a mutual fund that fits our outlook. We believe these decisions should be made by the fund manager.

The 10%/year figure I quoted was not the return. It was the amount by which a couple of our All Star Fund Managers beat their index in the last decade - which is huge.

We do quite a bit of leverage. Having confidence in our fund managers in an important component of having confidence to leverage and kept us confident even at the bottom of the market crash in early 2009.

If you become a client, of course you would know what specific fund managers and funds we would be recommending for you beforehand. Details about the fund managers, their performance and we why recommend them specifically in your case would be part of your written financial plan.

Your question about your role and rights is an interesting one. Most of our clients leave this completely up to us, since we have a well-researched, customized investment process and have done a lot of research to identify the best fund managers. However, in the end, it is your money, so if you want to discuss or suggest ideas, that is fine.

The issue here is that the suggestions we get from clients are usually not good ideas, at least in our opinion. Suggestions from clients are usually something that has performed well recently or is currently popular - instead of being something we would consider to be a high quality investment. So, we might strongly recommend against your suggestions.

What involvement would you like to have in the investment process, Cris?

The best exit strategy is NOT to exit. Your questions about exit strategy and tax on the investment income after you retire take a little explaining. You are thinking correctly that, if you do the Smith Manoeuvre, it is best that it be part of your long term retirement plan.

The Smith Manoeuvre for our clients is not just a cool tax & investment strategy - it is an important part of their retirement plan. In some cases, we sell enough to pay off the investment loan when they retire, but in most cases, we maintain the investment loan and investments for life.

The reason this is important is that borrowing to invest is a risky strategy and the best way to reduce that risk is to make it a long term strategy. When you retire, you probably still have 30 years in front of you, which is definitely "long term". So there is lots of time for investments to recover from bear markets.

Historically, there has been 1 or 2 bear markets every decade, but the markets have recovered within 2 years 88% of the time. Most people believe the stock market is far more erratic than it actually is.

Even after 2008, we have retired clients that have maintained the Smith Manoeuvre and they are fine. In some cases, we had to reduce their monthly withdrawals from the investments, but by staying invested, they should all recover fully in time.

The other reason that it often makes sense to maintain the Smith Manoeuvre after retirement is that the interest deduction may make a bigger difference after retirement than before. When you add the clawbacks on various government income and tax programs to income tax, many Canadians are in higher tax brackets after they retire than before.

If you maintain your investments after you retire and just sell a bit each month to provide your retirement income, our experience is that, in most years, the tax on the investment income is still less than the tax saved by the interest deduction. This is because it is only the 1/2 of the gain portion that is taxable.

For example, let's say you retire with $500,000 investments and take out 6%/year, or $30,000/year, and the original loan was $250,000. Then the amount invested of your $30,000 is $15,00, so your gain is only $15,000. Only half the gain is taxable, or $7,500. Meanwhile, you may still have a $10,000 interest deduction (assuming 4% interest rate on $250,000).

Therefore, you receive $30,000 in income, while paying only $10,000 in interest, but you pay no tax on your income. In fact, you get a tax refund!

Does this answer your questions, Cris?



Ed

[ACC-Major]

Nice Ed, you pretty much sums up what we need to know on picking good funds.



1. Quality of the investor - The stocks a top fund manager would pick would be far better than what I could find. I've been in the investment industry for 16 years and am also an accountant, so I know how to analyze stocks, but we talk with these fund managers regularly and I get to see how much more they know and do. They know so much more about the companies, management, competitors, industry, etc. Most of our fund managers are global, not just in Canada and the US, and often they will pick smaller caps or mid-cap.

For example, last week one our fund managers was telling us about a mid-cap company in Malaysia selling at a P/E of only 7, has zero debt, has been growing profits at 40%/year, a dynamic management and is in an industry with great long term growth potential. That looks like an awesome investment! How would I find a company like that?

Yes, smaller caps and mid caps do give you better returns that is only if you are right. If you are wrong, you can easily lose up to 50%+ of the fund assets. Then the fund gets folded and they will start a new one.

I wonder how is that low P/E, zero debt, 40% growth/year company is doing now. What industry would that be? I know managers have the time to seek out good stocks, and that their connections will certainly help in the search for great companies. However, due to industry regulations, managers are restricted from the following:
1) To invest in certain small caps (too small, or priced too low like penny stocks, not saying that penny stocks are lowly priced, in fact they are heck of an expensive category)
2) Owning certain percentage of a company
3) Certain percentage of the fund's allocation to a single company

Therefore, your low P/E, zero debt, 40%growth/year company might just add like 1-1.5% to the bottom line. Rest of the fund will be allocated to other companies that don't have a low P/E, zero debt, 40% growth/year.



2. Number of choices - You can have a well-diversified portfolio with 3-5 mutual funds, but you need at least 20-30 stocks to be properly diversified.

It is hard enough to pick out a good fund, and you want us to try and pick 3-5?
I don't diversify much. In fact 50% of my portfolio is in a single stock. My total holding never exceeded 10 stocks. I don't feel the volatility because I don't look at my portfolio for months. I only look at my portfolio when I know the market dropped significantly, that is when I back up the truck, not sell in a panic.



3. Less monitoring - Fund managers we identify as being superior stock pickers usually tend to maintain their skill. Most remain among our top choices for quite a few years. Individual stocks require constant monitoring.

Seriously? do you really needs to monitor stocks constantly? If you own a business, does your business constantly fluctuate in value? If you have done your home works before putting the money in, you should just ignore the short term fluctuations. The biggest mistake I have made in the past is to constantly monitor my stocks.



4. Only need to be right once - With stocks, you need to decide when to buy and when to sell. With fund managers, we stick with them as long as we believe they are an All Star Fund Manager.

But sir, you told us to pick 3-5 funds for diversification purpose. I wish I had invested in Berkshire Hathaway before I was born. Talk about being right only once. How would I know if the single fund I have picked is right before it appears to be right?



5. Measure risk & return - With a bunch of individual stocks, it is hard to understand the risk level. Any stock is far more volatile than a mutual fund, and you can reduce this with diversification, but measuring it is difficult. Most amateur portfolios I've seen are either several times the index risk (so a blow-up is inevitable) or quite a bit more conservative (so that the will likely underperform the index). With a mutual fund, there are all kinds of risk stats.

What is risk? Volatility? Beta? Alpha? Risks come from what you don't know, and the terms I have mentioned before are well known and got priced into the stock price.
I would rather own a volatile stock than a mutual fund that under performs the market constantly.



We do quite a bit of leverage so this is important. It is one thing if you are investing $5,000 or $50,000, but if you are investing $500,000 or $5 million, measuring risk is important. This is especially important if the $500,000 is borrowed.

You earn fast and lose fast, enough said.



6. Better chance to beat the index - When we invest with a fund manager that has beaten his index by a wide margin over his career and we believe it is because of skill, I have confidence that we have a good chance of out-performing. If I buy an ETF, I have zero chance to beat the index. If I pick individual stocks, can I beat the index other than by being more risky?

However, studies show that the chances of a fund that can't beat the index is greater than beating the index due to massive fees.
Yes, those index beaters do exist (including myself, but I manage an ultra small family fund). When their names are well known, money will start to pour into their funds, that is when the problems start.
As stated before, managers have numerous restrictions, they just can't buy to the point where they have some influences in a company due to regulations. So, the manager must go out and find 100 of those low P/E, zero debt, 40% growth/year companies. On the other hand, I can have 100% of my money dumped into that company if I want. My point is that it's much easier to manage a small fund than a big one.



7. Peace of mind - I can go on vacation with complete confidence that my fund managers are on top of anything that happens. I've seen lots of amateur investors worried about their stocks while on vacation. So sad! Even if there is dramatic news, I can relax on my entire vacation.

Yes, human nature do get the best of us. I truly agree with you 100% on this one. It is just not logical to worry so much especially on vacation. I mean, if you have done your home work and believes that the stocks you have picked will soar in the future, then there is nothing to worry about. Short term fluctuations in stock price is pure emotional, and does not reflect the long term prospect of a company.



In short, why would we try to play like Sidney Crosby when we could just hire him?

Not a big fan of hockey, I am a big fan of legendary investors.

[TheCris]

Hi Ed and thank you for your answer.
It did answer my questions, but only partially and unfortunately not necessary what I wanted to hear. :) Let me explain myself.



If you want to work with us, the main reason should be for our financial planning expertise, not just to do the Smith Manoeuvre. We are a boutique financial planning firm that focuses on planning. We prepare a professional, comprehensive written financial plan for every client for no charge, but we are selective on who we work with and are looking for clients that want to work 100% with us. We find this gives our clients the best chance of achieving their life goals. I can explain this if you like.

I understand the advantage of a written plan and I acknowledge the merits of a good financial advisor that is why I am looking for one. To find a FP to work with I have to understand him in order to trust him. I will not give you 400 to 600k in the next few decades, money that I borrowed if our relationship isn’t fully based on trust. From your posts in this thread what I didn’t understood and for this reason trust is the investment part.
The “we are selective on who we work with and are looking for clients that want to work 100% with us” part worries me; and I am not afraid you will say you don’t want to work with me; I am afraid that you will say you want to work with me. I want to work with someone that I fully trust (and he trusts me) and in the moment I don’t trust him any more I will leave. The “fear factor” will not make me trust you. There is an add at diamonds I think that says: “the more you look, the better we look”. Do you see the difference between this and “we are selective on who we work with” and “ we are looking for clients that want to work 100% with us”. If you are the best, why shouldn’t work 100% with you?

Creating a written financial plan for free is a good start to build the trust. Do I have to sign a contract before the plan, because if so, than it is not free any more, and there is no trust either.



We do quite a bit of leverage. Having confidence in our fund managers in an important component of having confidence to leverage and kept us confident even at the bottom of the market crash in early 2009.


This is exactly what I am looking for too. Trust and confidence in my FP. How do you build this with your client regarding the investment part? How can I be confident that the "All Star Fund Managers" exists and they really are as good as you say they are?



What involvement would you like to have in the investment process, Cris?


I think I explained what I am looking for, but let me reiterate it. I do not want to make suggestions; you are the expert; that’s why I came to you. I want to build confidence in you. But I am an analytical person. I want proof not words. ;)



The best exit strategy is NOT to exit. Your questions about exit strategy and tax on the investment income after you retire take a little explaining. You are thinking correctly that, if you do the Smith Manoeuvre, it is best that it be part of your long term retirement plan.


As I sad, I am not an investing expert, but I am trying to see this from the point of view of a person who retires, and for the “do not exit” strategy I have some concerns. Let me give some examples:
- When I retire I look for a steady and secure income. Having to “reduce my monthly withdrawals from the investments” doesn’t sound right for me.
- if at one point I have 400k, with a growth of only 4% I will be able to withdraw 10 more years; but if the market crushes and my portfolio drops at 200K and stays down for a while I will be able to withdraw only 4 years. This isn’t a long term investment any more.
- I have a 500K loan. When I retire, I will sell my 625k house and move to a smaller 300k one. I will have to pay down at least 260k from my loan. You don’t want me to pay takes on 130k do you?

[TheCris]

The advisor will likely DSC the fund also, collect the 5% commission up front, and tell you its a long term strategy and you don't have to pay anything, each year he will redeem 10% of the fund and roll it into a 0% commission front end same fund and collect a 1% trailer.


Honestly, I did understood NOTHING from what you said here, but the way you said it looks serious :)

It looks like I have to start doing my homework if I don’t want to lose my money. And I was really hoping to be able to find an “All star financial planner” and don’t worry about my investments any more.

Seriously guys; if I am not good at investing the only chance to have good investments is to become good at it?

Cris.

[TheCris]

The dividend stream on one's investments should over time grow at a rate that is adequate to make the mortgage payments, and ultimately, extinguish all debt arising from the SM. If you're not investing in stuff that pays a dividend, or will eventually pay a dividend, then you're not doing the SM correctly (and you will have a hard time deducting the interest on money borrowed to invest if the CRA catches up with you!).

Maybe is my ignorance, or lack of knowledge, but I thought most mutual funds don’t pay dividends and yet peoples on this thread are using SM with mutual funds. How come?

[Mark77]

Maybe is my ignorance, or lack of knowledge, but I thought most mutual funds don’t pay dividends and yet peoples on this thread are using SM with mutual funds. How come?

Plenty of mutual funds pay dividends. As has been written earlier, the best results with the SM likely will come from cost-efficient ETFs which almost always pay dividends.

[ACC-Major]

Maybe is my ignorance, or lack of knowledge, but I thought most mutual funds don’t pay dividends and yet peoples on this thread are using SM with mutual funds. How come?

When you go buy a mutual fund, the financial planner will want you to sign a dividend reinvestment form and other reinvestment forms such as capital return reinvestment form. You won't get the dividends deposited in to your bank account, it will be used to buy more fund shares. Therefore, it feels like you never got a dividend before. However, on your tax slip, it will indicate how much dividend and return of capital you received. That dividend alone, no matter how small will qualify you to deduct interests from borrowing to invest.

[TheCris]

When you go buy a mutual fund, the financial planner will want you to sign a dividend reinvestment form and other reinvestment forms such as capital return reinvestment form. You won't get the dividends deposited in to your bank account, it will be used to buy more fund shares. Therefore, it feels like you never got a dividend before. However, on your tax slip, it will indicate how much dividend and return of capital you received. That dividend alone, no matter how small will qualify you to deduct interests from borrowing to invest.

If I reinvest the dividends and the CR, will I have to pay taxes for the year I get it?

[ACC-Major]

If I reinvest the dividends and the CR, will I have to pay taxes for the year I get it?

yes sir

[TheCris]

yes sir

Then what Mark said is the correct strategy: cost-efficient ETFs giving dividends from Canadian companies which are tax efficient. The problem is what about diversification?

[ACC-Major]

Then what Mark said is the correct strategy: cost-efficient ETFs giving dividends from Canadian companies which are tax efficient. The problem is what about diversification?

Most ETF's are widely diversified, except for sector ETF's.
If you choose a dividend paying ETF, it usually consists of the financial, oil and gas, utilities, Real Estate etc... They are pretty diversified.

[DanP]

So i spent about the past half hour reading through the last sets of posts and all i could think was, "Never argue with a fool, onlookers may not be able to tell the difference"

Not saying which one i think the fool is, but this seems a bit much. The only thing i wanted to add was when comparing mutual funds to index returns, i don't think that's a fair comparison at all. I think more mutual funds then not don't try to beat the index. Alot of mutual funds carry fixed income, they have GICs, cash, and bonds. If you look at a balanced mutual fund, with a medium risk tolerence, it'll be made up of 60% equities, and 40% fixed income. How can something that has just over half in equities possibly beat an index? Now in down turn years, that balanced mutual fund will definitly beat an index.

I just dont think that indexes can be compared to mutual funds...everything has a place in a porfolio. Saying anything else would be a generalization....is cash better then stocks? Well in 2008 it was...so was the average mutual fund. In 2009, holding equities would have made u tonnes of money....im sure not many mutual funds beat indexes that year because rarely is the average mutual fund invested 100% in equities. So perhaps the best idea is to hold some mutual funds, some cash, and some personal stocks. Diversifcation is everything...

At the end of the day, and this argument over "all star managers" and indexes or self made porfolios is sort of nonsense. These are all tools to financial security. There's alot more to financial planning then fixating on returns.

[TheCris]

Most ETF's are widely diversified, except for sector ETF's.
If you choose a dividend paying ETF, it usually consists of the financial, oil and gas, utilities, Real Estate etc... They are pretty diversified.

Sorry, my mistake. I was thinking lack of diversification because of: “dividends from Canadian companies which are tax efficient”.
Dividends from foreign companies are taxed as regular income.

[SustainablePF]

Plenty of mutual funds pay dividends. As has been written earlier, the best results with the SM likely will come from cost-efficient ETFs which almost always pay dividends.

Dangerous waters here. Many ETFs and MFs also pay out in non-tax friendly ways which neuter the value of the SM. (such as capital gains) This can make tax time REALLY messy.

IMO the best way to use the SM is blue chip aristocrat Cdn dividend payers that have growing yields over time.

[ACC-Major]

So i spent about the past half hour reading through the last sets of posts and all i could think was, "Never argue with a fool, onlookers may not be able to tell the difference"

lol. why do I get the felling that you are talking about me?



Not saying which one i think the fool is, but this seems a bit much. The only thing i wanted to add was when comparing mutual funds to index returns, i don't think that's a fair comparison at all. I think more mutual funds then not don't try to beat the index. Alot of mutual funds carry fixed income, they have GICs, cash, and bonds. If you look at a balanced mutual fund, with a medium risk tolerence, it'll be made up of 60% equities, and 40% fixed income. How can something that has just over half in equities possibly beat an index? Now in down turn years, that balanced mutual fund will definitly beat an index.

The only purpose why we are investing is to earn exceptional returns with the right amount of risks.
If a Mutual Fund consists of cash, GIC's, bond's ect... it will certainly not beat the market over the long term. They may appear to be doing good when the market crushes; however, when the recover (and they recover fast), it will leave your mutual funds in the dust. I am supportive of being fully invested. I know the good and bad of this method, and I am willing to accept the bad.

Hence, if you really want to carry 40% Cash, GIC, and Bonds in your portfolio, why not just just buy 60% equity index funds (like S&P500, TSX Composite) and then allocate your remaining 40% to cash, GIC, Bonds index funds? The MER for fixed income indices are usually below 0.25% whereas you are paying 2-3% MER for a mutual fund. Imagine, charging you 2-3% for carrying cash for you. If you come across a mutual consists of a huge cash position, you better be careful, you are paying 2-3% for someone to help you carry your cash.



I just dont think that indexes can be compared to mutual funds...everything has a place in a porfolio. Saying anything else would be a generalization....is cash better then stocks? Well in 2008 it was...so was the average mutual fund. In 2009, holding equities would have made u tonnes of money....im sure not many mutual funds beat indexes that year because rarely is the average mutual fund invested 100% in equities. So perhaps the best idea is to hold some mutual funds, some cash, and some personal stocks. Diversifcation is everything...

I have seem many mutual funds sits in cash when the market tanks (appear to be smart), and they are still sitting in cash when the market recovered (wow, what a loser). Most of the time, you do not know when the market will tank, not even the professionals. However, when the market recovers, it recovers super fast, and most of the time caught managers off guard while they are still sleeping with cash. There are many cases in the US where managers just use their clients' money to buy up toxic assets. It is basically a transition of money from your pockets to the banks' pockets.



At the end of the day, and this argument over "all star managers" and indexes or self made porfolios is sort of nonsense. These are all tools to financial security. There's alot more to financial planning then fixating on returns.

I have a friend who cares about taxes more than the returns. For example, he borrowed on margin to buy dividend paying stocks. The dividend yield was just enough to cover the margin interest rate at prime +1%. So, basically he is getting the upside potential of the stocks he bought with margin and leave the dividends to the bank. There is this tax advantages because you pay little taxes on dividends; however, you gets to deduct 100% on your interest expense. What happened? the stocks tanked, and margin called. You get the idea. I warned him (actually 2 other people did too) not to pursue this move, but he laid out the good's and bad's of this technique. And I was convinced that it sounds ok, and backed off. Conclusion, never ever use margin for long term purposes. By the looks of it, he was intended to hold the stocks for a long long long time due to tax advantages.

[DanP]

ACC-Major, overall, i actually agree with many of your points....Especially regarding mutual funds holding cash. Most mutual funds will usually hold bonds, a sector that not enough ppl research. I try to avoid balanced funds myself...i'd create my own split and save money on the MER's myself too.

The point im trying to get across is that mutual funds aren't for everyone, but they are there for some ppl. I actually work in personal finance, and the amount of ppl that come through my office that no nothing is amazing. They'll be 40 yrs old and have 250k sitting in a 1 yr redeemable term getting .50%. They just dont know better...u do. If u came into my office, i'd hand you a brochure on a discount brokerage and send you on your way.

I think EFT's are good vessels, but i do believe that mutual funds are good vessels also...both have a time and place for everyone.

And no, the fool was not you...i've read stuff by Ed on other blogs, and i just dont believe in his presentation, and "my way is the right way" attitude. Feels very close minded to me, and in an everchanging world that is finance, being close minded isnt something i can afford to do. But if you keep arguing with him......well lets just say there are smarter ways to spend your time on the internet...like looking at porn :)

[edrempel]

Hi Ed and thank you for your answer.
It did answer my questions, but only partially and unfortunately not necessary what I wanted to hear. :) Let me explain myself.


I understand the advantage of a written plan and I acknowledge the merits of a good financial advisor that is why I am looking for one. To find a FP to work with I have to understand him in order to trust him. I will not give you 400 to 600k in the next few decades, money that I borrowed if our relationship isn’t fully based on trust. From your posts in this thread what I didn’t understood and for this reason trust is the investment part.
The “we are selective on who we work with and are looking for clients that want to work 100% with us” part worries me; and I am not afraid you will say you don’t want to work with me; I am afraid that you will say you want to work with me. I want to work with someone that I fully trust (and he trusts me) and in the moment I don’t trust him any more I will leave. The “fear factor” will not make me trust you. There is an add at diamonds I think that says: “the more you look, the better we look”. Do you see the difference between this and “we are selective on who we work with” and “ we are looking for clients that want to work 100% with us”. If you are the best, why shouldn’t work 100% with you?

Creating a written financial plan for free is a good start to build the trust. Do I have to sign a contract before the plan, because if so, than it is not free any more, and there is no trust either.



This is exactly what I am looking for too. Trust and confidence in my FP. How do you build this with your client regarding the investment part? How can I be confident that the "All Star Fund Managers" exists and they really are as good as you say they are?



I think I explained what I am looking for, but let me reiterate it. I do not want to make suggestions; you are the expert; that’s why I came to you. I want to build confidence in you. But I am an analytical person. I want proof not words. ;)



As I sad, I am not an investing expert, but I am trying to see this from the point of view of a person who retires, and for the “do not exit” strategy I have some concerns. Let me give some examples:
- When I retire I look for a steady and secure income. Having to “reduce my monthly withdrawals from the investments” doesn’t sound right for me.
- if at one point I have 400k, with a growth of only 4% I will be able to withdraw 10 more years; but if the market crushes and my portfolio drops at 200K and stays down for a while I will be able to withdraw only 4 years. This isn’t a long term investment any more.
- I have a 500K loan. When I retire, I will sell my 625k house and move to a smaller 300k one. I will have to pay down at least 260k from my loan. You don’t want me to pay takes on 130k do you?

Hi Cris,

"Fear factor"? I never thought of it that way. Perhaps we need to word things differently.

Let me try to explain what I meant by "we are selective in who we work with." The issue is that there is a lot of work involved in preparing an effective financial plan - and we have talked with many people that want our help, but don't want a long term relationship of trust.

We have found that financial planning is about your life - it's not just numbers and investments - and that the most important part is actually having a written plan. It should define exactly what you want to do in your life and what you need to do to achieve it.

From experience, we have found that the plan means we are doing the right things, tells us what strategies to recommend, makes our recommendations relevant to your life, and helps keep us and you focused long term.

It takes us about 30 man-hours between 2 meetings, brainstorming the best strategies, writing and implementing a professional plan. So, we only want to do that if you are serious about working with us.

As far as we know, we are the only no-fee financial planning firm in Canada that prepares a professional written plan for every client. We have a trade-off that seems to work for us and our clients. We don't charge for preparing a written financial plan, for doing tax returns for clients or for any financial advice. We then want our clients to invest all their serious long term money with us, partly because that allows us to not charge for planning and partly so that we can have the best chance of making the return on investment required in their financial plan.

Over the years, we have had many people wanting us to prepare a plan, but not wanting to invest with us. They may want to invest with us only when stocks are moving up Or they may want to invest some with us and some in several other places, so they can add new money every year to whichever part did the best last year. Or they may want to invest each year based on whatever is popular. Or they may want to do some other ineffective investment strategy.

The other key issue for us, since we do quite a bit of leverage, is that you are focused on the long term plan. The big fear is what we call the "Big Mistake" - which is to sell or switch to more conservative investments after a decline. This is the single worst error in investing. So, we only want to recommend leverage to clients where we are confident they will stay focused long term and maintain faith in their investments when they are down.

You asked a great question about how to build trust and confidence with our client in the investment part. That is challenging. The best investments are not just the ones at the top of the performance charts. And all investments have periods of time when they underperform.

We have all kinds of data and information about our fund managers and we always explain why we think each one we recommend for you is an All Star Fund Manager and why he is appropriate for you.

We do believe in our investments. Every member of our team invests 100% of their money with the same fund managers and in the same funds we recommend for our clients (with similar risk tolerance).

I guess, though, in the end it comes down to trusting us that we know what we are doing.

All of this is what I meant with my comments. We'll have to think of a more positive way to express it.


Your retirement example shows the importance of always thinking long term. If you retire and have $400K in investments and need income of 4%, or $16,000/year, then we may want to invest so that we should make at least 6-8% or more/year long term. That way, we should be able to provide your target income for life - and possibly increase it by inflation every year.

Then if there is a market crash, we can still maintain the same strategy until your investments recover. Declines of 50% are actually very rare in the stock market. The stock market normally recovers much faster than most people realize. 88% of losing years since 1871 were fully recovered in 1 or 2 years.

Occasionally, it is best to adjust your income a bit to allow the investments time to recover. This may sound negative, but this process generally provides a significantly higher income than virtually any other strategy. We can guarantee your retirement income at 5%/year, but all guarantees have costs and will reduce your returns and your income.

Sorry, but I don't quite understand your downsizing question. Most of our clients don't want to downsize and we usually find you don't clear much money after all costs. Your example shows quite a bit of cash cleared up, much more than we usually see. There are a variety of strategies to handle that situation to minimize tax, though.






Ed

[TheCris]

Hypothetical questions :)

1. I want to do the SM and invest let’s say in dividend-paying blue-chip canadian stocks ETF’s. I have a starting loan to invest of 100k. How should I start?
- Invest all at once – Advantage: the dividends will start immediately and maybe the capital appreciation also.
- Invest a fixed amount, let’s say 10k each month - Advantage: take advantage of the “dollar cost average” per unit of ETF and maybe in the end (after 10 month) will have more than the first option. The potential loss is reduced by the fact that I do not have to pay interest on the amount that is not borrowed yet (opposed to invest all at once)
- Other option??

2. If in a few years if I decide to sell some of the ETF’s and by stocks, how will selling ETF’s influence the loan?
Ex: Have 140k in ETFs after a few years; the loan is 100k. During one year I sell 50k ETF and by 50K worth of stocks.
- Is the entire loan still tax deductible?
- What portion of 50K is ROC and I have to pay taxes on it?

[TheCris]

Your retirement example shows the importance of always thinking long term. If you retire and have $400K in investments and need income of 4%, or $16,000/year, then we may want to invest so that we should make at least 6-8% or more/year long term. That way, we should be able to provide your target income for life - and possibly increase it by inflation every year.


I thought it shows exactly the opposite. Let me explain.
My original question was “exit strategy” and you sad “do not exit”. My example was created on this assumption, so I will give more details: I retire at 50 with let’s say 600k portfolio designed for growth (8-10% return). At 70 I will have let’s say 400K. The question starts here. If the market crashes and will not recover fast and I will have 200K, withdrawing 50K/year the money will be over in 4 years. On the other hand with a 400K portfolio designed for let’s say capital preservation with 4% growth it we have crush and very slow recovery I will still have money for 10 more years so I can die broke at 80. :)
The point I was trying to prove is: can we always consider it “long term investment” even if we are 60 or 70? Can we “do not exit” forever? This is more a financial planning strategy than an investment one.



Occasionally, it is best to adjust your income a bit to allow the investments time to recover. This may sound negative, but this process generally provides a significantly higher income than virtually any other strategy. We can guarantee your retirement income at 5%/year, but all guarantees have costs and will reduce your returns and your income.


Again, this is not long term any more. I am retired for a few years already. If you ask me to reduce my income I will be really, really, unhappy. Don’t do this to a pour old man :)

Cris

[edrempel]

He'll get you 10% which will include ROC(return of capital), you will get a 10% payout, some of this will be your own money getting paid back to you. This will bring down your ACB(adjusted cost base), and yes you will have a capital gain to pay in the end on the investment.
Take this one:

http://www.iaclarington.com/en/products/mutual-funds/corporate-class-funds/dividend-growth-class-t10.aspx

It started as a T10 class, but is now paying out approx 8.3c/unit/month, the NAVPU is 12.33 = 8% payout approx.

Look at the fund details and you will see that it is mostly ROC, and the underlying holdings are mainly banks yielding approx 4% through dividends.

The advisor will likely DSC the fund also, collect the 5% commission up front, and tell you its a long term strategy and you don't have to pay anything, each year he will redeem 10% of the fund and roll it into a 0% commission front end same fund and collect a 1% trailer.

Just FYI.

Hi Kerdon,

I share your sentiment about that strategy. You are referring to the Smith/Snyder, which is one of the 7 main Smith Manoeuvre strategies. To our knowledge, we are the only financial planning firm in Canada doing the Smith Manoeuvre that does NOT do ONLY the Smith Snyder.

The Smith Snyder is a version that involves taking out a large investment loan to buy a fund (usually the Clarington fund you mentioned) that pays out a fixed monthly distribution of 8-10% (or sometimes more). It is usually used to pay down the mortgage and then borrow back on a linked credit line to buy the same (or a different) fund.

There is a tax problem with it because (as you pointed out), the fund pays mainly ROC (return of capital). The distribution is not income - it is paying your own principal back. If you borrow to invest, but then cash in the investment and spend the money, the loan is no longer deductible. This is what the ROC distribution does.

This strategy is popular because it LOOKS like you are paying your mortgage down very quickly. However, since every dollar of ROC received means a dollar of the investment loan is no long deductible, the mortgage is being replaced by a NON-deductible investment loan of the same amount. It does not reduce debt or non-deductible debt at all.

In addition, they invest all in one fund chosen mostly for its distribution, instead of investing in a portfolio chosen for its risk/reward. And you're right - its mainly banks with all 5 banks in the top 10 holdings. It's what we consider to be a "closet indexer".

We have modeled the Smith/Snyder and found that having NO distribution creates more wealth (believe it or not).




Ed

[TheCris]

After considering different scenarios, I believe the best thing for me (and maybe for others who will read this) will be to look for the following:

"Fee only planner who can create a professional written financial plan for me and my family, will include the Smith Manoeuvre in the plan and can offer long term investment recommendations. The investment part will be implemented by me or a broker."

Since I will invest 200K in the next couple of years, I think that 1% cost to create this plan is acceptable. If I am lucky and the planner will be able to save me some money in taxes and some optimizations to the overall plan that I didn't thought about, maybe the cost is even smaller.

The big question is can I find this person or it will be more difficult than creating the plan myself ?
I should stop talking and start writing emails. :)

P.S. If someone knows such a planner please PM me and I will be forever grateful... :)

Cris

[liorsyncro]

Send me an email (lior at liorh dot com) with your contact information and I'll send you all the details. I work with a fee-based CFP. Very experienced with these things.

[edrempel]

When you go buy a mutual fund, the financial planner will want you to sign a dividend reinvestment form and other reinvestment forms such as capital return reinvestment form. You won't get the dividends deposited in to your bank account, it will be used to buy more fund shares. Therefore, it feels like you never got a dividend before. However, on your tax slip, it will indicate how much dividend and return of capital you received. That dividend alone, no matter how small will qualify you to deduct interests from borrowing to invest.

Hi ACC,

Dividends are NOT required to deduct interest when you borrow to invest. That is a common misperception. CRA in IT-533 essentially accepts any stock market type investment - mutual funds, stocks, ETFs - as long as it is possible for them to pay a dividend sometime in the future. Essentially the only exception are investments where the prospectus prevents the payment of dividends or other income.

We have modeled the Smith Manoeuvre and found that receiving dividends REDUCES the projected benefit of the SM. This is true even if the dividend is used to reduce your mortgage. The only exception is for investors in the lowest tax bracket (taxable income under $41K).

This is called the "tax bleed". Every dollar of tax you pay on the investments is a dollar less invested.

The most effective Smith Manoeuvre is to focus on long term total returns and minimize the tax on the investments.

For example, corporate class mutual funds often have no taxable distributions for many years. The best of both worlds is if you can claim your full interest deduction but have zero tax from the investments.



Ed

[edrempel]

Hypothetical questions :)

1. I want to do the SM and invest let’s say in dividend-paying blue-chip canadian stocks ETF’s. I have a starting loan to invest of 100k. How should I start?
- Invest all at once – Advantage: the dividends will start immediately and maybe the capital appreciation also.
- Invest a fixed amount, let’s say 10k each month - Advantage: take advantage of the “dollar cost average” per unit of ETF and maybe in the end (after 10 month) will have more than the first option. The potential loss is reduced by the fact that I do not have to pay interest on the amount that is not borrowed yet (opposed to invest all at once)
- Other option??

2. If in a few years if I decide to sell some of the ETF’s and by stocks, how will selling ETF’s influence the loan?
Ex: Have 140k in ETFs after a few years; the loan is 100k. During one year I sell 50k ETF and by 50K worth of stocks.
- Is the entire loan still tax deductible?
- What portion of 50K is ROC and I have to pay taxes on it?

Hi Cris,

1. Investing a lump sum vs. dollar cost averaging depends mainly on your risk tolerance and return goal. Since the stock markets go up about 75% of the time, the most likely result is that the lump sum should result in higher returns. Dollar cost averaging generally results in reduced risk and reduced return.

2. If you sell the ETFs to buy stocks, you can still deduct the interest as long as all the money is still invested. CRA is concerned about the "current use" of the money you borrowed.

Your selling scenario is calculated proportionately. It you borrow $100K, it grows to $140K and then you sell $100K, but keep the investment loan, then 100K/140K of the loan is no longer deductible. The amount that would be deductible would be the interest on 40K/140K x $100K = $28.6K.

Ed

[edrempel]

After considering different scenarios, I believe the best thing for me (and maybe for others who will read this) will be to look for the following:

"Fee only planner who can create a professional written financial plan for me and my family, will include the Smith Manoeuvre in the plan and can offer long term investment recommendations. The investment part will be implemented by me or a broker."

Since I will invest 200K in the next couple of years, I think that 1% cost to create this plan is acceptable. If I am lucky and the planner will be able to save me some money in taxes and some optimizations to the overall plan that I didn't thought about, maybe the cost is even smaller.

The big question is can I find this person or it will be more difficult than creating the plan myself ?
I should stop talking and start writing emails. :)

P.S. If someone knows such a planner please PM me and I will be forever grateful... :)

Cris

Hi Cris,

We are aware of nearly everyone that does the SM and are not aware of anyone that is fee-only. "Fee-only" means the planner bills you for his time.

I think the reason for this is that fee-only planners are usually relatively cautious. They bill like accountants and usually think a lot like accountants. Remember, the Smith Manoeuvre is borrowing to invest, which is a high-risk strategy. If a planner recommends it and then you invest elsewhere and it blows up, the planner is theoretically at risk of you suing him for the loss - even though he only billed for his time.

Financial planners normally will not recommend the Smith Manoeuvre or any significant leverage strategy unless they can manage the investments, in order to minimize the chance of failure.

This is because investors tend to make a few very common mistakes, such as buying investments that are too risky or following the herd. Most investors invest with the herd, which means they buy after the market rises and then sell after it falls. This is why the average investor makes about 1/3 of the return of the investments they own.


To give you a little perspective, we debated about being fee-based or commission-based, and decided to be commission-based. What we found is that fee-only clients tend to be temporary, while commission clients tend to be permanent. Clients that are billed for time often only get the first plan written, but then hesitate review their plan over the years or even contact the planner, because they know they are "on the clock" when they call.

We found that what clients need most is to have a professional plan to figure out what they want to do with their lives and how to achieve it. A critical part is the on-going monitoring of the plan, including adapting to changing conditions or revising the plan if the goals change or your life changes. Managing the investments so they fit with the plan is also very important. This is why we decided to only work with clients that we think will be long term clients.

Canadians tend to be very fee-sensitive. Few will write a cheque to their financial planner every year. We are not used to even paying for medical care!

By being commission-based, we are able to be "no-fee". This means we can provide all the advice clients need, prepare a professional plan, review & monitor the plan, answer any client questions, do their tax returns, etc. all without billing them. Then if our investments can match or beat the index, there is no cost to our client at all.




Ed

[Germack]

By being commission-based, we are able to be "no-fee". This means we can provide all the advice clients need, prepare a professional plan, review & monitor the plan, answer any client questions, do their tax returns, etc. all without billing them. Then if our investments can match or beat the index, there is no cost to our client at all.
Ed

Of course there is a cost to your client even if your investments beat or match the index. You give advice to you clients therefore you should get paid, but why do financial planners always need to hide their fees and pretend their advice is free where it is clearly not.

[Germack]

Hi ACC,


We have modeled the Smith Manoeuvre and found that receiving dividends REDUCES the projected benefit of the SM. This is true even if the dividend is used to reduce your mortgage. The only exception is for investors in the lowest tax bracket (taxable income under $41K).

Ed

I guess when you modeled the Smith Manouevre you made the mistake of assuming that the return of dividend paying stocks equaled the return of non dividend paying stocks.

This was clearly not the case for the last 30 years.
http://img338.imageshack.us/img338/614/dividend.png

[larry81]

Hello folks,

quick question regarding Smith Manoeuvre.

I have a president account at TD, i get a very good rate on leverage. I already have a non-registered account in the mid 6 figures.

Could someone just buy a dividends paying ETF on margin account, use the dividends to pay his mortrage and deduce interest to CRA ?

My mortrage is due for renewal in 3-4years and i just getting started to read on Smith

[Jungle]

Yes, you can buy a dividend etf, ideally you want it to be Canadian dividends, so you can apply the dividend tax credit.

[SustainablePF]

Yes, you can buy a dividend etf, ideally you want it to be Canadian dividends, so you can apply the dividend tax credit.

you positive on this Jungle? I've read that even dividend ETFs don't pay simply pure dividends - lots of other payouts as well (e.g. ROC), and most of those aren't nearly as tax friendly as dividend income. I'll happily stand corrected, but I wouldn't want to get hit with capital gains taxes from the SM

[larry81]

Yes, you can buy a dividend etf, ideally you want it to be Canadian dividends, so you can apply the dividend tax credit.

my question was a little more complex that simply asking if i could purchase an ETF.

Can a mortrage be funded simply by using a margin account ? Is this what the "smith manoeuvre" is all about ???

[Jungle]

you positive on this Jungle? I've read that even dividend ETFs don't pay simply pure dividends - lots of other payouts as well (e.g. ROC), and most of those aren't nearly as tax friendly as dividend income. I'll happily stand corrected, but I wouldn't want to get hit with capital gains taxes from the SM

You're right. I've forgetting that ETFs or mutual funds can produce ROC from rebalancing or distribution payments, (not same as dividends) that mock dividend payments. To make matters worse, some ETFs are doing swap agreements, while not holding any stock at all.

A dividend ETF does have its place. If you are not comfortable holding individual stocks, you can elect a basket with an ETF, eliminating some individual company risk. In the 08/09 crash, if you were uneasy about buying a few companies, an ETF could give you a piece of mind by being more diversified, instead of concentrated on a few selections.

Regardless, if it pays ROC, interest, etc, anything that will or does pay income qualifies for the tax deduction, but I think the question is, is it the most tax efficient way to receive income?

[SustainablePF]

You're right. I've forgetting that ETFs or mutual funds can produce ROC from rebalancing or distribution payments, (not same as dividends) that mock dividend payments. To make matters worse, some ETFs are doing swap agreements, while not holding any stock at all.

A dividend ETF does have its place. If you are not comfortable holding individual stocks, you can elect a basket with an ETF, eliminating some individual company risk. In the 08/09 crash, if you were uneasy about buying a few companies, an ETF could give you a piece of mind by being more diversified, instead of concentrated on a few selections.

Regardless, if it pays ROC, interest, etc, anything that will or does pay income qualifies for the tax deduction, but I think the question is, is it the most tax efficient way to receive income?

I'd prefer ETFs but the SM is complicated enough (come tax time) that mixing dividends, ROC and/or distribution payments could make things messy. Now, if you have a CFP or a great accountant who can wade through the taxation mess it may be worthwhile to look at ETFS. However, once you add the MER, plus the fees from the CFP/accountant and the increased tax on the non-dividend income, you've really lost a lot of the benefit of the dividends themselves. At that point you may as well be looking at what Ed suggests which is not dividends, but growth.

Personally, I like dividends and the idea of applying them to the mortgage balance which in turn increases the amount I can invest/leverage. But it sure does take a lot more care on the DIY Investors part to select stocks when they are at a good value.

I think Dividends ETFs are a good thing, but I hold them in my RRSP/TFSA accounts instead. I'm no accountant and I loathe paying more tax than I planned to pay!

[edrempel]

Of course there is a cost to your client even if your investments beat or match the index. You give advice to you clients therefore you should get paid, but why do financial planners always need to hide their fees and pretend their advice is free where it is clearly not.

Hi Germack,

Of course you're right that a portion (roughly 30-40% of the MER) is supposed to pay for investment advice and financial planning advice. However, there should also be a benefit of the advice. There is only a disadvantage if the benefit is less than the cost.

From our experience, having a professional financial plan has far greater benefits than most people realize. It means you are doing enough and doing the right strategies to achieve your life goals. (Most people will fall far short of the goal they would like to achieve.) It also means all your financial decisions are made with a long term focus, are setup in the most tax-efficient way short and long term, and that your investments are suitable to your goal.

For investment advice, the cost/benefit depends on what you would do without advice. For those just buying ETFs, there should be no cost, since all our fund managers have out-performed their index over long periods of time and over their career. In addition, there is a variety of errors most amateurs make that can be avoided with good advice, such as too much trading, investing too aggressively or too conservatively, following the herd, etc. (Admittedly, financial planners and brokers often make these same mistakes as well.)

I agree that much of the "advice" from financial planners is actually a sales pitch, instead of comprehensive financial planning and professional advice. But I think many people don't ask for advice that would benefit them because they think all financial advice has no value.


Ed

[edrempel]

I guess when you modeled the Smith Manouevre you made the mistake of assuming that the return of dividend paying stocks equaled the return of non dividend paying stocks.

This was clearly not the case for the last 30 years.
http://img338.imageshack.us/img338/614/dividend.png

Hi Gremack,

What is that chart? Dividend stocks are extremely popular and have out-performed the market somewhat, but nowhere close to that amount. "High yield" usually refers to corporate bonds of low quality companies. In addition, the highest dividend paying stocks are usually massive cash cows, while most non-dividend stocks are small and mid-cap stocks.

I've heard some commentators claim they believe dividend stocks are in a bubble. They are so popular today that some say "dividend stocks are the new tech stocks". I think that is grossly exaggerated, but that chart really supports that belief. It looks almost exactly like tech stocks vs. the market in 1999.



Ed

[Jungle]

Has anyone moved with their SM? Scotia said the HELOC would have to be paid off in full, in order to clear the title. They basicly said the HELOC is not portable. How could you get around this?

[gregtd]

Has anyone moved with their SM? Scotia said the HELOC would have to be paid off in full, in order to clear the title. They basicly said the HELOC is not portable. How could you get around this?

We went from Scotia to Manulife a few years ago, our SM/HELOC balance was about $100k. We issued a payment from the new Manulife account for the exact $ amount of the HELOC balance so that we'd have clear paper trail to show no co-mingling of the SM loan with anything else and then set this up as a sub-account. However we have not been audited by CRA so I'm not 100% certain this would pass their test, but it seems logical that it would.

[Jungle]

We went from Scotia to Manulife a few years ago, our SM/HELOC balance was about $100k. We issued a payment from the new Manulife account for the exact $ amount of the HELOC balance so that we'd have clear paper trail to show no co-mingling of the SM loan with anything else and then set this up as a sub-account. However we have not been audited by CRA so I'm not 100% certain this would pass their test, but it seems logical that it would.

Thanks for your input. It's relieving to hear that. Ed Rampel has posted a bulletin from the CRA that says you can transfer debt to a new account/company, so long as there is a clear paper trail and no co-mingling the debt with anything else.

[Germack]

Hi Gremack,

What is that chart? Dividend stocks are extremely popular and have out-performed the market somewhat, but nowhere close to that amount. "High yield" usually refers to corporate bonds of low quality companies. In addition, the highest dividend paying stocks are usually massive cash cows, while most non-dividend stocks are small and mid-cap stocks.

I've heard some commentators claim they believe dividend stocks are in a bubble. They are so popular today that some say "dividend stocks are the new tech stocks". I think that is grossly exaggerated, but that chart really supports that belief. It looks almost exactly like tech stocks vs. the market in 1999.



Ed

Hi Ed,

The graph was generated by Kenneth French who is a professor of finance at the Dartmouth college. The graph shows the performance of 4 different portfolios. The blue line represent the S&P TSX index. The orange line tracked stocks who did not pay dividends at all. The purple line tracked stocks that paid the lowest 30% of dividend yields, and the green line tracked stocks in the highest 30% yield group. Portfolios were rebalanced every year.

As can be clearly seen a strategy focusing on "growth" stocks paying no dividends did not work well over the last 30 years. Tax wise this strategy is theoretically better but performance wise the dividend strategy clearly outperformed.

[edrempel]

Has anyone moved with their SM? Scotia said the HELOC would have to be paid off in full, in order to clear the title. They basicly said the HELOC is not portable. How could you get around this?

Hi Jungle,

If you refinance a tax deductible loan with a new loan with no co-mingling, the new loan is normally also tax deductible. When you buy your new home, make sure the starting balance of your credit line is exactly the same as the ending balance from your former home.



Ed

[edrempel]

I'd prefer ETFs but the SM is complicated enough (come tax time) that mixing dividends, ROC and/or distribution payments could make things messy. Now, if you have a CFP or a great accountant who can wade through the taxation mess it may be worthwhile to look at ETFS. However, once you add the MER, plus the fees from the CFP/accountant and the increased tax on the non-dividend income, you've really lost a lot of the benefit of the dividends themselves. At that point you may as well be looking at what Ed suggests which is not dividends, but growth.

Personally, I like dividends and the idea of applying them to the mortgage balance which in turn increases the amount I can invest/leverage. But it sure does take a lot more care on the DIY Investors part to select stocks when they are at a good value.

I think Dividends ETFs are a good thing, but I hold them in my RRSP/TFSA accounts instead. I'm no accountant and I loathe paying more tax than I planned to pay!

Hi SustainablePF,

I appreciate your comments.

Actually, it's not just growth we are looking for. It is total return.

Dividends are the amount of a company's profit they decide to pay out. Growing companies tend to retain their profits to finance their fast growth. Mature companies tend to pay out a portion of their profits as a dividend.

In the end, what really matters is the total profit. What portion of it they pay out as a dividend is a less important factor.

I realize most people here seem focused on dividends. We ran simulations on a custom version of the Smith Manoeuvre calculator. It shows that the more dividends you receive, the less money you have over time. This is strictly because of the tax. Compounding growth is not taxable, while dividends are.

Even if you pay the dividend onto your mortgage, you still lose money. For example, if you receive a $1,000 dividend, you can pay it onto your mortgage and then reborrow to invest. This means you have converted $1,000 of your mortgage to tax deductible. If your credit line is at 3%, then you have $30/year on which you can claim a tax deduction.

However, the tax savings on $30/year are minor compared to the tax on the $1,000 dividend. Overall, you have paid a bunch of money in tax that could have remained invested compounding for years.

The one exception to this is low income people under $41,000/year, but in most cases, they should not be doing leverage strategies anyway.

You have a valid point, that in addition to paying more tax, the dividend means you have a lot more accounting and tax issues.

If you can have a 100% tax-efficient investment, then you make the most money over time, plus you have no tax or accounting issues at all, other than deducting 100% of the interest every year.

I'm obviously exaggerating this a bit, but it seems like everyone doing the Smith Manoeuvre is just focused on paying down debt, instead of focusing on building a huge nest egg or saving tax.

There are many versions of the Smith Manoeuvre. We have a version we call the "Smith Manoeuvre with Dividends". We have a mutual fund that pays a fixed 6% eligible dividend. That is higher than any dividend portfolio or dividend ETF. The entire 6% dividend can be paid onto your mortgage and then reborrowed to invest.

It sounds like a cool strategy, but when we show clients a projection of this vs. a tax-efficient fund with zero dividend, everyone prefers the tax-efficient version.

For example, here are the projected benefits of the Smith Manoeuvre over 25 years with a $400,000 mortgage. Assume prime averages 4.5% and the mortgage is variable at prime -.85%:

Option 1: Smith Manoeuvre with growth: 10% growth + 0% dividend. Mortgage fully converted in 21.2 years. Projected benefit = $739,881
Option 2: Smith Manoeuvre with dividends: 4% growth + 6% dividend. Mortgage fully converted in 16.3 years. Projected benefit = $600,284.

Would you rather have your mortgage converted 5 years sooner or have an extra $140,000? Personally, I like the $140,000.

Remember, when the mortgage is fully converted, your mortgage payment is not gone. You than have to pay the interest on the credit line. It is less than your mortgage payment because it is interest only and fully tax deductible, but it is usually a higher interest rate (.85% higher normally).

In short, with option 1 you get an extra $140,000 while with scenario 2 your mortgage payment reduces a bit 5 years sooner.

When we show our clients these projections, so far everyone has chosen option 1 (including me). We believe we can do the Smith Manoeuvre with Dividends strategy extremely well, but people who clearly see the 2 options rarely choose it.



Ed

[peterchaorocks]

Can someone explain what is a Smith Manoeuvre in simple terms?

[FrugalTrader]

Can someone explain what is a Smith Manoeuvre in simple terms?

It's where you obtain a special HELOC on your house (at least 20% equity) and use the balance to invest. The resulting interest on the HELOC is tax deductible. It's simply a leveraged investment strategy.

[edrempel]

Can someone explain what is a Smith Manoeuvre in simple terms?

Hi Peter,

Nice photo. Is that you? :)

The Smith Manoeuvre, in short, is a systematic strategy to borrow the equity in your home to invest as it becomes available. It helps you build up a large next egg while converting your mortgage into a tax deductible credit line over time. The process should not require any of your cash flow.

Essentially, you get a readvanceable mortgage (most banks have a version, some better than others) and then you borrow the principal portion of each mortgage payment to invest. You have the credit line pay its own interest (called "capitalizing" the interest), so that your cash flow is only used to pay down your mortgage.

Over time, you are building up a tax deductible credit line of money you have borrowed to invest. You can claim the interest as a deduction on your tax return, which creates tax refunds. You can use the refunds to pay down your mortgage more quickly. With a readvanceable mortgage, you can then reborrow to invest.

Many people do the Smith Manoeuvre in order to pay their mortgage off more quickly or to save on tax, but these are not the best reasons. The real reason that people may want to consider the Smith Manoeuvre is to create a nest egg over time that can help them save for their long term goals, such as retirement, without using their cash flow.

It is a risky strategy, since you are borrowing to invest. The best way to deal with the risk is to make sure it is a long term strategy.

Does that answer your question, Peter?


Ed

[gujju73]

I have just learned / read about SM strategy. I understood most of it.. One thing still confuse me is "what will happen to investment income? If i invest in dividend stock then they are in different taxable income bracket. But If I buy the property and rent them.. Don't I have to claim the rental income as my personal income? If I have to show rental income as personal income then where is the saving on tax? Any idea...

[Jungle]

I have just learned / read about SM strategy. I understood most of it.. One thing still confuse me is "what will happen to investment income?

The investment income will be deposited in your brokerage account, according to the dividend payment schedule. What you're supposed to do with the income, is to make pre-payments on your mortgage.




If i invest in dividend stock then they are in different taxable income bracket. Your dividend tax rate is set by the province, based on your marginal tax rate. Check out marginal tax rate tables here: http://taxtips.ca/taxrates/on.htm (ontario)




But If I buy the property and rent them.. Don't I have to claim the rental income as my personal income? Yes.


If I have to show rental income as personal income then where is the saving on tax? Any idea... Your confusing the SM deduction with rental property deductions. Rental properties have their own set of tax deductions, (different from smith manoeuver deduction) refer to this guide: http://www.cra-arc.gc.ca/E/pub/tg/t4036/t4036-09e.pdf

I know the CRA says you can claim anything borrowed used to create income, but rental properties are not the best for the true smith manoeuvre, it's best to stick with dividend paying Canadian stocks.

[gujju73]

I know the CRA says you can claim anything borrowed used to create income, but rental properties are not the best for the true smith manoeuvre, it's best to stick with dividend paying Canadian stocks.

Thanks, One of the website where i have heard for SM was suggesting to invest either in rental property or in dividend.

So to if I understood clearly...
- your monthly payments (liabilities) are regular mortgage payment + interest on the loan. And your income / savings will be Dividend (monthly / quarterly) + tax savings (yearly).
- We can claim interest on mortgage + interest on loan on annual tax return.
- There is a risk of market price fluctuation of the dividend paying companies stock price.

[Jungle]

Thanks, One of the website where i have heard for SM was suggesting to invest either in rental property or in dividend.

So to if I understood clearly...
- your monthly payments (liabilities) are regular mortgage payment + interest on the loan. And your income / savings will be Dividend (monthly / quarterly) + tax savings (yearly).
- We can claim interest on mortgage + interest on loan on annual tax return.
- There is a risk of market price fluctuation of the dividend paying companies stock price.

You can't claim your mortgage interest on your principal residence , however, as you said above, you can claim the interest cost on the loan (HELOC).

Here is one way you could do both if you own a rental property. (Risky but I might be doing this as I already have rental and SM my principal residence)

Buy a rental property. You have to report your rent cheques as regular taxable income, however, there are a lot of deductions allowed with rentals, such as: mortgage interest, insurance, utilities (if tenant pays them) and percentages of other costs associated used to run your rental.

Take out a HELOC on the the renal property. Do Smith Manoeuvre; buy stocks with the HELOC, self service the loan and use dividends and tax return as pre-payment on rental mortgage.

Now because a rental property costs are already tax deductible, it's best to pay off your non-tax deductible debt first. IE, work on the principal mortgage first.

[gujju73]

You can't claim your mortgage interest on your principal residence , however, as you said above, you can claim the interest cost on the loan (HELOC).

Here is one way you could do both if you own a rental property. (Risky but I might be doing this as I already have rental and SM my principal residence)

Buy a rental property. You have to report your rent cheques as regular taxable income, however, there are a lot of deductions allowed with rentals, such as: mortgage interest, insurance, utilities (if tenant pays them) and percentages of other costs associated used to run your rental.

Take out a HELOC on the the renal property. Do Smith Manoeuvre; buy stocks with the HELOC, self service the loan and use dividends and tax return as pre-payment on rental mortgage.

Now because a rental property costs are already tax deductible, it's best to pay off your non-tax deductible debt first. IE, work on the principal mortgage first.

So if I rent portion of the principal residence (basement... here in GTA, I've seen so many ppl doing for variety reasons...), then rental income and SM both work at the same time..
May be that is the trick why so many ppl are renting their basements :)

[edrempel]

So if I rent portion of the principal residence (basement... here in GTA, I've seen so many ppl doing for variety reasons...), then rental income and SM both work at the same time..
May be that is the trick why so many ppl are renting their basements :)

Hi gujju73,

You CAN rent out a portion of your home and claim proportionate expenses - and also do the Smith Manoeuvre. The Smith Manoeuvre means you are building up a tax deductible credit line. What happens with your mortgage itself would be the same as it would be without the Smith Manoeuvre.

It sounds like you should read more of this thread. You seem to be thinking that the investment income somehow pays for the credit line interest or needs to be more than the credit line interest.

With the Smith Manoeuvre, investment income is optional.

Some people think it is necessary to receive investment income to make the credit line interest tax deductible, but that is a misinterpretation of the tax rules. You only need to buy investments that theoretically could one day pay investment income. Nearly all stocks and mutual funds are fine.

With the classic Smith Manoeuvre, there is no investment income at all. Ideally, you would do the SM for 20-30 years or more, claim zero investment income and still deduct 100% of the credit line interest. Then you can pay 100% of your tax refund onto your mortgage and reinvest the same amount from the credit line. This process grows wealth far faster than you would if you receive investment income because you avoid the "tax bleed".

You do NOT pay the interest on the credit line from your cash flow or from investment income. The interest on the credit line is "capitalized", which means the credit line pays its own interest. If you have a proper Smith Manoeuvre readvanceable mortgage, you gain credit available with every mortgage payment, which you can use to pay the credit line interest - and then invest the rest.

This is why the Smith Manoeuvre requires none of your cash flow, even if you have no investment income.

Some people invest for income either because they like income investments or because they are focused on paying off the mortgage. Dividend paying stocks are the most popular investments today - which is one reason to consider avoiding them. Dividend-paying stocks and mutual funds are almost as popular today as technology stocks and mutual funds were 10 years ago. Investing for dividends is a proven long-term strategy because they are usually cheap. But when they are so extremely popular, then they are not cheap - so there are better opportunities elsewhere.

Other people invest without investment income in order to maximum long term wealth and minimize tax. Receiving investment income means you reduce your tax refunds or may even have to pay tax, while investing in tax-efficient investments means you maximize your tax refund - which you can pay onto your mortgage or reinvest.

Either way works for the Smith Manoeuvre though. Receiving investment income is optional.



Ed

[Jungle]

Can anyone suggest a good index fund for the smith manoeuvre? Or does anyone use index funds for their smith manoeuvre?

[Mark77]

Can anyone suggest a good index fund for the smith manoeuvre? Or does anyone use index funds for their smith manoeuvre?

Least expensive exposure to the Canadian market is XIU, at a MER of 0.17% per annum. It replicates the TSX60 index, which unfortunately has lagged the full TSX Composite Index over the past year or two.

[Jungle]

Thanks Mark77.

How does that the small roc distribution affect the tax deductibility? ALso would extra the cost of xic be worth it?

[Mark77]

Thanks Mark77.

How does that the small roc distribution affect the tax deductibility? ALso would extra the cost of xic be worth it?

If you put the ROC right back into paying down the SM debt (ie: the deductible stuff), then I don't see why it would have any impact on deductability. However, if you take a ROC distribution and use it to pay off otherwise non-deductible debt, then you would have a deductability problem if the CRA subjected you to close scrutiny.

The point is kind of moot with XIU, because the ROC distribution is immediately re-invested in more XIU units, and then XIU is subject to a reverse split, such that, the number of units are unnaffected.

But if, for instance, you bought a trust that paid out its entire capital at the end of the year, you couldn't use that ROC distribution to 'launder' non-deductable debt into deductible debt. That most certainly would be disallowed.

[Jungle]

The point is kind of moot with XIU, because the ROC distribution is immediately re-invested in more XIU units, and then XIU is subject to a reverse split, such that, the number of units are unnaffected.

Are you sure? The distribution schedule says a small percentage of ROC is distrubuted out in quartly payments:
http://ca.ishares.com/product_info/fund/distributions/XIU.htm << check down the page, it says the how the distribution is broken up.

About 8.09% of the distribution is "ROC" and "other income."

Also I was wondering you opinion on XIC. It has returned more in the past couple years as it tracks the index, but the MER is a little higher.

[Mark77]

Are you sure? The distribution schedule says a small percentage of ROC is distrubuted out in quartly payments:
http://ca.ishares.com/product_info/fund/distributions/XIU.htm << check down the page, it says the how the distribution is broken up.

About 8.09% of the distribution is "ROC" and "other income."


Yeah, you would need to be careful then, that you're not using the ROC portion of the distribution, against non-deductible debt. But that's not stopping you from taking the rest of the distribution and applying it against non-deductible debt.




Also I was wondering you opinion on XIC. It has returned more in the past couple years as it tracks the index, but the MER is a little higher.

I don't really like small-caps, but there definitely is a lot of excitement around them, particularly in the resource sector. Also, if you've read my other posts, I'm fairly bullish on Canadian banks, which have a lower index concentration in XIC versus XIU. IMHO, its really a wash overall. XIC is more volatile and suffers more heavily during a market crash, that's for sure, than XIU. But has more upside.

[Jungle]

We own few stocks including a couple banks and a financial company in our SM. But I was looking to invest a lump sum, to get my portfolio bigger, maybe with an index fund. I like the idea of some capital growth and I believe the index will achieve that over the next couple years.

The only mess that concerns me is this ROC and other income.
But As you stated, if you just take the portion of the ROC and other income and pay the heloc, should be fine?
Print off the transaction receipts, put them in the tax filing folder.

[edrempel]

We own few stocks including a couple banks and a financial company in our SM. But I was looking to invest a lump sum, to get my portfolio bigger, maybe with an index fund. I like the idea of some capital growth and I believe the index will achieve that over the next couple years.

The only mess that concerns me is this ROC and other income.
But As you stated, if you just take the portion of the ROC and other income and pay the heloc, should be fine?
Print off the transaction receipts, put them in the tax filing folder.

Hi Jungle,

If you receive ROC or sell an investment, you can maintain full tax deductibility of the SM as long as you either:

1. Pay it down on the HELOC (the tax deductible part) OR
2. Reinvest it.

You need to be able to track it separately from taxable portions of a distribution. The easiest method is to just reinvest all of your distributions.




Ed

[eiad77]

Least expensive exposure to the Canadian market is XIU, at a MER of 0.17% per annum. It replicates the TSX60 index, which unfortunately has lagged the full TSX Composite Index over the past year or two.

FYI, XIU is no longer the lowest cost ETF. HXT by Horizons has a MER of 0.07. Also, it does not give out distributions. You might want to take a look at it: http://www.hbpetfs.com/pub/en/etfs/?etf=HXT&r=o

[Jungle]

What Mark77 (or Pitz) was referring to was that XIU is the lowest cost (amlost) index based ETF that you can use for the SM. The problem is they say very clearly that they do not intend to pay any income.


"HXT will not pay any quarterly dividend distributions" -right from their perspectous

Read my post I made earlier in the SM thread regarding this:

http://forums.redflagdeals.com/smith-manoeuvre-150279/29/#post11707602

It's too bad really, that HXT would be amazing for SM.

[Jungle]

Hi Jungle,

If you receive ROC or sell an investment, you can maintain full tax deductibility of the SM as long as you either:

1. Pay it down on the HELOC (the tax deductible part) OR
2. Reinvest it.

You need to be able to track it separately from taxable portions of a distribution. The easiest method is to just reinvest all of your distributions.




Ed

Thanks Ed. So once the distribution is deposited, just buy more shares? Do you have to keep paper work in your tax file to prove this transaction?

This does sound easier then figuring out what percentage the ROC and other income is, then withdrawing it and depositing it to HELOC. :)

[SustainablePF]

Thanks Ed. So once the distribution is deposited, just buy more shares? Do you have to keep paper work in your tax file to prove this transaction?

This does sound easier then figuring out what percentage the ROC and other income is, then withdrawing it and depositing it to HELOC. :)

So I CAN go the etf route, as long as I use any "profit" to pay down the HELOC or reinvest?
I just want to be crystal clear :)

[Jungle]

^^ Check out Frugal's post on return on capital. ROC

ED also posts a lot in the comments section too.

http://www.milliondollarjourney.com/how-return-of-capital-works.htm

[edrempel]

Thanks Ed. So once the distribution is deposited, just buy more shares? Do you have to keep paper work in your tax file to prove this transaction?

This does sound easier then figuring out what percentage the ROC and other income is, then withdrawing it and depositing it to HELOC. :)


So I CAN go the etf route, as long as I use any "profit" to pay down the HELOC or reinvest?
I just want to be crystal clear :)

Hi Jungle and Sustainable PF,

The best way to think of this is to just keep all your tax deductible accounts separate from the non-deductible. Your tax deductible accounts are the investment account and the SM credit line (and possibly a chequing account if used only for the SM). Transactions that keep money entirely within these accounts are generally fine.

So, if you receive a distribution from the investment, as long as you put all of it either on the credit line or back into the SM investment account, you should be fine. Similarly, if you sell and investment, just keep all the proceeds in the investment account and reinvest them, you should be fine.

You will need to prove a paper trail if you are ever audited. If you never mixed any money from the SM group of accounts with any non-deductible account and you can show that, you should be fine.

CRA is concerned with the "current use" of the money you borrowed to invest. To determine whether the credit line is tax deductible, you need to prove to CRA that all the borrowed money was invested and is still invested. That is usually not difficult to prove if you never mixed any deductible money with non-deductible money.






Ed

[edrempel]

^^ Check out Frugal's post on return on capital. ROC

ED also posts a lot in the comments section too.

http://www.milliondollarjourney.com/how-return-of-capital-works.htm

Hi Jungle,

Good post. Yes, ROC creates a tax problem. Most of the time, you only get it if you are trying to get cash payments out of your investments, which is not necessary with the Smith Manoeuvre. Many people are doing ordinary leverage and just having the investments make the interest payments. However, with the SM, you can capitalize the tax-deductible interest so it does not come from your cash flow.

Then you can have your investments compound. Taking any cash out will obviously reduce the investment growth.

Some people have the investments pay taxable dividends or distributions, so that they can use them to pay down their mortgage more quickly. They can then also readvance and rebuy the investments. This seems like an advantage, because it pays down the mortgage more quickly. However, in most cases, the tax on the investment income is a larger loss than the benefit of converting the mortgage to tax-deductible more quickly. Essentially, nearly anyone with a taxable income over $41,000 is usually better off trying to minimize any tax on the investments.

It is a bit strange that some people use the SM primarily as a debt-reduction strategy (convert the mortgage more quickly) rather than the real benefit, which is to build a large nest egg without using your cash flow. We have modeled many versions of the SM on special software and the biggest benefits come from leaving your investments to compound without taking out cash and with the least tax possible.

I think people that try to pay down the mortgage more quickly are usually looking for financial security. What they miss is that it is the large nest egg from the SM that provides real financial security.



Ed

[sTeViE26]

Hi Jungle,

Good post. Yes, ROC creates a tax problem. Most of the time, you only get it if you are trying to get cash payments out of your investments, which is not necessary with the Smith Manoeuvre. Many people are doing ordinary leverage and just having the investments make the interest payments. However, with the SM, you can capitalize the tax-deductible interest so it does not come from your cash flow.

Then you can have your investments compound. Taking any cash out will obviously reduce the investment growth.

Some people have the investments pay taxable dividends or distributions, so that they can use them to pay down their mortgage more quickly. They can then also readvance and rebuy the investments. This seems like an advantage, because it pays down the mortgage more quickly. However, in most cases, the tax on the investment income is a larger loss than the benefit of converting the mortgage to tax-deductible more quickly. Essentially, nearly anyone with a taxable income over $41,000 is usually better off trying to minimize any tax on the investments.

It is a bit strange that some people use the SM primarily as a debt-reduction strategy (convert the mortgage more quickly) rather than the real benefit, which is to build a large nest egg without using your cash flow. We have modeled many versions of the SM on special software and the biggest benefits come from leaving your investments to compound without taking out cash and with the least tax possible.

I think people that try to pay down the mortgage more quickly are usually looking for financial security. What they miss is that it is the large nest egg from the SM that provides real financial security.



Ed

I have a question for you, Ed:

Well, I'll start with a statement - I think we can agree that people like the idea of dividend stocks for several reasons:

1) cashflow
2) tax-advantaged income
3) a significant and tangible component of the total return - one not subject to market fluctuations
4) passive income for retirement
5) historical data suggesting dividends make up a substantial portion of total return and outperformance vs. non-dividend paying stocks

In the case of the Smith Manoeuvre, dividends also allow the faster conversion of debt from non-deductible to deductible. I think people also like the idea of being able to live off of their dividends without having to touch their capital - deferring capital gains and avoiding selling when prices are depressed.

I don't think anyone will argue with you that total returns are what ultimately matters, but my question in regards to the Smith Manoeuvre is how are retirees to draw their income from a large portfolio which pays little to no income? If they are to keep the investment loan forever, what happens when you sell (presumably mutual fund units) to live off the capital? Is that portion of the loan no longer deductible as the current use of the investment loan is consumption and not investment?

Or do you advise your clients to switch from funds focused on capital appreciation to income once they reach retirement and require income?

Thanks,

Steve

[edrempel]

I have a question for you, Ed:

Well, I'll start with a statement - I think we can agree that people like the idea of dividend stocks for several reasons:

1) cashflow
2) tax-advantaged income
3) a significant and tangible component of the total return - one not subject to market fluctuations
4) passive income for retirement
5) historical data suggesting dividends make up a substantial portion of total return and outperformance vs. non-dividend paying stocks

In the case of the Smith Manoeuvre, dividends also allow the faster conversion of debt from non-deductible to deductible. I think people also like the idea of being able to live off of their dividends without having to touch their capital - deferring capital gains and avoiding selling when prices are depressed.

I don't think anyone will argue with you that total returns are what ultimately matters, but my question in regards to the Smith Manoeuvre is how are retirees to draw their income from a large portfolio which pays little to no income? If they are to keep the investment loan forever, what happens when you sell (presumably mutual fund units) to live off the capital? Is that portion of the loan no longer deductible as the current use of the investment loan is consumption and not investment?

Or do you advise your clients to switch from funds focused on capital appreciation to income once they reach retirement and require income?

Thanks,

Steve

Hi Steve,

Good question & interesting statement.

All the reasons you mentioned for liking dividends are good reasons for owning dividend-paying stocks. However, we don't believe they are the main reason for the popularity of dividends today. The main reason people like dividends today - they have performed well recently. Dividend-paying stocks often become popular after market declines, but then tend to lose their popularity in the next bull market.

Regarding converting the Smith Manoeuvre to pay income during retirement, the answer is somewhat complex and depends on the desired retirement income, your risk/return profile, and tax bracket. It is different for each client.

I could write a book on this topic, but here are some of the main issues.

When most people retire, they still have an average life expectancy of 25-30 years, which qualifies as long term. Therefore, they can still invest similar to the way they did before they retired. One of the main reasons most retirees have such low incomes is that they tend to invest far too conservatively and don't maintain a reasonable equity exposure.

The most important factors with retirement income from the SM is how much income you want or need from your investments and the level or risk you are comfortable with. The tax issues are important, but less important than the risk/return and quality of the investments. It is best to choose your investments based on risk/return first. Many people make the mistake of letting tax issues be the main reason for their investment choice.

Normally, you should be able to safely take income each year of 4-6% of an equity portfolio. Dividends are generally far less than this, say 2-3%. So, taking dividends may mean your income is far lower than necessary. If you want to take the maximum sustainable income, you probably can't rely just on dividends.

Income from the SM in retirement can be in 4 main forms:

1. Systematic withdrawal plan (SWP) - Sell a bit each month. This would be some of your original capital and some capital gains.
2. Capital gains - Take out profits only.
3. Dividends
4. Return of capital (ROC) - Withdraw your capital only.

The most important factor is the qualify of your investment - the long term total risk and return. This usually dwarfs the effect of taxes in its effect on your retirement income. Therefore, in practice the most common strategy we use is the SWP, because it allows us to maintain the same high-quality investments that clients had before retiring.

There are pros and cons of each type of income:
1. SWP plans allow you to keep the same equity investments you had before, but a little bit of your investment credit line will probably become non-deductible.
2. Capital gains are taxed at a low rate, but very each year.
3. Dividends are usually steady, but are lower than the income most people want to take from their investments. They are taxed at a low rate at some brackets, but are clawed back at a very high rate for those seniors affected by clawbacks of government income programs.
4. Return of capital is tax-free, but reduces the tax-deductibility of your investment credit line. It also reduces the cost for tax purposes of your investment. When you sell or your cost is reduced to zero, than it is taxed as a capital gain.

Having the tax-deductibility of your investment credit line reduced slowly over the years (because you are using a SWP or ROC) is not the end of the world either. It is a calculation you need to do each year. The reduction in tax savings can be very small compared to your investment growth if this allows you to invest more effectively.

A big issue in planning retirement incomes is the clawbacks. There are 4 main ones - GIS, age credit, GST and OAS clawbacks. All 4 are essentially government income programs that are taken back based on your income, in addition to income tax. The biggest one is the GIS, which is a 50% clawback affecting couples with income under $21,000.

Because of the clawbacks, dividends are actually tax very highly for many seniors. For example, many articles mistakenly say that if you have only dividend income, you can earn over $30,000 tax-free. For seniors, if no income, you qualify for the GIS. If you then receive $1.000 of dividends, you will lose $725 of your GIS!

Dividends for couples earning under $21,000 are essentially taxed at 72.5% (plus possibly some income tax)! This compares to 50% on interest, 25% on capital gains and 0% on return of capital.

Depending on your taxable income, you may or may not be affected by the various clawbacks. By planning your retirement income and which type of income you receive, you can plan your taxable income.

There are some creative mutual funds that can simplify the tax issues. You can buy the same mutual fund to get the type of income you want. For example, I can have a global equity fund (or even a bond fund) and it can pay out:

1. a fixed 6% eligible dividend
2. a fixed 8% return of capital
3. all growth as a taxable capital gain each year
4. a SWP of any of the above 3.

This flexibility can be very helpful. For example, we can get 6%/year income all taxed as an eligible dividend, which is far more than nearly all dividend-paying stocks and would not affect the deductibility of the investment credit line.

One point I should make about dividends. The "safety" of dividends is mostly an illusion. Think of rainfall and snowfall. Both are precipitation. This is similar to growth and dividends. Both are created by the profit of a company. Taking income only from dividends is like only considering rainfall when you measure precipitation.

As long as the companies you are invested in continue to grow their profits over time, both the growth and the dividend will probably grow over time. Market fluctuation is mostly a short-term phenomenon and is far less in the long run. The growth of the stock market in the long run is actually far more consistent than most people realize. This is because it is based on the profits of companies growing over time. For example, Warren Buffett's company, Berkshire Hathaway, has never paid a dividend. If your retirement income was invested in it, you would have to sell shares regularly. This income would be just as reliable as a dividend.

These are some of the main issues, but they should give you an idea of the various options and that planning it properly can make a huge difference in your retirement income.



Ed

[crimsondr]

Is there any problem with depositing non-deductible money into my deductible heloc? Will this affect the deductibility of the heloc?

If I decide to sell my home, what happens to the heloc and it's deductibility?

[edrempel]

Is there any problem with depositing non-deductible money into my deductible heloc? Will this affect the deductibility of the heloc?

If I decide to sell my home, what happens to the heloc and it's deductibility?

Hi Crimsondr (is that a blood doctor reference?),

If you pay non-deductible dollars on to your HELOC, you will have reduced your deductible HELOC by that amount. The reduced HELOC should remain fully deductible.

If you take the money back out later, deductibility would depend on the purpose that you take it out for. If you invest that amount, then you are fine.

If you sell your home and buy a new home, you can just transfer the deductible credit line to the new home. Just make sure you start with the same balance you ended with on your existing home.

If you sell and don't buy another home, then you will have to pay off the secured credit line when you sell. You may be able to maintain the tax deductible loan by transferring it somewhere else, such as to an investment loan or an unsecured credit line. If you refinance a deductible loan and keep it separate, it should remain deductible.



Ed

[Jungle]

Hey I just wanted to post a couple of thoughts.

I was thinking about the whole idea of reinvesting the dividends (or distributions) on stocks or funds used for the SM, instead of using the income to pay down the mortgage.

Would it be correct to assume that, if the investment return can beat your mortgage rate, it's better to reinvest the income?

With this thought, what do you (or anyone reading this) think of using DRIPS in the SM? Some companies, for example, CIBC, Transalta, give you a 2-3% discount on reinvested dividends, making your repurchased share price even cheaper.



My second thought, based on my experience so far, since doing the SM since July, I have noticed that our dividend paying stock portfolio have not beat the performance of the benchmark index. We got kinda lucky with one stock return, but the rest we like duds in appreciation, however thankfully they paid a nice dividend.

Picking stocks is not easy. Beating the benchmark is not easy. Last year the TSX comp total return was like 17%, our portfolio with dividend return was like 12%. I think it's just easier to use an index based approach and re-invest the distributions. You don't have to worry about financials, company reports, loss quarters, etc. Less stressful with index investing, you can do other things with your time. Just let the historical history of benchmark returns do the work.

What do you guys think of all this?

[gregtd]

Picking stocks is not easy. Beating the benchmark is not easy. Last year the TSX comp total return was like 17%, our portfolio with dividend return was like 12%. I think it's just easier to use an index based approach and re-invest the distributions. You don't have to worry about financials, company reports, loss quarters, etc. Less stressful with index investing, you can do other things with your time. Just let the historical history of benchmark returns do the work.

What do you guys think of all this?

Does your 12% return factor in the value of the dividends you received?

I'm also curious as to any recommended ETFs that generate a monthly distribution. In the past we've used mutual funds through an advisor however I'm thinking of taking a DIY approach via ETFs

[Jungle]

Does your 12% return factor in the value of the dividends you received?

I'm also curious as to any recommended ETFs that generate a monthly distribution. In the past we've used mutual funds through an advisor however I'm thinking of taking a DIY approach via ETFs


Actually I am wrong. Since I based the returns on about half a year timeline (July to Dec 31), I should be including half of the yearly dividend, as that's all we've received, really. So on Dec 31, the portfolio was up 8%, plus received just over a 2.5% worth of dividend. (half a year) So, half year return from July-Dec 31 was 10.5%.

Now if the stocks hold in price until July 2011, I can say the stocks appreciated 8% + 5% dividend (12%) from July 2010 -July 2011.

To do a fair comparison, the TSX total return, starting July 2010 until Dec31, still beat our stock portfolio. At the low, the TSX was down to 11092 in July, ended Dec 31 at 13443, this increased almost 22%, not including dividends!!

I guess what I am seeing/experiencing is might as well just index invest. I'm sure if there's a great deal on a stock, it's worth buying. But I think, going forward, we are going to put more of our portfolio in an index fund.

I have already started adding positions and we're using XIC. I chose this over XIU, because it's total return has been higher than XIU, despite having a higher MER.

[crimsondr]

Can I have a bank account as an intermediary between my LOC and investment accounts? The bank account would only be used to move money between the LOC and investment accounts. I would also park money in the bank account to make interest payments on the LOC.

edit:
Another question, is it a problem if the LOC is joint but the investment account is individual?

[Jungle]

Can I have a bank account as an intermediary between my LOC and investment accounts? The bank account would only be used to move money between the LOC and investment accounts. I would also park money in the bank account to make interest payments on the LOC.

edit:
Another question, is it a problem if the LOC is joint but the investment account is individual?

I would say no, because if you have "other" money in the chequing account used to pay the heloc, they could consider that co-mingling. Best to keep it clean as possible, with a paper trail that can't be disputed. Does your brokerage allow you to pay bills directly from your HELOC? That's what we do, just print off the confirmation after, throw it in the tax file, with the paperwork from the securities bought.

Not a problem, but from what I understand, you must choose one person to make the tax deduction and stick with that same person year after year. You can't switch to whomever gets the best tax deduction, just because it suits your advantage.

[crimsondr]

I would say no, because if you have "other" money in the chequing account used to pay the heloc, they could consider that co-mingling. Best to keep it clean as possible, with a paper trail that can't be disputed. Does your brokerage allow you to pay bills directly from your HELOC? That's what we do, just print off the confirmation after, throw it in the tax file, with the paperwork from the securities bought.

Not a problem, but from what I understand, you must choose one person to make the tax deduction and stick with that same person year after year. You can't switch to whomever gets the best tax deduction, just because it suits your advantage.

The chequing account would contain only money from either the LOC or investment account. My interest payments on the LOC are deducted from the chequing account, so I need to have money there to cover the payment. So I would move money from the LOC to the chequing account each month to cover the interest.

From my understanding I can deposit "outside" money into the investment accounts and it wouldn't affect the deductibility of the loan. As long as money doesn't flow out of the investment/deductible accounts into a non-deductible account, then I should be fine?

edit: Looks like what I propose should be find. See here (http://www.milliondollarjourney.com/the-smith-manoeuvre-money-flow.htm).

[crimsondr]

How do you account for distributions? For example, ishares only provides the break down of distributions yearly. But what if you did not receive all distributions? How do I determine the ROC of the distributions I did receive?

[Jungle]

How do you account for distributions? For example, ishares only provides the break down of distributions yearly. But what if you did not receive all distributions? How do I determine the ROC of the distributions I did receive?

I'm just going to reinvest all distributions, Questrade offers a free drip for this.

[crimsondr]

I'm just going to reinvest all distributions, Questrade offers a free drip for this.

But don't you still need to make the calculation fir dividends/income?

[Jungle]

From what I understand, only if you are splitting up the distribution(s) and applying the dividend to your mortgage.

However, this would take too much time and paperwork for my liking.

So, as Ed has posted, easiest way is just to re-invest the entire distribution (dividend, ROC and other income) and buy more shares.

With this, you will more than likely:

Beat your mortgage rate with the return on the re-investment, and,
Allow a bigger compound on the investment.

[kerdon]

How should I explain to a prospect I came across that their fund the advisor put them in that is guaranteed to return 8% has some ROC in it?

Their current advisor DSC'd the fund($180,000), and said the whole LOC is tax deductible...this has been going on for a couple years....

Client's have been claiming LOC interest deductibility, and previous advisor did not say there was any ROC in it...

What to do?

[Jungle]

Look up an read Ed's post, #1256, then ask your friend if they are doing that.

[kerdon]

Look up an read Ed's post, #1256, then ask your friend if they are doing that.

Unfortunately they are using the distrib to pay down the non-ded mortgage, and re-advancing the LOC.

[crimsondr]

From what I understand, only if you are splitting up the distribution(s) and applying the dividend to your mortgage.

However, this would take too much time and paperwork for my liking.

So, as Ed has posted, easiest way is just to re-invest the entire distribution (dividend, ROC and other income) and buy more shares.

With this, you will more than likely:

Beat your mortgage rate with the return on the re-investment, and,
Allow a bigger compound on the investment.
I plan on using the distribution to pay the LOC so there's no problem with deductibility. My point is I still have to pay taxes on the dividends/income. So how do I know how much dividends/income I received if I only received partial distributions for the year but they (ishares) gives the breakdown yearly?

[kdang]

Hi,
I have a question setting up the SM.

My situation:
I'm currently living in a 255,000 condo thats already paid off,
its a perfect rental suite where i can get about $1300 / mo for.

I'm looking to purchase a townhouse and rent out my current condo.

Ive read that alot of people are setting up the SM using investments, but how does it work with rental property?

[Jungle]

Unfortunately they are using the distrib to pay down the non-ded mortgage, and re-advancing the LOC.

I would seek advice from a tax professional on what to do.

I am not a tax expert, but I would guest the *right* thing to do is:

Amend old tax returns and make them correct. This will result in the tax being paid back. Again, seek professional advice.

[Jungle]

I plan on using the distribution to pay the LOC so there's no problem with deductibility. My point is I still have to pay taxes on the dividends/income. So how do I know how much dividends/income I received if I only received partial distributions for the year but they (ishares) gives the breakdown yearly?

Your brokerage should give you a tax slip (around this time) that shows a break down on what was paid.

[Jungle]

Hi,
I have a question setting up the SM.

My situation:
I'm currently living in a 255,000 condo thats already paid off,
its a perfect rental suite where i can get about $1300 / mo for.

I'm looking to purchase a townhouse and rent out my current condo.

Ive read that alot of people are setting up the SM using investments, but how does it work with rental property?

You would just secure a HELOC against your rental property, then buy investments with the HELOC. Collect your rent cheques, then deduct your rental expenses but keep it separate from HELOC/Investment side.

PS: (this is off topic but..)

Since your mortgage is paid off, you will not have any mortgage interest to deduct from the rent cheques you receive. This makes rental properties rather tax inefficient. The rent cheques will be added to your regular income and taxed at your marginal tax rate.

Check your yield/profit margin/cash flow after paying tax and doing deductions. In most cases, it's not that attractive for rental properties.

[kdang]

You would just secure a HELOC against your rental property, then buy investments with the HELOC. Collect your rent cheques, then deduct your rental expenses but keep it separate from HELOC/Investment side.

PS: (this is off topic but..)

Since your mortgage is paid off, you will not have any mortgage interest to deduct from the rent cheques you receive. This makes rental properties rather tax inefficient. The rent cheques will be added to your regular income and taxed at your marginal tax rate.

Check your yield/profit margin/cash flow after paying tax and doing deductions. In most cases, it's not that attractive for rental properties.

this may be a dumb question but:
since the rental property is paid off, is it possible to borrow money against the rental property to put a larger down payment on the principle residence, somehow making the interest from the rental property tax deductible?

[Jungle]

this may be a dumb question but:
since the rental property is paid off, is it possible to borrow money against the rental property to put a larger down payment on the principle residence, somehow making the interest from the rental property tax deductible?

Absolutely not. This would be borrowed money used for principal residence. Not deductible.

The only way around this, would be to sell your rental property, then buy it back, but using a new mortgage. But that's a mess and a headace. You will incure lawyer and land transfer taxes.

Interesting, there is recent post in MDJ concerning your exact question:

http://www.milliondollarjourney.com/converting-a-principal-residence-into-a-rental-property-the-solution.htm

But honestly, in theory selling and then buying back your property is just not realistic or with the time/hassle/etc.

[edrempel]

Hey I just wanted to post a couple of thoughts.
My second thought, based on my experience so far, since doing the SM since July, I have noticed that our dividend paying stock portfolio have not beat the performance of the benchmark index. We got kinda lucky with one stock return, but the rest we like duds in appreciation, however thankfully they paid a nice dividend.

Picking stocks is not easy. Beating the benchmark is not easy. Last year the TSX comp total return was like 17%, our portfolio with dividend return was like 12%. I think it's just easier to use an index based approach and re-invest the distributions. You don't have to worry about financials, company reports, loss quarters, etc. Less stressful with index investing, you can do other things with your time. Just let the historical history of benchmark returns do the work.

What do you guys think of all this?

Hi Jungle,

I agree. Beating the index is harder than most people think. In strong bull markets, dividend-paying stocks normally trail growth stocks. Picking stocks that have performed well recently means you are probably buying in higher and may well have lower than index returns going forward. There are a variety of easy mistakes to make and it is difficult to research all the stocks fully.

Most professionals underperform the index and I'm sure the percentage of amateurs that underperform the index is much higher. For example, a variety of studies have shown that the average investor makes only 1/3 of the return OF THE INVESTMENTS THEY OWN. This is because they normally buy when it is doing well and sell when it is not.

My own strategy to try to outperform has been to focus my research on the fund managers and invest with the ones I think are the best stock-pickers long term. I think investing with these All Star Fund Managers is my best chance to beat the index.

For amateur investors, I agree that most should stick to index investments.


Ed

[edrempel]

Can I have a bank account as an intermediary between my LOC and investment accounts? The bank account would only be used to move money between the LOC and investment accounts. I would also park money in the bank account to make interest payments on the LOC.

edit:
Another question, is it a problem if the LOC is joint but the investment account is individual?

Hi Crimsondr,

If you use the chequing account only for the Smith Manoeuvre transfers, then you should be fine. The issue is tracing the money from the LOC to the investments and not mixing it up with non-deductible money.

Jungle is right about your other question. The credit line is usually joint, since it needs to be in the name of the home owners. The investments are often best purchased joint as well for estate planning purposes, but it is no problem if you purchased them in your name only.

When you file your first tax return after starting the SM, you are declaring who borrowed to invest. This can be either one or both. Once you have declared this, it applies for all future years. For this reason, it is important to think of who will benefit most from claiming both the tax deductions and the investment income - not just this year but for the entire length of time you intend to maintain the Smith Manoeuvre.

Of course you can sell and pay off the loan and then borrow again to show it all in a different name for tax purposes, but that means you will have to pay tax on all the capital gains up until that point.


Ed

[edrempel]

How should I explain to a prospect I came across that their fund the advisor put them in that is guaranteed to return 8% has some ROC in it?

Their current advisor DSC'd the fund($180,000), and said the whole LOC is tax deductible...this has been going on for a couple years....

Client's have been claiming LOC interest deductibility, and previous advisor did not say there was any ROC in it...

What to do?

Hi Kerdon,

Unfortunately, quite a few advisors have been flogging the Smith/Snyder version of the Smith Manoeuvre that includes paying out the ROC distribution. I have come across quite a few in exactly the situation you mentioned. If they are audited, they will probably lose.

This is actually a fear of mine. Many people are doing this and not being told the interest is not deductible. If they are audited and lose, this could hit the news, which could say there is a problem with the Smith Manoeuvre. The SM could be falsely dragged into some clients tax problem.

So, let's be clear - any strategy that involves taking non-taxable distributions out of the investments is NOT the Smith Manoeuvre. It is the Smith/Snyder, which has a tax problem unless you do the complex "Snyder tax calculation" to prove how much of the interest is still deductible.

This is why I think people should only do the Smith Manoeuvre with a financial advisor that will also do their tax return and put his name on their return as the tax preparer.

Mutual funds that pay a fixed 8% distribution are almost all paying mainly ROC. The way to explain it is to ask them if their T3 or T5 slip includes the income for the entire distribution. Any distribution paid must be capital gains, dividends, interest or ROC. Any amount not on the T3 or T5 slip is ROC. ROC is really just getting your principal back.

Here is how I explain it. Let's say you borrow $100,000 to invest. Then you cash in the investments and spend the money. Is the interest still tax deductible? Of course not. It is only deductible as long as the money is invested.

When you receive tax-free distributions from a mutual fund, they are tax-free because you are receiving your principal back. This is similar to the above example. If you take your money out, that amount of the loan is no longer deductible.

Therefore, if they received $1,200/month of distributions that are not taxable, then $14,400 of your investment loan is no longer tax deductible. After 12.3 years, NONE of the investment loan is tax deductible.

The issue can be worse than this. The calculation is complicated. If they are audited, CRA does not do the calculation. It is up to them to show how much of the interest is tax deductible. If they can't, CRA could deny all the interest until they show how much is deductible.

Show your prospects this email. I am an accountant, registered e-filer with CRA and financial advisor. If they still doubt you, have them show this email to an accountant.

I hope that is helpful, Kerdon.




Ed

[edrempel]

I plan on using the distribution to pay the LOC so there's no problem with deductibility. My point is I still have to pay taxes on the dividends/income. So how do I know how much dividends/income I received if I only received partial distributions for the year but they (ishares) gives the breakdown yearly?

Hi Crimsondr,

I'm not sure I understand your question. If you pay the entire distribution onto the LOC or reinvest the entire distribution, then tax deductibility of the LOC is not an issue. You then receive your ishares tax detail at the end of the year and claim that amount on your tax return.

If you want to separate the dividend from the ROC portion and do something different with them, that is tricky. As you said, you do not know the split when you receive the distribution. You could accumulate the distributions all year in a separate bank account and then only split them up when you get your tax detail.

My advice would be to pay the entire amount onto the LOC or reinvest the entire amount.



Ed

[edrempel]

Hi,
I have a question setting up the SM.

My situation:
I'm currently living in a 255,000 condo thats already paid off,
its a perfect rental suite where i can get about $1300 / mo for.

I'm looking to purchase a townhouse and rent out my current condo.

Ive read that alot of people are setting up the SM using investments, but how does it work with rental property?

Hi KDang,

I agree with all Jungle's comments. You can't borrow against the rental to pay down on your home, since that would not be deductible. You can sell it and buy it back, but that is expensive.

Rental properties without a mortgage are usually very tax-inefficient, so you should do the calculations, but it may be best to sell it to buy faster growing investments. In the last 30 years, real estate has had 1/6 of the growth of the stock market. In fact, in the last 30 years, real estate has had about 1/2 of the growth of GICs, which are also tax-inefficient. The cash flow from the rental must be compelling to be worth keeping it.

There is an option with the SM, though. If you borrow against the rental to invest and you buy tax-efficient investments, you can claim the interest, which can counter most of your rental income. If you invest to have little or no investment income, then you can offset the taxable rental income.

This highlights one difference between the Smith Manoeuvre and investing in a rental property. In a rental property with a large mortgage, you can claim the interest against rent and hope to pay no tax (especially if you claim some CCA). However, with the SM, you can get tax REFUNDS most years, if you borrow to invest in tax-efficient investments.

If you do a tax-efficient SM, it can make up for the tax-inefficient rental property.




Ed

[funkybeats]

Hello All,

I would like to start the SM this year as I have a large tax return (to apply to my principal mortgage) and I have accumulated enough capital in my home to set up a HELOC. I currently have my mortgage with RBC and can set up the Homeline auto-readvanceable HELOC with them. The problem is I do not want to be locked into renewing my mortgage with RBC in two years time in case they don't play ball. How does it work if I sign with someone else? Is the HELOC terminated and are there tax implications from this? If not, how does RBC know how much to auto-readvance if the mortgage is held by another institution? My investment would most likely be an ETF like XIC through Questrade.

Any comments/criticism of this approach is most welcome.

Thanks,

FB.

[gregtd]

Hello All,

I would like to start the SM this year as I have a large tax return (to apply to my principal mortgage) and I have accumulated enough capital in my home to set up a HELOC. I currently have my mortgage with RBC and can set up the Homeline auto-readvanceable HELOC with them. The problem is I do not want to be locked into renewing my mortgage with RBC in two years time in case they don't play ball. How does it work if I sign with someone else? Is the HELOC terminated and are there tax implications from this? If not, how does RBC know how much to auto-readvance if the mortgage is held by another institution? My investment would most likely be an ETF like XIC through Questrade.

Any comments/criticism of this approach is most welcome.

Thanks,

FB.

In two years you can move your HELOC along with your mortgage. No tax implications as long as you have a clear paper trail documenting that the investment loan (HELOC) moved from one bank to another with no co-mingling of non-deductable interest expenses. I'm in the process of doing this right now.

Also you'll want to be careful with XIC as I believe there is a ROC component of their distribution. As long as you are re-investing the distribution there is no problem, however if you use the distribution for something else (i.e. to pay your mortgage) you'll need to factor this into the amount of deductable interest expense you're claiming on your tax return.

[edrempel]

Hello All,

I would like to start the SM this year as I have a large tax return (to apply to my principal mortgage) and I have accumulated enough capital in my home to set up a HELOC. I currently have my mortgage with RBC and can set up the Homeline auto-readvanceable HELOC with them. The problem is I do not want to be locked into renewing my mortgage with RBC in two years time in case they don't play ball. How does it work if I sign with someone else? Is the HELOC terminated and are there tax implications from this? If not, how does RBC know how much to auto-readvance if the mortgage is held by another institution? My investment would most likely be an ETF like XIC through Questrade.

Any comments/criticism of this approach is most welcome.

Thanks,

FB.

Hi FB,

Royal's Homeline is one of the better ones for the way it works with the SM, but our experience is the they are a 5-year bank. They tend to have good 5-year rates, but are often far from competitive on 1-year or 2-year (which it sounds like you have) fixed rates. (We are recommending 1-year fixed rates today, which keeps your options open a year from now, probably saves you money over any other term, and allows you to probably get a better rate on a variable next year.)

Royal is also at prime +1% on the credit line portion, which is higher than some other banks.

If you move, you need to move the entire mortgage and HELOC to another readvanceable mortgage. The key is to make sure you start with the same tax deductible credit line that you end with before the move.



Ed

[kerdon]

A few of you guys will like this one I recently came across.

Some Financial Planners, and Investment retirement planners. You should be able to figure out what bank these people work for.

Are using a CHIP mortgage, and invest the clients into a managed payout solution, then telling them that the interest paid on the investment loan(chip mortgage) is deductible as an interest expense.

Unfortunately the managed payout solution includes ROC, which will reduce what interest amount can be claimed as the borrowing to invest....

tisk tisk to these planners....

[funkybeats]

Hi FB,

Royal's Homeline is one of the better ones for the way it works with the SM, but our experience is the they are a 5-year bank. They tend to have good 5-year rates, but are often far from competitive on 1-year or 2-year (which it sounds like you have) fixed rates. (We are recommending 1-year fixed rates today, which keeps your options open a year from now, probably saves you money over any other term, and allows you to probably get a better rate on a variable next year.)

Royal is also at prime +1% on the credit line portion, which is higher than some other banks.

If you move, you need to move the entire mortgage and HELOC to another readvanceable mortgage. The key is to make sure you start with the same tax deductible credit line that you end with before the move.



Ed

Ed,

Unfortunately I'm stuck with a fixed rate for the next two years due to some bad timing on the purchase of my house. I won't be able to switch to another product until then due to the size of the IRD penalty. However, I don't want to wait until then to start implementing the SM. This leaves me with homeline as an option due to the simplicity of the re-advance and transfers from the account.

Thanks,

FB.

[zzricezz]

Is there a fee to setup a HELOC with my bank? And is Prime + 0.5% good? or I can still shop around?

[gregtd]

Is there a fee to setup a HELOC with my bank? And is Prime + 0.5% good? or I can still shop around?

There are legal / appraisal fees but the bank may waive them (shop around)

Prime + 0.5% is the best rate you'll get unless you are an engineer, then National will give you prime + 0%.

[funkybeats]

I was doing some reading on canadiancouchpotato.com and the advice they were giving was to not set an ETF for monthly purchases due to the trading commissions. They indicated that you should try to keep your trading cost to 1% or less of the value of the stock trade. My question is: I believe that by waiting and making one lump sum purchase a year to reduce trading costs will cause me to miss out on too much upside on the ETF. Twelve trades a year only costs ~$120.00. What are your thoughts...?

Thanks,

FB.

[crimsondr]

I was doing some reading on canadiancouchpotato.com and the advice they were giving was to not set an ETF for monthly purchases due to the trading commissions. They indicated that you should try to keep your trading cost to 1% or less of the value of the stock trade. My question is: I believe that by waiting and making one lump sum purchase a year to reduce trading costs will cause me to miss out on too much upside on the ETF. Twelve trades a year only costs ~$120.00. What are your thoughts...?

Thanks,

FB.

You could buy e-series mutual funds from TD throughout the year. Then periodically sell those and buy ETFs.

[funkybeats]

You could buy e-series mutual funds from TD throughout the year. Then periodically sell those and buy ETFs.

Would that not incur capital gains, which I would then be taxed on?

Thanks,

FB.

[gregtd]

Would that not incur capital gains, which I would then be taxed on?

Thanks,

FB.

Correct, that would incur capital gains.

You'll also want to diversify, so your monthly contribution may result in multiple ETF purchases (and multiple commission fees). You could look into the Claymore PAC plan if your broker offers this (mine doesn't)

I'm leaning towards going the no-load low MER mutual fund route (PH&N or Mawer for example)

[funkybeats]

So I met with my contact at RBC and to set the HELOC up there is a $460.00 fee. This is to discharge my current mortgage with them and set up the new mortgage that includes the homeline HELOC. Has anyone had any experience getting around this fee?

Thanks,

FB.

[FrugalTrader]

So I met with my contact at RBC and to set the HELOC up there is a $460.00 fee. This is to discharge my current mortgage with them and set up the new mortgage that includes the homeline HELOC. Has anyone had any experience getting around this fee?

Thanks,

FB.

I would start getting some quotes from other banks. The fee is likely the appraisal/legal fees but some banks will pay it out of their own pockets to obtain your business.

[Eyies]

I have a question regarding the tax deductibility of an investment loan in a non-registered account.

Regarding Line 221, from the CRA it reads, that you can claim

.. most interest you pay on money you borrow for investment purposes, but generally only as long as you use it to try to earn investment income, including interest and dividends. However, if the only earnings your investment can produce are capital gains, you cannot claim the interest you paid.

Reading around I've found two arguments:
1) The interest charges from borrowed money used to purchase non-dividend paying common stocks are not deductible as they do not produce interest or dividends.
2) The interest is still deductible due to the possibility that in the future the common stocks can start paying dividends. As long as the company does not have some sort of explicit clause which states that they will indefinitely never pay dividends.

So which is it? Anyone ever get into tax troubles or ineligibility on non-dividend stocks?

[edrempel]

I have a question regarding the tax deductibility of an investment loan in a non-registered account.

Regarding Line 221, from the CRA it reads, that you can claim


Reading around I've found two arguments:
1) The interest charges from borrowed money used to purchase non-dividend paying common stocks are not deductible as they do not produce interest or dividends.
2) The interest is still deductible due to the possibility that in the future the common stocks can start paying dividends. As long as the company does not have some sort of explicit clause which states that they will indefinitely never pay dividends.

So which is it? Anyone ever get into tax troubles or ineligibility on non-dividend stocks?

Hi Eyies,

Argument 2 is correct. If you buy a stock or mutual fund that could some day pay a dividend, then the interest is normally deductible. The exception would be an investment structured so that it is prevented from paying a dividend.

We normally invest in tax-efficient mutual funds, some of which have never paid a dividend, but deducting the interest is no problem, since they could pay a dividend someday.

Here is a direct quote from CRA (IT-533):

"Where an investment does not carry a stated interest or
dividend rate such as some common shares, the
determination of the reasonable expectation of income at the
time the investment is made is less clear. Normally, however,
the CCRA considers interest costs in respect of funds
borrowed to purchase common shares to be deductible on the
basis that there is a reasonable expectation, at the time the
shares are acquired, that the common shareholder will
receive dividends. Nonetheless, each situation must be dealt
with on the basis of the particular facts involved.
These comments are also generally applicable to investments
in mutual fund trusts and mutual fund corporations."

IT-533 then goes on to give examples with a normal company that does not pay a dividend but might someday:

"Example 9
S Corp. is raising capital by selling common shares. Its
business plans indicate that its cash flow will be required to
be reinvested for the foreseeable future and S Corp. discloses
to shareholders that dividends will only be paid when
operational circumstances permit (i.e., when cash flow
exceeds requirements) or when it believes that shareholders
could make better use of the cash. In this situation, the
purpose of earning income test will generally be met and any
interest on borrowed money to acquired S Corp. shares
would be deductible."


Ed

[edrempel]

So I met with my contact at RBC and to set the HELOC up there is a $460.00 fee. This is to discharge my current mortgage with them and set up the new mortgage that includes the homeline HELOC. Has anyone had any experience getting around this fee?

Thanks,

FB.

Hi Funky,

We have had a couple of banks convert from their regular mortgage to their readvanceable mortgage for no fee. Most will charge, but Scotia will sometimes do it for no fee and I believe Royal is the other one.

The $430 fee must be a legal fee. It looks like they are not charging you an appraisal fee. Does that mean they are absorbing it, or are they not doing an appraisal? If you are starting the Smith Manoeuvre, you may want to start with a new appraisal to get the maximum available equity to invest.

I'm not positive, but I believe this fee can be waived. The issue is that you have 2 years left in your mortgage term. Any time during your mortgage term, you have virtually no negotiating power. They probably can waive the fee - but why should they? You are stuck with them for 2 years no matter how badly they treat you.

All you can do is try to bluff and say you are talking with another bank that will set one up for you without charging you appraisal or legal fee. We can refer you to one if necessary, but for now you can just bluff and see if they will waive the fee.

This is one of the reasons that going with short term mortgages, such as 1-year fixed, is often a great idea. We don't recommend locking in unless you get a really good deal.

You said the IRD penalty is too high to leave. Have you calculated it? How much is the penalty and how much could you save if you took today's rate? We are recommending 1-year fixed and are getting 2.64% today.

Call Royal to get the exact penalty and compare it to 2 years' interest savings at lower rates to see what it would cost or save you to leave. Compare that to the $430 fee it would cost you to stay.





Ed

[Mark77]

1) The interest charges from borrowed money used to purchase non-dividend paying common stocks are not deductible as they do not produce interest or dividends.
2) The interest is still deductible due to the possibility that in the future the common stocks can start paying dividends. As long as the company does not have some sort of explicit clause which states that they will indefinitely never pay dividends.

So which is it? Anyone ever get into tax troubles or ineligibility on non-dividend stocks?

Generally 2). But you have to stay away from things like GLD, SLV, U, USO -- 'stocks' that trade on the 'stock' exchanges, but really aren't stocks at all, and will never produce income. Generally speaking, it needs to be an active business, or a trust that holds active businesses, not merely a commodity fund.

Also, if you receive any sort of return of capital, or a payment that is made as a reduction of 'stated' capital, then you will have to use this money to repay your loans, and not use it for any other purpose, in order to maintain full deductibility.

[funkybeats]

Hi Funky,

We have had a couple of banks convert from their regular mortgage to their readvanceable mortgage for no fee. Most will charge, but Scotia will sometimes do it for no fee and I believe Royal is the other one.

The $430 fee must be a legal fee. It looks like they are not charging you an appraisal fee. Does that mean they are absorbing it, or are they not doing an appraisal? If you are starting the Smith Manoeuvre, you may want to start with a new appraisal to get the maximum available equity to invest.

I'm not positive, but I believe this fee can be waived. The issue is that you have 2 years left in your mortgage term. Any time during your mortgage term, you have virtually no negotiating power. They probably can waive the fee - but why should they? You are stuck with them for 2 years no matter how badly they treat you.

All you can do is try to bluff and say you are talking with another bank that will set one up for you without charging you appraisal or legal fee. We can refer you to one if necessary, but for now you can just bluff and see if they will waive the fee.

This is one of the reasons that going with short term mortgages, such as 1-year fixed, is often a great idea. We don't recommend locking in unless you get a really good deal.

You said the IRD penalty is too high to leave. Have you calculated it? How much is the penalty and how much could you save if you took today's rate? We are recommending 1-year fixed and are getting 2.64% today.

Call Royal to get the exact penalty and compare it to 2 years' interest savings at lower rates to see what it would cost or save you to leave. Compare that to the $430 fee it would cost you to stay.





Ed

Ed,

I'll see what I can do to get them to waive it, however my IRD as of February this year was $11,000. Due to timing, life issues, I got screwed on this mortgage (my first one). They are waiving the appraisal fee, so the agent I'm working with is trying to work it a bit. I think it may be harder to waive the legal fee because it is subcontracted to another firm that handles the title search for RBC. If I can't have the fee waived then based on my calculations it wouldn't make sense to implement my strategy at this point in time (Boo!).

Thanks,

FB.

[edrempel]

Ed,

I'll see what I can do to get them to waive it, however my IRD as of February this year was $11,000. Due to timing, life issues, I got screwed on this mortgage (my first one). They are waiving the appraisal fee, so the agent I'm working with is trying to work it a bit. I think it may be harder to waive the legal fee because it is subcontracted to another firm that handles the title search for RBC. If I can't have the fee waived then based on my calculations it wouldn't make sense to implement my strategy at this point in time (Boo!).

Thanks,

FB.

Hi FB,

With an IRD of $11,000, it is best for you to stay with RBC. Their Homeline works fine for the SM. It only requires one more manual transaction/month than working with some other banks. So if they will convert for only $430 and you want to start the SM, it is probably worth it.

Just insist that you just want to move your current mortgage into a Homeline - you don't want to extend your term for years from now.





Ed

[edrempel]

Hi Mark,

What did you do to get thanked 549 times for 439 posts? That's impressive!

I thought I was making helpful comments, but obviously nothing like you.




Ed

[Jungle]

Ed your posts and Marks posts are both very helpful, Mark just posts a lot more than you.

On Topic:

How does using the HELOC affect your credit rating?

[edrempel]

Ed your posts and Marks posts are both very helpful, Mark just posts a lot more than you.

On Topic:

How does using the HELOC affect your credit rating?

Hi Jungle,

A HELOC will show on your credit report as "revolving" credit. Most people have at least one "revolving" loan (credit line) of some sort. With the Smith Manoeuvre, the strategy generally is to stay close to the limit on the credit line, which can have a bit of a negative effect. Our experience is that having one SM credit line maxed out does not have much of an effect at all, but people that have several SM credit lines all maxed for investment, that can start to reduce your credit rating.

Some of readvanceable mortgages show both the mortgage and the credit line portions as if they are one huge credit line. For example, if you have a $300K mortgage and a $100K credit line portion all within one readvanceable, it is really a credit line with a limit of $400,000 with the mortgage (fixed portion) being part of it. From some banks, this will show as a $400,000 credit line that you have maxed.

Our mortgage contacts tell us that any lender would understand a HELOC and would know that it may include the mortgage. They would also know that the credit rating may be slightly lower than it should be because of the HELOC, especially if the HELOC is being used for a positive purpose such as for investment.



Ed

[edrempel]

Is there a fee to setup a HELOC with my bank? And is Prime + 0.5% good? or I can still shop around?

Hi zzricezz,

Were you able to negotiate a HELOC with no fee? Some banks will absorb the legal and appraisal fees, if you know how to negotiate well. It is worth shopping around, though, since there is no reason that your HELOC needs to be with your main bank. Knowing what other banks will do is also the key to effective negotiation.

We have contacts at all the banks that have Smith Manoeuvre mortgages/HELOCs and can refer you to a bank that will setup a HELOC with no legal or appraisal costs - much of the time. If you tell me about your situation, I can give you our contact at the bank that would work best for you.



Ed

[TitaniumWarrior101]

Hi Ed,

We just got setup with a HELOC from TD. We did not get an official appraisal as our place is brand new and we used the purchase cost as the assessed value. TD charged us a $335 setup fee to setup the HELOC. (Will the bank waive this fee?)

We did not do any research as we bank with TD and assumed all HELOC interest rates are the same...we got Prime + 1%.

The problem I have is that TD would only give me 35% loan to equity. I guess this is because my income is not that high. ($40,000) What do you think I could get at another place? Manulife ONE is the first one that comes to mind.

We purchased our place outright and have no mortgage. So technically if i use the HELOC to invest, am I just doing leveraged investing?

We also have a significant cash position. What are your thoughts about just using the cash to invest vs using the HELOC (and being able to deduct the interest payments) Our annual income is not high and I am afraid the deductible interest will go to waste.

Also, capitalizing the interest on the loan -- is it as simple as just withdrawing the interest payment from the HELOC and redepositing it back in? This would improve cash flow but wouldn't each interest payment I capitalize add onto the amount of the loan and thus incur more interest?

Thanks.

[edrempel]

Hi Ed,

We just got setup with a HELOC from TD. We did not get an official appraisal as our place is brand new and we used the purchase cost as the assessed value. TD charged us a $335 setup fee to setup the HELOC. (Will the bank waive this fee?)

We did not do any research as we bank with TD and assumed all HELOC interest rates are the same...we got Prime + 1%.

The problem I have is that TD would only give me 35% loan to equity. I guess this is because my income is not that high. ($40,000) What do you think I could get at another place? Manulife ONE is the first one that comes to mind.

We purchased our place outright and have no mortgage. So technically if i use the HELOC to invest, am I just doing leveraged investing?

We also have a significant cash position. What are your thoughts about just using the cash to invest vs using the HELOC (and being able to deduct the interest payments) Our annual income is not high and I am afraid the deductible interest will go to waste.

Also, capitalizing the interest on the loan -- is it as simple as just withdrawing the interest payment from the HELOC and redepositing it back in? This would improve cash flow but wouldn't each interest payment I capitalize add onto the amount of the loan and thus incur more interest?

Thanks.

Hi Titanium,

That was a few questions!

First, TD does not normally waive that fee (although our contact sometimes will). The $335 is probably a legal fee, not a setup fee. TD is at prime +1% on a HELOC, while quite a few other banks are at prime +.5%. HELOCs are not locked in, so it may make sense to get a different one right away, if another bank will give you a higher limit or lower interest rates, and especially if another bank will not charge you a legal or appraisal fee.

Without knowing your overall position, it is hard to comment. 35% is not much. Your income is probably the issue, although unless you have an expensive home or some other debts, it seems surprising to be that low.

The best strategy here depends on what you are trying to do. If you are trying to leverage as much as you can, you can try to get a higher HELOC limit somewhere (Manulife will do 50% without proof of income.) or you can get an investment loan. If you have cash, several trust companies may lend you up to 2 or 3 times the cash you have to invest.

Leveraged investing can be a very effective strategy if done properly and long term, whether or not you get much of a tax savings from the interest. However, if your income is that low, you should be careful not to get in over your head. You can capitalize the interest to avoid having to make the interest payments if you have little cash flow, and yes the investments will almost certainly go up in the long term, but don't forget that you still owe the money. The best strategy is usually to make sure any leverage is important and long term by making it part of your retirement plan.

The 2 main differences between the Smith Manoeuvre and regular leveraged investing are converting your mortgage to tax deductible over time (which doesn't apply to you with no mortgage) and capitalizing the interest (which you could do).

Capitalizing the interest is just one manual transaction you need to do each month, so that the investment credit line pays its own interest. It does mean that the credit line grows over time, as does the interest on the credit line. Whether or not this makes sense to do depends again on your goal. It is generally more effective for you to use your cash flow to invest than to pay tax deductible interest. The interest is at a low rate and tax deductible, and the interest on the interest would also be tax deductible. Therefore, the after-tax cost of the interest that you would save would be a very low return. For example, if you are paying prime +.5%, or 3.5%, even at your low 21% tax bracket, the interest is costing you about 2.75%. You should be able to invest or have other uses for your cash flow at higher returns over time than 2.75%.

However, capitalizing the interest means your debt does grow. You could, in theory, leverage quite a bit between your HELOC, cash and investment loan. But you need to plan around how much debt is too much debt for you, even if it is tax deductible, and how much you would need to do to have the retirement that you want.

Do you think your income will always be this low, Titanium?

If you would like a referral to the best HELOC for you, we have free, no obligation SM mortgage referral service if you answer a few questions on our web site (http://www.edrempel.com/mortgage_referral.php ).



Ed

[bcbud3]

i have a mortgage due for renewal may1. It's approx. 200k. My house is roughly worth 550k. Do you have anyone you can recommend here in BC? (Lower mainland, vancouver area?) Do i need a financial advisor as well as a banker? thanks for any help.

[edrempel]

i have a mortgage due for renewal may1. It's approx. 200k. My house is roughly worth 550k. Do you have anyone you can recommend here in BC? (Lower mainland, vancouver area?) Do i need a financial advisor as well as a banker? thanks for any help.

Hi BC Bud,

Yes. Mortgage people can work anywhere in Canada. It also does not matter if your mortgage is at a branch somewhere else. You can still keep your banking convenient - just have the mortgage somewhere else. They can take the payments from your regular bank account.

****************************************

You only need a banker for a mortgage, but if you are planning to do the Smith Manoeuvre, it is usually a good idea to work with a financial advisor. It is essentially borrowing to invest, which is an aggressive strategy. It is not hard to do, but it is also not hard to screw up.


Ed

[Jungle]

Ed

Have you seen/done any math or read any discussion about contributing to registered accounts to invest, vs pre-paying mortgage, reborrowing and investing the money in non-reg?

I know this is kinda the whole point of SM, but does is seem advantagous to stop registered account investing and just use the cash flow for SM?

[cannon_fodder]

Ed

Have you seen/done any math or read any discussion about contributing to registered accounts to invest, vs pre-paying mortgage, reborrowing and investing the money in non-reg?

I know this is kinda the whole point of SM, but does is seem advantagous to stop registered account investing and just use the cash flow for SM?

I posted a few of my own Excel-based spreadsheet/calculators at Canadian Money Forum. Perhaps you can get some ideas from them...

http://www.canadianmoneyforum.com/showthread.php?t=897

[edrempel]

Ed

Have you seen/done any math or read any discussion about contributing to registered accounts to invest, vs pre-paying mortgage, reborrowing and investing the money in non-reg?

I know this is kinda the whole point of SM, but does is seem advantagous to stop registered account investing and just use the cash flow for SM?

Hi Jungle,

I just returned from vacation in Cuba and noticed your interesting question.

Yes, we've analyzed this in depth for many clients. The answer is different depending on the situation.

In general, though, here are several ways to look at it:

1. The Smith Manoeuvre can already be done with only your basic mortgage payment, since you will already be paying some principal. So, it is easily possible to do some Smith Manoeuvre and then use extra cash flow for either more Smith Manoeuvre or RRSP or something else.

2. if you use extra cash flow for just increasing your plain Smith Manoeuvre, then RRSPs will give you larger tax deductions. If you use $10,000 extra cash to make an RRSP contribution, you get a deduction for the full $10,000. If you use that $10,000 to increase your mortgage payment and reborrow with the Smith Manoeuvre, you only get a tax deduction for the interest on the $10,000.

There are tax advantages both ways, depending on your situation and the method you use, but RRSPs will normally give you a large refund in the early years, which you can use to invest more.

3. You can get a similar tax refund by using a different version of the Smith Manoeuvre, such as the Rempel Maximum. For example, you can contribute your extra $10,000 to an RRSP or you can take out an investment loan for about $200,000 with interest payments of $10,000. Both ways, you get a tax deduction for $10,000, but with the Rempel Maximum version of the Smith Manoeuvre, you have $200,000 invested - not just $10,000. This is obviously a much more aggressive version, but the cash flow is the same with much greater long term potential than RRSPs.

4. In practice, we most commonly do a combination. Many of our clients are doing a version of the Smith Manoeuvre and are also on a plan to maximize their RRSPs. So, during their working life, they will pay off their mortgage and reborrow with the Smith Manoeuvre AND contribute the maximum RRSP. When this is true, their extra cash flow is only used to determine how much Smith Manoeuvre vs. how much RRSP to do this year.

The answer, then, is somewhat different. The optimal strategy most of the time is to set the mortgage payment to pay it off before you retire and then use the remaining cash flow for RRSP, making sure it is enough to maximize the RRSP room before you retire.


--------
The answer in each situation could be different, depending on factors like:

- your tax bracket today vs. when you retire
- how much you leverage
- how tax-efficient your investments will be
- how far your taxable income is from a tax bracket break
- how aggressive you want to build wealth.

Does that answer your question, Jungle?


Ed

[Jungle]

Hi Jungle,

I just returned from vacation in Cuba and noticed your interesting question.

Yes, we've analyzed this in depth for many clients. The answer is different depending on the situation.

In general, though, here are several ways to look at it:

1. The Smith Manoeuvre can already be done with only your basic mortgage payment, since you will already be paying some principal. So, it is easily possible to do some Smith Manoeuvre and then use extra cash flow for either more Smith Manoeuvre or RRSP or something else.

2. if you use extra cash flow for just increasing your plain Smith Manoeuvre, then RRSPs will give you larger tax deductions. If you use $10,000 extra cash to make an RRSP contribution, you get a deduction for the full $10,000. If you use that $10,000 to increase your mortgage payment and reborrow with the Smith Manoeuvre, you only get a tax deduction for the interest on the $10,000.

There are tax advantages both ways, depending on your situation and the method you use, but RRSPs will normally give you a large refund in the early years, which you can use to invest more.

3. You can get a similar tax refund by using a different version of the Smith Manoeuvre, such as the Rempel Maximum. For example, you can contribute your extra $10,000 to an RRSP or you can take out an investment loan for about $200,000 with interest payments of $10,000. Both ways, you get a tax deduction for $10,000, but with the Rempel Maximum version of the Smith Manoeuvre, you have $200,000 invested - not just $10,000. This is obviously a much more aggressive version, but the cash flow is the same with much greater long term potential than RRSPs.

4. In practice, we most commonly do a combination. Many of our clients are doing a version of the Smith Manoeuvre and are also on a plan to maximize their RRSPs. So, during their working life, they will pay off their mortgage and reborrow with the Smith Manoeuvre AND contribute the maximum RRSP. When this is true, their extra cash flow is only used to determine how much Smith Manoeuvre vs. how much RRSP to do this year.

The answer, then, is somewhat different. The optimal strategy most of the time is to set the mortgage payment to pay it off before you retire and then use the remaining cash flow for RRSP, making sure it is enough to maximize the RRSP room before you retire.


--------
The answer in each situation could be different, depending on factors like:

- your tax bracket today vs. when you retire
- how much you leverage
- how tax-efficient your investments will be
- how far your taxable income is from a tax bracket break
- how aggressive you want to build wealth.

Does that answer your question, Jungle?


Ed

Yes. Thank you for your response, much appreciated.

At the end of this year, we will have maxed out both our TFSA. Then, I am at the tax threshold for maxing my RRSP, without falling into a lower tax bracket. My wife has lots of contribution room in her RRSP, but her tax rate is low.

I believe over the long term, we can beat our mortgage rate by putting money in the markets. However, I do want to pay the mortgage sooner rather than later.

So for right now, we are going to apply our extra cash flow to our TFSA, RRSP, and double our mortgage payment. If the TSX dropps again tomorrow, I will be adding more to our leveraged index fund. (which is sm)

[Jungle]

There seems to be a consensus that if your investments are paying dividends, Canadian stocks are the most tax efficient, due to the dividend tax credits.
I would think a lot of people just have Canadian Equity in the SM portfolios..

How do you properly diversify so you don't have too much Canadian exposure? Can you put US and international funds in your SM portfolio? What are the tax implications like?

[goriders]

So I get the idea of the Smith Manoeuvre and in a perfect world I think it would work but if you keep your home leveraged to the max so you can invest it in RRSP's what would happen if the markets turn again and you owe more on your house than what its worth or your RRSPs goes down in value. The way I look at it is if I had a paid for house would I take a mortgage to invest and the answer for me is no. Just my 2 cents. Not to mention the inevitable fact that mortgage rates are at an all time low right now and are only going to increase.

[Jungle]

Leveraged inveting is not for everybody and doing it depends on your risk tolerance. What makes it ideal, is that you can deduct the interest used to invest. So this really lowers your effective borring rate. And yes, rates are headed up. Less ROE. However , with the right investments, you can beat your interest rate over a long period time.

Not sure what would happen if you max out your avaliable equity and the home dropped in value. That's why I do not max out our avaliable equity.

I was leverage investing when the stock market crashed. If this happens again, I will just buy more. The value on stocks was amazing. We are also invested for the long term.

[gregtd]

So I get the idea of the Smith Manoeuvre and in a perfect world I think it would work but if you keep your home leveraged to the max so you can invest it in RRSP's what would happen if the markets turn again and you owe more on your house than what its worth or your RRSPs goes down in value. The way I look at it is if I had a paid for house would I take a mortgage to invest and the answer for me is no. Just my 2 cents. Not to mention the inevitable fact that mortgage rates are at an all time low right now and are only going to increase.

This is a long-term strategy and you need to be willing and able to ride out the inevitable market fluctuations.

Also keep in mind that you can not deduct interest expense on money borrowed for RRSP investments. Your investments need to be non-registered.

[Anonymouse]

Does TD have a HELOC product whose credit limit goes up as you pay down the mortgage?

[Jungle]

Yes they do. Check this handy SM mortgage guide here. TD is at the bottom:

http://www.myvirtualmortgagebroker.com/Smith-Manoeuvre-Mortgages-Smith-Maneuver.html

[Anonymouse]

Yes they do. Check this handy SM mortgage guide here. TD is at the bottom:

http://www.myvirtualmortgagebroker.com/Smith-Manoeuvre-Mortgages-Smith-Maneuver.html

Thanks for the link. I just got a HELOC with TD intending to invest with, but my rep told me they have no product whose limit increases automatically with mortgage pay-down. Instead, I have to apply for periodic increases. Was I misled by the rep?

[Jungle]

Odd, maybe it changed? Best to search and check with another rep.

[cannon_fodder]

I think there may be some confusion. The SM friendly mortgages have readvanceable line of credit attached. The limit of the two portions doesn't change automatically. That would require a formal process involving an assessment of your homes value.

The SM mortgage allows you to withdraw from your LOC an amount equal to your mortgage principle payment each and every time you make a payment. The limit doesn't change but the available credit does.

[edrempel]

There seems to be a consensus that if your investments are paying dividends, Canadian stocks are the most tax efficient, due to the dividend tax credits.
I would think a lot of people just have Canadian Equity in the SM portfolios..

How do you properly diversify so you don't have too much Canadian exposure? Can you put US and international funds in your SM portfolio? What are the tax implications like?

Hi Jungle,

Yes, it seems that the "home country bias" is very strong in Canada these days. Nearly all investors we meet are 80-100% in Canada. That is obviously a risky position with 50% in cyclical resources and 30% in banks. That's 80% in 3 of 14 sectors, which cannot possibly be considered diversified. We don't actually consider a large cap Canadian fund to be a core holding now, because of the extreme lack of diversification.

In addition, Canada's banks are the most expensive banks in the world. You can buy banks much cheaper almost anywhere. And resources have a lot of speculation built into them. Oil has about $30/barrel of risk premium built in because of mid-east unrest. That may well eventually disappear if things calm down at some point. Gold is essentially purely speculative, with jewelry and central bank demand down in the last decade. The entire price rise of gold in the last decade results from a 1500% rise in speculative investment demand, mainly because of the introduction of gold ETFs. Canada's resource companies are also priced higher than many other countries. Why buy an oil company in Canada if you can get a more profitable one at half the P/E in Malaysia?

The point is that Canada is not diversified and relatively expensive, so there is quite a bit of risk. Diversification is highly recommended.

--------
You are right that Canadian dividends are tax-preferred over foreign dividends, but of course No dividends is tax-preferred to receiving dividends. Any dividend you receive costs you tax, unless you are in the lowest tax bracket.

The lowest tax results from capital gains deferred for 20-30 years from now, which you can accomplish with tax-efficient investments.

------------
There is no problem with investing SM investments internationally in global mutual funds, for example. The investments are still fully deductible. Many of the best fund managers are global fund managers.





Ed

[edrempel]

So I get the idea of the Smith Manoeuvre and in a perfect world I think it would work but if you keep your home leveraged to the max so you can invest it in RRSP's what would happen if the markets turn again and you owe more on your house than what its worth or your RRSPs goes down in value. The way I look at it is if I had a paid for house would I take a mortgage to invest and the answer for me is no. Just my 2 cents. Not to mention the inevitable fact that mortgage rates are at an all time low right now and are only going to increase.

Hi goriders,

Go Bombers! (I'm originally from Winnipeg.)

Jungle is right that the Smith Manoeuvre or any leverage strategy is not for everybody.

A couple of points, though. One is that you cannot invest it in RRSPs. It has to be non-registered investments. This could be the same investments you would buy in your RRSP, except that you would be more concerned with tax-efficiency.

Market declines in the value of your home or your investments is probably not a problem if you are a long term investor. In the past, the banks did not reduce credit line limits when home values declines. In the early 1990s, Toronto homes fell 31% and every credit line I am aware of maintained its credit limit. So, you should be able to continue with the Smith Manoeuvre with a decline in the price of your home. The only issue that may come up is if you sell before it recovers.

Your investments should probably eventually recover from any market decline. The major stock markets have recovered within 1-2 years from 88% of all declines and nearly 100% of the time in 6 years, so if you are properly diversified, don't try to time the market, and invest long term, temporary market declines should not be a problem.

There is also no problem specifically from having your investments lower than the credit line. The security is normally your home, so there is no risk of a margin call if the investments go down in value.

Mortgage rates are very low right now, but will probably only rise to a more normal value. We are getting secured credit lines at 3.5% today, while the average in the last decade is between 4.0-4.5%. After you deduct the tax refund, the cost of borrowing is relatively low.

For example, even if you are just in a middle tax bracket of about 33%, a 4.5% credit line rate would only cost you 3% after tax. So your investments only need to make more than 3% after tax long term for you to make money with the Smith Manoeuvre. The long term return of the stock market is 10-11% and it is possible to defer most of the capital gains tax for many years.

There is an element of LOWER risk from leverage as well. I'm just reading a book "Lifecycle Investing" by 2 Yale researchers. They found that doing leverage in your 20s to mid-50s (phasing it down over the years) actually REDUCED risk during your life. The issue is that most people build up investments slowly and after they finish paying off their mortgage, so their major investment holdings usually are only built up in the last 5-10 years before retirement. This can be very risky, since lower stock market returns in that 5-10 year period can severely reduce your retirement.

In fact, if you track a proper retirement plan, you normally don't reach half of your required nest egg until 5 years before retirement. For example, if you need $1 million (future dollars) by age 60 to have the retirement you want and you graph a constant conservative 8% return on investments, you will find that you only reach $500,000 by age 54.

In short, from age 20-54 you built up your first $500,000 and the other $500,000 is built up between age 54-60. If that ends up being a bad time in the markets, your retirement is in jeopardy. This normal way of saving for retirement gives you a lot of risk in the last few years before you retire.

If instead you leverage 2:1 in your 20s and kept it through your 40s and then phased it out by your mid-50s, your equity holdings are closer to even over many years. The Yale researchers found that the risk of failing to reach your retirement goal was 20% LOWER with leverage from your 20s to mid-50s than with no leverage.

Again, leverage is not for everyone, but there are sound financial reasons to consider it, especially when you are younger.




Ed

[edrempel]

Thanks for the link. I just got a HELOC with TD intending to invest with, but my rep told me they have no product whose limit increases automatically with mortgage pay-down. Instead, I have to apply for periodic increases. Was I misled by the rep?

Hi Anonymouse,

Is your mortgage a fixed portion within the HELOC or is it separate from the HELOC? If you have separate mortgage and HELOC, then you have the wrong product.

If they are one product, then Jungle is right. TD's HELOC does automatically allow you to readvance the principal portion of your mortgage payment from the credit line portion. The limit is one total limit for the 2 and does not increase, but the available credit in the credit line portion increases with each mortgage payment.




Ed

[wealthbuilder]

Ed,

Would you be able to comment on the B2B loans and why you don't like this strategy?

Would it not make sense for long term wealth building to get a 3-1 loan rather than doing just the regular smith mano. If you had 50k, did a 3-1 and turned this into 200k you will have a larger amount of money in the market to get growth on.

My accountant mentioned that the ROC that is used to fund this will eventually become non-deductible and thus making this strategy not a good long term strategy.

If you want to increase your exposure to stocks using a leverage strategy but not using ROC how is this possible? Is it?

From your posts on the milliondollar journey it appears to be with the rempel maximum.

Thanks for your time.

[edrempel]

Ed,

Would you be able to comment on the B2B loans and why you don't like this strategy?

Would it not make sense for long term wealth building to get a 3-1 loan rather than doing just the regular smith mano. If you had 50k, did a 3-1 and turned this into 200k you will have a larger amount of money in the market to get growth on.

My accountant mentioned that the ROC that is used to fund this will eventually become non-deductible and thus making this strategy not a good long term strategy.

If you want to increase your exposure to stocks using a leverage strategy but not using ROC how is this possible? Is it?

From your posts on the million dollar journey it appears to be with the rempel maximum.

Thanks for your time.

Hi Wealthbuilder,

Where did you get the idea that we don't like to use B2B Trust investment loans? We designed a strategy for the maximum growth without using more of your cash flow. Yes, we call it the "Rempel Maximum". It usually uses investment loans, but not always.

Using additional investment loans with the Smith Manoeuvre is definitely more aggressive and not for everyone, but for long term investors that want to grow serious wealth, it is probably the most effective strategy.

The Rempel Maximum would often involve borrowing the maximum amount that you can without increasing your mortgage payment. Every dollar of principal you pay down creates a dollar of credit available in the linked investment credit line, which you can reborrow to pay the interest on the investment loan and the investment credit line.

It is similar to the Smith Manoeuvre, except instead of reborrowing monthly to invest, you use that amount to pay interest on an investment loan and credit line.

The Rempel Maximum is the highest long term growth strategy that does not affect your cash flow.

The strategy we don't normally like is the "Smith Snyder" strategy that has been heavily marketed by some mortgage broker firms. This strategy involves investing in a mutual fund that pays a monthly ROC distribution. The problem is actually what you mentioned - the distribution from the fund reduces the tax deductibility of the investment loan.

I see it as a marketing ploy that sells well because it fools people into thinking that they are converting their mortgage to tax deductible faster. In fact, in involves what we call the "4 Meaningless Transactions". Every month, there are 4 transactions that do absolutely nothing except fool you into thinking something is happening.

The 4 transactions are:

1. Fund pays out a distribution that is considered ROC, say $1,000.
2. You pay the $1,000 onto your mortgage.
3. You borrow back an extra $1,000 from the linked investment credit line to reinvest.
4. At the end of the year, you pay your accountant to do the "Smith Snyder Tax Calculation" to see how much of the investment credit line/loan interest is still deductible.

After these 4 transactions, you:

1. Have the same dollars of non-deductible debt. You have reduced your mortgage by $1,000, but the interest on $1,000 of the investment loan is no longer tax deductible.
2. Have the same dollars of tax deductible debt. The interest on $1,000 of your investment loan is no longer deductible, but $1,000 more is deductible in the investment credit line.
3. Have the same dollars invested. You took $1,000 distribution out of the fund and then bought it right back.

All that work does absolutely nothing, except:

1. The interest rate on the investment credit line where you borrowed back is higher than your mortgage interest rate.
2. You have lost the full tax deductibility of your investment loan, so you will have to pay your accountant every year to do the complicated calculation of how much of the loan interest is still deductible.
3. Your investment choices are restricted because you focused on finding a fund that pays out a high monthly amounts, instead of choosing your investments purely for investment quality (risk/return).

Why is this strategy promoted heavily by some mortgage brokers? It sells well, because most people are really focused on paying off the mortgage and this strategy gives them the false impression that they are reducing their debt.

We do occasionally use a version of this strategy (usually with only the secured credit line) for people looking for income. If you have been doing the Smith Manoeuvre and then retire and want to keep it (which is the most effective strategy), then there are several different strategies for paying out income. The best one depends on your tax bracket and risk tolerance.

The Smith Snyder does work relatively well sometimes for retirees that are "house rich and cash poor". It is fairly common for retirees to have a home with lots of equity, but very little in investments. That means they are retiring with a good net worth, but hardly any income. In these situations, one option can be to use their home equity to invest and have the investments pay out income.

It is more risky to invest in funds that are paying out distributions, since they have little ability to recover from a large decline, such as in 2008.





Ed

[sharp21]

Hi KDang,

I agree with all Jungle's comments. You can't borrow against the rental to pay down on your home, since that would not be deductible. You can sell it and buy it back, but that is expensive.

Rental properties without a mortgage are usually very tax-inefficient, so you should do the calculations, but it may be best to sell it to buy faster growing investments. In the last 30 years, real estate has had 1/6 of the growth of the stock market. In fact, in the last 30 years, real estate has had about 1/2 of the growth of GICs, which are also tax-inefficient. The cash flow from the rental must be compelling to be worth keeping it.

There is an option with the SM, though. If you borrow against the rental to invest and you buy tax-efficient investments, you can claim the interest, which can counter most of your rental income. If you invest to have little or no investment income, then you can offset the taxable rental income.

This highlights one difference between the Smith Manoeuvre and investing in a rental property. In a rental property with a large mortgage, you can claim the interest against rent and hope to pay no tax (especially if you claim some CCA). However, with the SM, you can get tax REFUNDS most years, if you borrow to invest in tax-efficient investments.

If you do a tax-efficient SM, it can make up for the tax-inefficient rental property.




Ed

I've got one rental & am getting ready to start the SM on a new home. We are also going to get a second rental in a few months time. With 2 rental properties, using the cash dam should help pay down my home mortgage fairly quickly.

Reading the above post I am wondering if this is the most tax efficient option?

S.

[edrempel]

I've got one rental & am getting ready to start the SM on a new home. We are also going to get a second rental in a few months time. With 2 rental properties, using the cash dam should help pay down my home mortgage fairly quickly.

Reading the above post I am wondering if this is the most tax efficient option?

S.

Hi Sharp,

Are you just looking for the most tax-efficient option or the one that makes you the most money? The vast majority of the benefit of the Smith Manoeuvre is based on the long term growth of the investments (vs. the after-tax interest). Generally, the tax savings are a relatively small portion of the benefit. We have seen quite a few people wanting to do the SM just because of the tax savings, but I would suggest to look at the best overall strategy.

You asked about the most tax-efficient strategy, though. Adding the Cash Dam will help you convert your home mortgage to tax deductible more quickly. Depending on how much your rental expenses are, this could be a very tax-efficient strategy. It is only tax-efficient if you keep the rentals for a long time, though, since the amount of your home mortgage that relates to the Cash Dam only remains deductible as long as you own the rentals. Generally, you should convert your home mortgage to completely deductible with both the SM and Cash Dam, and then you can convert the Cash Dam credit line to a mortgage and do the SM on it to make it all deductible against investments. Then you could sell the rentals without losing deductibility.

The Cash Dam is a pure tax strategy with no risk (since it does not involve investments). This makes it a definite benefit, but the benefit is usually very small compared to the Smith Manoeuvre, which also has large investment gains over time.

The Cash Dam is a simple concept, but is tricky to implement. You need to set your mortgage payment very high, which is a risk if you have trouble collecting the rent. It is best to keep your mortgage term short to keep flexibility.

Adding the SM on 2 rental properties is also a good strategy. However, the SM on rentals is usually very small, since you normally set the mortgage to pay down the minimum possible principal.

One downside of your strategy is that you would be heavily overweight in real estate. You would have 3 properties, but hardly any stock market investments. This makes you vulnerable to a real estate crash, which would be very serious for you, with little other investments to counter it.

You may want to consider adding more investments to your strategy. For people that love real estate, it is usually still a good idea to try to have similar amounts invested in the stock market to diversify. With 3 Smith Manoeuvres, you would be able to use the principal portion to support a reasonably large investment loan. If you invest in tax-efficient investments, this would make your strategy even more tax-efficient, since the taxable investment income can be far less than the interest deduction. This can also add a lot of long term growth.

This may may or may not fit with your Financial Plan and risk/return objectives, but it can give you more diversification, more tax-efficiency and more growth opportunities.



Ed

[sharp21]

Why do you have to set the mortgage payment very high for the cash dam? I was going to pay it off as slowly as possible as it is tax deductible, UNTIL my primary mortgage is converted. Then I'll start accelerating payments on the rentals to pay them off one at a time. My first rental is 5yr fixed, but the new one will be variable.

You say the benefit of the cash dam is small, but with 2 rentals plus my regular payment plus prepayments I should be mortgage free 20+ years sooner! No mortgage payment after 5 years is going to free up a tremendous amount of cash monthly & I'll be using that to invest as well.

I do have diversification aspirations & will be getting into the market as well, don't worry. I'm not sure about taking a loan right at the start ala Rempel Max but I'll be building a position as my principle allows.

Thanks
S.

[sslinn]

The Cash Dam is a simple concept, but is tricky to implement. You need to set your mortgage payment very high, which is a risk if you have trouble collecting the rent. It is best to keep your mortgage term short to keep flexibility.

I am also curious about this statement? Why would you have to set the mortgage payment high?

You are only worried about the interest portion of the payment which is the same regardless if the payment is high or low.

[sslinn]

Hi Ed,

Myself and another member have been having a discussion via PM about cash damning a rental property and we can't agree on 1 key point. Hopefully you can clear it up for us. Here is the example.

I have a readvancable mortgage on my primary residence. I have a separate mortgage for the rental property and the monthly mortgage payment is $850. The taxes on the rental property are $150 for a total cash outlay of $1,000. Conveniently that is exactly what the monthly rent collected is. :)

So, I collect the $1,000 rent and make a $1,000 prepayment against the readvancable mortgage on my primary residence which leaves me with a $1,000 available on the LOC portion. I now pay the mortgage of $850 for the rental and the $150 for taxes from the LOC. And repeat monthly.

The debate is, is the interest on the $1,000 from the LOC fully tax deductible?

My view is that because a portion of the $850 is a principle payment (not a rental expense, reduced the amount owed on the rental mortgage) against the mortgage on the rental property, the principle portion paid from the LOC does not create an interest expense which would be tax deductible. The only solution being to only pay the interest portion of the monthly mortgage payment on the rental from the LOC to keep everything neat, tidy and deductible.

Hopefully this scenario makes sense. Your input is appreciated! Any one else free free to pipe in.

Thanks!!

[edrempel]

Why do you have to set the mortgage payment very high for the cash dam? I was going to pay it off as slowly as possible as it is tax deductible, UNTIL my primary mortgage is converted. Then I'll start accelerating payments on the rentals to pay them off one at a time. My first rental is 5yr fixed, but the new one will be variable.

You say the benefit of the cash dam is small, but with 2 rentals plus my regular payment plus prepayments I should be mortgage free 20+ years sooner! No mortgage payment after 5 years is going to free up a tremendous amount of cash monthly & I'll be using that to invest as well.

I do have diversification aspirations & will be getting into the market as well, don't worry. I'm not sure about taking a loan right at the start ala Rempel Max but I'll be building a position as my principle allows.

Thanks
S.

Hi Sharp,

It is your home mortgage that needs a high mortgage payment - unless you have quite a bit of unused equity in your home. Most mortgages only allow one prepayment each year. You need to pay your home mortgage down enough so that you have credit available to reborrow to pay all your rental expenses.

This means you either need equity available in your credit line for 6 months' or 1 year's expenses available in the credit line when you start - or you just increase your home mortgage payment by the amount of the rental expenses. This can convert your mortgage to tax deductible relatively quickly, since the additional payment is all principal.

The benefit is comparatively small, however. Let's say your rental expenses are $1,500/month. You can convert $18,000/year of your home mortgage to tax deductible. If your home mortgage is $200,000, then you will have it fully converted in a bout 10 years (including your normal payment).

The benefit, if you are in the highest tax bracket could be $200,000 * 4% (normal prime) * 45% = $3,500/year. It would be lower for the first 10 years. So, your estimated benefit over 25 years could be about $50,000.

The estimated benefit of the Smith Manoeuvre over 25 years is usually $500,000, and often $1 million, for most of the cases we have seen. The bulk of this is the difference between the long term compound investment growth vs. the interest cost after tax.

Typically, the estimated benefit of the Cash Dam is perhaps 1/10 of the benefit of the Smith Manoeuvre. This is what I mean when we see people focus entirely on small tax savings, instead of focusing on the large total gains.

When you do both the SM and the Cash Dam, you need 2 separate credit lines, but you can normally only readvance one automatically. This is what can make the Cash Dam tricky to do. Normally, we would readvance the one that pays down the mortgage more quickly, and prepay the mortgage for the other one.




Ed

[edrempel]

Hi Ed,

Myself and another member have been having a discussion via PM about cash damning a rental property and we can't agree on 1 key point. Hopefully you can clear it up for us. Here is the example.

I have a readvancable mortgage on my primary residence. I have a separate mortgage for the rental property and the monthly mortgage payment is $850. The taxes on the rental property are $150 for a total cash outlay of $1,000. Conveniently that is exactly what the monthly rent collected is. :)

So, I collect the $1,000 rent and make a $1,000 prepayment against the readvancable mortgage on my primary residence which leaves me with a $1,000 available on the LOC portion. I now pay the mortgage of $850 for the rental and the $150 for taxes from the LOC. And repeat monthly.

The debate is, is the interest on the $1,000 from the LOC fully tax deductible?

My view is that because a portion of the $850 is a principle payment (not a rental expense, reduced the amount owed on the rental mortgage) against the mortgage on the rental property, the principle portion paid from the LOC does not create an interest expense which would be tax deductible. The only solution being to only pay the interest portion of the monthly mortgage payment on the rental from the LOC to keep everything neat, tidy and deductible.

Hopefully this scenario makes sense. Your input is appreciated! Any one else free free to pipe in.

Thanks!!

Hi Sslinn,

Sorry to tell you this but - the other member is right and you are wrong. :)

Good logic though.

The reason the credit line is fully tax deductible is that the principal portion of the payment is essentially just transferring a tax deductible debt.

To clarify, let's say you borrowed $10,000 from your credit line and paid it down on your rental mortgage. That $10,000 would still be tax deductible, since it is just transferring the tax deductible debt from the mortgage to the credit line.

That is what is happening with the principal portion of the mortgage payment. You reborrow from the credit line to make your mortgage payment on the rental.

Does that clarify it, Sslinn?

By the way, what was the other member's reason for thinking it would be tax deductible? Perhaps he is wrong too. :)


Ed

[sslinn]

Thanks for your response.

I hate being wrong, but it is worth it if I learn something. :)

Other member had it totally right. Was not deducting the actual principle payment, just the interest from the LOC.

This sounds like a good deal. :)

Once I get things organized we may have to chat more.

[edrempel]

Thanks for your response.

I hate being wrong, but it is worth it if I learn something. :)

Other member had it totally right. Was not deducting the actual principle payment, just the interest from the LOC.

This sounds like a good deal. :)

Once I get things organized we may have to chat more.

Hi Sslinn,

Is that like: "Once I'm feeling better, I'll go see a doctor?" :)



Ed

[sharp21]

Hi Ed,

It was me that sslinn was having the discussion with. I am signing papers on my second rental today & as soon as the house sells I'll be getting a readvanceable mortgage on the new one. I'm obviously been doing my homework prior to making the move & sslinn has been a big help & sounding board to get everything clear.

My reason for calling it tax deductible is twofold:

1. Classic debt swap

2. Proof of intent. The money borrowed is done so with the intent of making a future profit.

So we can put that to bed.


I understand now as well about the high mortgage payment as it relates to your yearly pre-payment maximum. I'm looking at the National All in One & they allow 20%/year, which I should be able to hit.

I WILL be splitting the Heloc into a Rental portion & a SM Investing portion, but will need to check how either side is readvanceable. I plan on obviously cash damming with one & then investing with the other, which will be readvanced from the principle that I pay down monthly with my regular mortgage payment, plus additional out of pocket pre-payments.

If both LOC's aren't readvanced proportionately, could a work around go as follows? It involves the Heloc PLUS an unsecured LOC

1. Rent goes in, mortgage goes in, Principle paid, LOC increased...

2. Pay the rental bills & mortgage with the unsecured LOC

3. SM invest from the Heloc, but only the portion freed by my own payments, not the rent

4. When the unsecured LOC is reaching its upper limit, transfer that amount onto the Heloc & start over! This would be done every 6 months or so...


I've read your views about the higher benefits of investing & I will certainly do so. But cash damming the rentals will allow me to be done with my mortgage payment sooner, which will free up more monthly income to invest with!

S.

[sslinn]

Hi Sslinn,

Is that like: "Once I'm feeling better, I'll go see a doctor?" :)



Ed

Hmm, it does seems that way doesn't it.

The reality is I will be purchasing a house or condo in December or January. I will then have to do some soul searching and see if leveraged investing is for me.

[edrempel]

Hi Ed,

It was me that sslinn was having the discussion with. I am signing papers on my second rental today & as soon as the house sells I'll be getting a readvanceable mortgage on the new one. I'm obviously been doing my homework prior to making the move & sslinn has been a big help & sounding board to get everything clear.

My reason for calling it tax deductible is twofold:

1. Classic debt swap

2. Proof of intent. The money borrowed is done so with the intent of making a future profit.

So we can put that to bed.


I understand now as well about the high mortgage payment as it relates to your yearly pre-payment maximum. I'm looking at the National All in One & they allow 20%/year, which I should be able to hit.

I WILL be splitting the Heloc into a Rental portion & a SM Investing portion, but will need to check how either side is readvanceable. I plan on obviously cash damming with one & then investing with the other, which will be readvanced from the principle that I pay down monthly with my regular mortgage payment, plus additional out of pocket pre-payments.

If both LOC's aren't readvanced proportionately, could a work around go as follows? It involves the Heloc PLUS an unsecured LOC

1. Rent goes in, mortgage goes in, Principle paid, LOC increased...

2. Pay the rental bills & mortgage with the unsecured LOC

3. SM invest from the Heloc, but only the portion freed by my own payments, not the rent

4. When the unsecured LOC is reaching its upper limit, transfer that amount onto the Heloc & start over! This would be done every 6 months or so...


I've read your views about the higher benefits of investing & I will certainly do so. But cash damming the rentals will allow me to be done with my mortgage payment sooner, which will free up more monthly income to invest with!

S.

Hi Sharp,

Good call on the deductibility issue.

The National Bank AIO is that it should work well for your plan. My understanding is that it does not have limits for the credit lines - just an overall limit for all mortgage and credit lines within it. Other readvanceable mortgages specify which credit line is readvanced.

I don't know exactly about the National Bank AIO, because we only have a couple clients that have it and none that are using multiple credit lines with it. We constantly monitor the rates on all readvanceable mortgages and they have never been the lowest rate. We do work with a mortgage broker that will absorb most or all fees in most cases for the AIO, though.

If I'm wrong or you go with another readvanceable, then your strategy should work fine. You will need to adjust the limits on the 2 credit lines every 6 months, which is normally no problem.

Cash damming will convert your mortgage to tax deductible more quickly, but it won't make you "done with your mortgage payment". You can capitalize the interest on both the Smith Manoeuvre and Cash Dam credit lines until your home mortgage is gone, but then you need to start paying the credit lines from your cash flow. This will be lower than your mortgage payment, since it is interest only (although a higher interest rate) and fully tax deductible - but you will still have a significant payment to make.





Ed

[sharp21]

I suppose "done with the mortgage payment" was a poor choice of words. But the interest only payment will significantly lower my monthly expenses & the difference can be put towards a combination of paying down the rental mortgage & portfolio building.

My plan is to pay the monthly interest, then at tax time use that portion of my return to pay it down a bit.

S.

[netriones]

My mortgage rate is 2.25% and if I pay down portion of the mortgage and re-borrow at prime + 0.5% =3.5% using HELOC, interest rate will be 55% higher. I have low income that I pay maybe 5%~10% income tax. To break even, I need to get back 35% of interest expense on HELOC. I am not considering the investment return since leveraged investing is another topic to be discussed and the main point of smith manoeuvre is to make mortgage interest deductible. Does it still make sense for me to do "smith manoeuvre"?

[Mark77]

My mortgage rate is 2.25% and if I pay down portion of the mortgage and re-borrow at prime + 0.5% =3.5% using HELOC, interest rate will be 55% higher. I have low income that I pay maybe 5%~10% income tax. To break even, I need to get back 35% of interest expense on HELOC. I am not considering the investment return since leveraged investing is another topic to be discussed and the main point of smith manoeuvre is to make mortgage interest deductible. Does it still make sense for me to do "smith manoeuvre"?

For portfolio diversification, sure, but of course, you need to watch overall leverage to ensure that you don't get yourself in too deeply. A good rule of thumb is the SM is completely not appropriate for anyone with less than 50% of their house paid off, and even then, should only be started slowly through dollar cost averaging.

Canadians, generally speaking, are quite overweight real estate, underweight ownership interests in businesses (ie: stocks). By positioning oneself ahead of an inevitable rebalancing of these asset classes, it is quite possible that the SM helps to hedge out some of the downfall in housing, which definitely can be beneficial for a lower income person.

[sharp21]

You don't need to make a return that "beats" the heloc rate, as you should be capitalizing that interest. That way you are never making that payment out of your own cashflow AND it gets written off at the end of the year.

If you are not considering investing in the market then what do you propose to borrow for? You have to invest in something. Leveraged investing in tax efficient lower risk vehicles is as safe as anything else, over the LONG TERM.

Or else in your case you could just keep paying your mortgage (good rate!), put enough into your RRSPs so that your effective tax is zero & use the rest to put into your tfsa.

S.

[edrempel]

My mortgage rate is 2.25% and if I pay down portion of the mortgage and re-borrow at prime + 0.5% =3.5% using HELOC, interest rate will be 55% higher. I have low income that I pay maybe 5%~10% income tax. To break even, I need to get back 35% of interest expense on HELOC. I am not considering the investment return since leveraged investing is another topic to be discussed and the main point of smith manoeuvre is to make mortgage interest deductible. Does it still make sense for me to do "smith manoeuvre"?

Hi Netriones,

I can't tell you whether the SM makes sense for you without knowing your entire situation, but here are 2 things you need to know:

1. The main point of the Smith Manoeuvre is to build a large nest egg for your future/retirement that does not require your cash flow. The tax deduction by converting your mortgage to tax deductible interest over time is a relatively small part of the benefit - say 20%. The long term, compound growth of the investments should provide about 80% of the benefit of the Smith Manoeuvre.

2. Your calculation of the savings is correct, but is not the entire story. Any interest you convert to tax deductible now will likely remain deductible for many years, not just this year. This will include future years when interest rates are somewhat higher than today. If interest rates rise by 1% across the board, then your calculation will reveal a more beneficial situation. For example, a mortgage of 2.25% vs. a tax deductible credit line of 3.5% requires a 35% tax rate to be worthwhile. However, a mortgage of 3.25% vs. a 4.5% tax deductible credit line only need 27% tax rate to be beneficial for you.


Ed

[Mark77]

You don't need to make a return that "beats" the heloc rate, as you should be capitalizing that interest. That way you are never making that payment out of your own cashflow AND it gets written off at the end of the year.

Actually, you really don't want to create a situation where, over time, you're relying perpetually on asset or stock appreciation. All debt (including your HELOC) has to come to a resolution at some point.

[edrempel]

Hmm, it does seems that way doesn't it.

The reality is I will be purchasing a house or condo in December or January. I will then have to do some soul searching and see if leveraged investing is for me.

Hi Sslinn,

"Soul searching"? What do you mean by soul searching?

When people say that, they usually mean they will "go with their gut" on it. I would suggest that making a decision about the Smith Manoeuvre by "going with your gut" is probably the worst way to make that decision. Your gut will tell you if you feel optimistic or pessimistic today, but not necessarily how you will feel during an inevitable bear market.

This type of decision is best made using your brain - not your gut. You should think about whether you are the type of person that can maintain your faith and patience over the long term.

Here are some of the things you should think about:

The Smith Manoeuvre is a great long term strategy if done right. Leverage magnifies your gains far more reliably than buying more aggressive investments. Your long term chance of success is very high. The S&P500's worst ever 25-year gain was 5%/year, which is nearly quadrupling your money. That was during the Great Depression and every other period has been far better. The stock market consistently goes up a lot in the long run.

However, there have been 1 or 2 bear markets every decade with declines of 20-45%. They will continue to happen. You need to be the kind of person that can ride through these, and hopefully add to your investments when they are down. Trying to time the bear markets makes it worse. You need a sound investment strategy to get the market gains. Market-timing and buying sectors that are in favour (like most people do) will likely drastically reduce your over time returns.

In short, if you are the type of person that can ride through inevitable downs, will go into it for a long time (20+ years), and have a sound investment strategy, then the Smith Manoeuvre (and other leverage strategies) can be one of the best ways to grow significant wealth for your future. If you would be worried about downturns and how to avoid them, try to keep changing your strategy, or just want to try it for a little while, then you are not the type of person that should do it.

I hope that is helpful for you.



Ed

[edrempel]

Actually, you really don't want to create a situation where, over time, you're relying perpetually on asset or stock appreciation. All debt (including your HELOC) has to come to a resolution at some point.

Hi Mark,

Actually - that's exactly the purpose of the SM - to create a situation where, over time, you're relying perpetually on stock appreciation. The purpose of the SM is to build a significant portfolio over time that does not require your cash flow - usually for your retirement. It needs to be a long term strategy, since the risks are mainly short term and the benefits are mainly long term.

The stock market is quite reliable over the long term. If you are "relying perpetually" on it and you have a sound investment strategy, then your future is probably bright.

------
The other point is that you do not necessarily need to have your debt come to a resolution during your lifetime. If you keep it and your investments, you can pass them on to your kids. If they keep them, the loan will be deductible to them as well. What tends to happen in practice for people doing the SM that maintain their investment credit line is that the kids will sell the home (since they don't plan to live there), they pay off the debt, and keep the equity - plus they still have all the investments.

Some people choose to pay off the debt because they feel more comfortable. Some choose to keep it because that is the most effective strategy long term. They still have 20-30 years left after retirement, which still counts as long term.

In short, you do not necessarily have to pay off your debt during your lifetime.



Ed

[Jungle]

Now is a good time to buy, stock market is down 10% since April. We added some positions to our portfolio. Our SM is now at around 41K. I also converted it to a 2.64% one year mortgage over 30 years. We will have to use some cash flow now to pay the min payment, but the lower interest will save us about $200 and that assumes rates will not go up in one year. They would not give us a better rate on the heloc and I just cant say no to 2.64% for one year.

[cannon_fodder]

I now maintain monthly Net Worth statements but since 2005 I only did one every 6 months. This weekend, looking back three years ago was quite surprising to my wife and I.

Three years ago we knew we wanted to renew our mortgage and take a readvanceable one. With Ed Rempel's help we secured a BMO Readiline at P-0.75% with an attached HELOC at Prime.

Fast forward three years later (although the period from September 2008 to May 2009 was often gruelling and did NOT fly by): our mortgage is eliminated; our HELOC is close to maxed (as a result we are $250k more in debt than we were when we started); and our SM portfolio is over $1M.

Thus, with some good (but not great) timing, strong willpower to stay the course and some aggressive investing, the SM strategy has accomplished all of what it purports to do.

One of the differences in our implementation was to tap into the majority of our available equity and "jump start" the investment portfolio rather than invest in small amounts periodically. In our case this was critical to our success.

So, all in all, I'd have to say the one best thing we ever did for our financial independence was implementing the SM.

[Jungle]

Cannon your updates have been inspiring and show how stock investments can build wealth. There is a point you get to and the compounding gains become quite nice. Granted you were able to buy before and after the crash (if I remember correctly), so you have seen nice gains from this.

[edrempel]

Now is a good time to buy, stock market is down 10% since April. We added some positions to our portfolio. Our SM is now at around 41K. I also converted it to a 2.64% one year mortgage over 30 years. We will have to use some cash flow now to pay the min payment, but the lower interest will save us about $200 and that assumes rates will not go up in one year. They would not give us a better rate on the heloc and I just cant say no to 2.64% for one year.

Hi Jungle,

Good deal on the 1-year mortgage rate. I have a question, though. If you are going to use your cash flow, why would you use it to pay your tax deductible debt? Why would you not increase your mortgage payment by the amount of your extra cash that you were going to use to make your minimum credit line payment? Then you can reborrow the principal to cover the credit line interest?

This would leave your cash flow exactly the same, but would pay down your mortgage more quickly.



Ed

[whitby3170]

Thanks to all who have been posting rearding this issue. It has been a great read!

I am contemplating converting my current current mortgage to SM/TDMP while at the same time purchasing a new property which will not be completed until June 2012.

Existing

Home Value $360,000
75% Mortgage $270,000
Outstanding Mortgage $175,000
Avaialble Credit $95000

New Home

Home value $690,000
75% Mortgage $518,000
Outstanding Mortgage $500,000
Avaialble Credit $18,000

The 25% payment for the new home would come from the sale of the existing. And I need to make downpayments (deposits) on the new home using the equity in the existing home in the amount of $75K. Question is what is the best approach. I am thinking covert the existing mortgage and use the available credit to pay the initial deposits on the new home. When I close on the new home, revise the TDMP. Does this make sense or is there a better approach.

W

[sTeViE26]

Thanks to all who have been posting rearding this issue. It has been a great read!

I am contemplating converting my current current mortgage to SM/TDMP while at the same time purchasing a new property which will not be completed until June 2012.

Existing

Home Value $360,000
75% Mortgage $270,000
Outstanding Mortgage $175,000
Avaialble Credit $95000

New Home

Home value $690,000
75% Mortgage $518,000
Outstanding Mortgage $500,000
Avaialble Credit $18,000

The 25% payment for the new home would come from the sale of the existing. And I need to make downpayments (deposits) on the new home using the equity in the existing home in the amount of $75K. Question is what is the best approach. I am thinking covert the existing mortgage and use the available credit to pay the initial deposits on the new home. When I close on the new home, revise the TDMP. Does this make sense or is there a better approach.

W

You can do 80% LTV, not just 75%.

[edrempel]

Thanks to all who have been posting rearding this issue. It has been a great read!

I am contemplating converting my current current mortgage to SM/TDMP while at the same time purchasing a new property which will not be completed until June 2012.

Existing

Home Value $360,000
75% Mortgage $270,000
Outstanding Mortgage $175,000
Avaialble Credit $95000

New Home

Home value $690,000
75% Mortgage $518,000
Outstanding Mortgage $500,000
Avaialble Credit $18,000

The 25% payment for the new home would come from the sale of the existing. And I need to make downpayments (deposits) on the new home using the equity in the existing home in the amount of $75K. Question is what is the best approach. I am thinking covert the existing mortgage and use the available credit to pay the initial deposits on the new home. When I close on the new home, revise the TDMP. Does this make sense or is there a better approach.

W

Hi Whitby,

You need at least 20% down in order to do the Smith Manoeuvre, which means you will need most of your existing equity in order to buy your new home. You have about $185,000 equity and will need $138,000 for the 20% down. Allow about $30,000 for commissions on selling, land transfer tax and other closing costs, will use almost all your equity.

Therefore, you have a few options. You could wait to start the Smith Manoeuvre, just start with a PAC or small amount for now ($10-15,000), or you could start with an investment loan, so that you can get going and still leave all your equity to buy your new home. The best choice for you here depends on your goals, risk tolerance and desire to build wealth.

I don't fully understand your comment. What do you mean by "revise the TDMP"? Are you thinking of starting a TDMP-style Smith/Snyder strategy now and then revising it, or were you just referring to the Smith Manoeuvre?

If you start the Smith Manoeuvre now, you can easily move it to your new home. There is no problem moving it. Just make sure that the starting balance in your Smith Manoeuvre credit line in your new home is the same as the closing balance on your existing home.

Therefore, you can start the Smith Manoeuvre now, but you have to plan to make sure you will have the 20% down on your new home.

Ed

[Jungle]

Hi Jungle,

Good deal on the 1-year mortgage rate. I have a question, though. If you are going to use your cash flow, why would you use it to pay your tax deductible debt? Why would you not increase your mortgage payment by the amount of your extra cash that you were going to use to make your minimum credit line payment? Then you can reborrow the principal to cover the credit line interest?

This would leave your cash flow exactly the same, but would pay down your mortgage more quickly.



Ed

We have to watch increasing our debt. We are upsizing to a house next year in Toronto (expensive..) and inaddition, we already have a rental property. So, I do not want our TDS ratios too high, because we'll need a bigger mortgage. After that, skys the limit. We'll be paying down the mortgage to reborrow and invest. Our TFSA will be maxed yearly and we really have no incentive to max RSP, due to my mid and my wife's to lower tax rates. The excess money would be put in non-reg anyway, so might as well do the SM, pay the mortgage off and collect tax deductions after we move.

[whitby3170]

Hi Whitby,

You need at least 20% down in order to do the Smith Manoeuvre, which means you will need most of your existing equity in order to buy your new home. You have about $185,000 equity and will need $138,000 for the 20% down. Allow about $30,000 for commissions on selling, land transfer tax and other closing costs, will use almost all your equity.

Therefore, you have a few options. You could wait to start the Smith Manoeuvre, just start with a PAC or small amount for now ($10-15,000), or you could start with an investment loan, so that you can get going and still leave all your equity to buy your new home. The best choice for you here depends on your goals, risk tolerance and desire to build wealth.

I don't fully understand your comment. What do you mean by "revise the TDMP"? Are you thinking of starting a TDMP-style Smith/Snyder strategy now and then revising it, or were you just referring to the Smith Manoeuvre?

If you start the Smith Manoeuvre now, you can easily move it to your new home. There is no problem moving it. Just make sure that the starting balance in your Smith Manoeuvre credit line in your new home is the same as the closing balance on your existing home.

Therefore, you can start the Smith Manoeuvre now, but you have to plan to make sure you will have the 20% down on your new home.

Ed

Thanks Ed, Many thanks to your commentary and Cannon Fodder for the spreadsheet.

My preferenece is to start the Smith Manoevre now. This would free up the $95K which would go into the investment LOC. There is enough to cover the the $75K in staged downpayments ($35K immediately, $35K in Nov 2011 and $5k in June 2012 when the new home is constructed and clsoed). This leaves $20K left over to start the investment part of the LOC. The question I have is does the $75 K have to be invested to meet Revenue Canada requirements or can it be left in the Investment LOC to pay the new condo downpayments???. Alternatively can I invest the full $95K -$35K=$60K and then draw it out of the investments later when the downpayments are required???? (Not sure if RC would have issue with this and possible tax implications). I am thinking the simplist thing would be to hold the new condo downpayments in cash in the investment LOC to pay the future condo downpayments and only invest the $20K to create the "revenue" which would satisfty the RC part of the SM.

What I meant when I said "revise the SM" was to update the SM to reflect the new home purchase when it closes in June 2012. So as you mention I need to be careful the closing balance on the old SM is the same as the new SM. Also the current mortage will be $150K not 175K when the new condo closes,, so that covers my closing costs.

Thanks

[staffpro]

can i do a smith maneuver on a smaller scale as a student with a student line of credit that i won't fully use? (20-30k/year student LoC at prime that i will only use maybe 10k of) over the 4 years that i'll be in school.

thanks!

[Asoul]

can i do a smith maneuver on a smaller scale as a student with a student line of credit that i won't fully use? (20-30k/year student LoC at prime that i will only use maybe 10k of) over the 4 years that i'll be in school.

thanks!

That isn't the smith maneuver, just leveraged investing.

[staffpro]

That isn't the smith maneuver, just leveraged investing.


isnt the smith manouvre leveraged investing to a certain extent as well, only difference in my case is i'd be graduating with a student debt as well as a small portfolio of stocks, just like the guy doing the SM having a mortgage as well as assets.

Like if i borrow at 3% (prime) and plow some of that money into some 4/5/6% dividend yielders, i know there is market risk and all that but how great is that risk and how can i calculate the amount of money I would need to survive say a market downturn?

[beonice]

Question to Ed (or anyone else who's had experience with the SM):

I have a decent income today but had a couple of very lean years a few years ago that wiped out my savings and left me with a large debt load. Over the past two years, I've slowly built back my credit rating and have enough in savings and RRSPs that I have qualified for a mortgage loan. However, this is only with a 5% down payment, not the 20% you say is required for the SM.

What I'd like to know is, is there something I can do today (or as soon as I have a mortgage, which will be in two to three months depending on when the condo is registered), in terms of setting up a re-advanceable HELOC? I understand the math behind it, just don't know whether I should (or even *can*) set this up now or should wait until the percentage of equity in my condo (downtown Toronto, *very* pricey) goes up to 20% of the value.

Thanks in advance!

[cannon_fodder]

can i do a smith maneuver on a smaller scale as a student with a student line of credit that i won't fully use? (20-30k/year student LoC at prime that i will only use maybe 10k of) over the 4 years that i'll be in school.

thanks!

staffpro,

The SM always involves a mortgage. What you are proposing doesn't involve a mortgage, thus it isn't an SM. That's why it was pointed out you are talking about simple leveraged investing.

[cannon_fodder]

Question to Ed (or anyone else who's had experience with the SM):

I have a decent income today but had a couple of very lean years a few years ago that wiped out my savings and left me with a large debt load. Over the past two years, I've slowly built back my credit rating and have enough in savings and RRSPs that I have qualified for a mortgage loan. However, this is only with a 5% down payment, not the 20% you say is required for the SM.

What I'd like to know is, is there something I can do today (or as soon as I have a mortgage, which will be in two to three months depending on when the condo is registered), in terms of setting up a re-advanceable HELOC? I understand the math behind it, just don't know whether I should (or even *can*) set this up now or should wait until the percentage of equity in my condo (downtown Toronto, *very* pricey) goes up to 20% of the value.

Thanks in advance!

Unless there is an additional cost (e.g. higher interest rate, or more onerous terms) OR you are concerned that you may not have full control over your spending, I can think of no downside of going for a readvanceable mortgage now and then take advantage of it when you can. However, you may not be granted one simply because you only have 5% down.

It would be a good idea to get a much better understanding of leveraged investing before embarking on it. The market gyrations right now are a good lesson to see if you can stomach such a strategy because you will have more (perhaps much more) $ invested and thus absolute paper losses/profits will be larger.

[beonice]

Unless there is an additional cost (e.g. higher interest rate, or more onerous terms) OR you are concerned that you may not have full control over your spending, I can think of no downside of going for a readvanceable mortgage now and then take advantage of it when you can. However, you may not be granted one simply because you only have 5% down.

It would be a good idea to get a much better understanding of leveraged investing before embarking on it. The market gyrations right now are a good lesson to see if you can stomach such a strategy because you will have more (perhaps much more) $ invested and thus absolute paper losses/profits will be larger.

Thank you! That was pretty much my guess, too, that there isn't particularly a downside, that perhaps it's just a question of not qualifying for one of the readvanceable mortgages without 20% equity.

Oh well, it doesn't hurt to talk to the banks and see what they have to offer, I guess.

[roweandmalidotcom]

Over the past few years the smith manouver has brought a couple cases that are before our courts. Proceed with caution, thats all.

[Jungle]

There is nothing illegal with the SM. The one before the courts was not SM. A couple were loaning money to each other to deduct interest costs and then using it for his business to pay dividends in the lower earner's name. Quite a scheme to defeat taxes-was ruled as abusive and evasive tax avoidance.

[edrempel]

Over the past few years the smith manouver has brought a couple cases that are before our courts. Proceed with caution, thats all.

Hi Roweandmall,

There is no question that the Smith Manoeuvre is legal. In fact, the main tax issue is simple. It is essentially just borrowing to invest, which every company and business owner in Canada does. I am a financial advisor, but also an accountant and registered e-filer, and have done a lot of tax returns for people doing the Smith Manoeuvre.

None of the court cases you are referring to affect the Smith Manoeuvre. They used a complex series of transactions that affected GAAR, but are irrelevant for the Smith Manoeuvre.

The only caution is that the Smith Manoeuvre has been marketed by some groups including a monthly tax-free payment coming from the investments, which is a tax problem. Almost any version involving monthly payments from the investments is a tax problem. The actual Smith Manoeuvre involves no monthly payments and has no tax issues.


Ed

[sharp21]

Should I be writing off CCA on my rental? I'm not yet into a readvanceable mortgage so it should be okay right?

Once in the SM mortgage then I can use my LOC to pay for capital expenses...

S.

[Jungle]

Do you think the SM beats TFSA and RSP for a MTR of 24% and 31%?

[Atlasjq]

Should I be writing off CCA on my rental? I'm not yet into a readvanceable mortgage so it should be okay right?

Once in the SM mortgage then I can use my LOC to pay for capital expenses...

S.

If you claim CCA on your rental property it will only be an issue whenever you sell the house. You'll get hit with a bigger cap gain as you will have to subtract any CCA from the original cost of the house (thus rising your cap gain).

[buy.A.gift]

Does anyone know how much normally would a Consultants charge on setting up a Smith Manoeuvre account?
One time Lump sum or by percentage of investment?
Also would it make sense for a guy (like me) who just barley have 20% downpayment to apply SM?
Should I save up more (25% or even 30%) before I start to consider using SM?

Anyone?

[Mark77]

Does anyone know how much normally would a Consultants charge on setting up a Smith Manoeuvre account?
One time Lump sum or by percentage of investment?
Also would it make sense for a guy (like me) who just barley have 20% downpayment to apply SM?
Should I save up more (25% or even 30%) before I start to consider using SM?

Anyone?

Yeah, its my view that with the SM, you really don't want to have so little equity in the house that you're going to be caught in a funding trap when it comes time to renew your mortgage during a housing downturn.

You could definitely start the process of getting the SM going with only 20% down, but it would be my suggestion that you do not use anywhere near the maximum amount of leverage possible.

[Jungle]

Do you think the SM beats TFSA and RSP for a MTR of 24% and 31%?

Have not thought about sheltered compounding, but RSP and TFSA would not be subject to interest rate risk.

[edrempel]

Should I be writing off CCA on my rental? I'm not yet into a readvanceable mortgage so it should be okay right?

Once in the SM mortgage then I can use my LOC to pay for capital expenses...

S.

Hi Sharp 21,

I don''t fully understand your question. What does the readvanceable have to do with CCA? You can claim CCA and still borrow against the property to invest at the same time.

Claiming CCA on a rental is a tax deferral that makes sense in most cases, especially if you plan to hold it for a long time. You get a tax deduction for the CCA (only to the extent that you have taxable net rent income after expenses), which you have to "recapture" when you sell the property. The recapture is fully taxable when you sell. This does not affect your capital gain.

For example, you buy a property for $100,000. Let's say you claim $50,000 CCA every year over 20 years. Then you sell the property for $150,000. You will have a $50,000 recapture plus a $50,000 capital gain. The total income added to your income is $75,000, since the capital gain is only 50% taxable.

The result is that you paid less tax for 20 years and then paid more in the last year. Because of the time value of money, you would normally be ahead. However, depending on your tax bracket today and how high your tax bracket would get when you sell and add $75,000 to your income, you may or may not be ahead.

Make sure your rental is 100% a rental and not a portion of your home. You cannot claim principal residence deduction on the property if you claimed CCA at the same time.



Ed

[edrempel]

Do you think the SM beats TFSA and RSP for a MTR of 24% and 31%?

Hi Jungle,

To fully answer your question, I would have to know your projected tax bracket when you retire (including possible clawbacks), how tax-efficiently you invest and how this fits with your plan.

In general, Smith Manoeuvre beats TFSA if you invest tax-efficiently, since you should be able to defer most or all of your investment income for many years, but still claim the tax deduction for the interest every year. That is why we try to invest in order to get little or no tax on the investments over the years.

TFSA might be better if you invest so there is tax on your investments every year.

RRSP often beats Smith Manoeuvre, since the entire amount is tax deductible, while with SM only the interest on the amount is tax deductible. For example, if you have $10,000 cash, you would get a $10,000 tax deduction by contributing it to an RRSP, but if you pay it down on your mortgage and borrow back to invest, you only get an additional tax deduction for the interest on $10,000. However, this is only a benefit if your tax bracket is noticeably less when you retire and access this money, since the RRSP tax deduction is only a deferral, while the SM provides a much smaller, but permanent tax deduction.

Therefore, with an MTR of only 24-31%, it is unlikely that you will retire with a lower tax bracket, so SM is probably better than RRSP.



Ed

[edrempel]

Does anyone know how much normally would a Consultants charge on setting up a Smith Manoeuvre account?
One time Lump sum or by percentage of investment?
Also would it make sense for a guy (like me) who just barley have 20% downpayment to apply SM?
Should I save up more (25% or even 30%) before I start to consider using SM?

Anyone?

Hi Buy.a.Gift,

Oops, I think I have the CAPS wrong. :)

There are 2 main types of "consultants" to setup the Smith Manoeuvre - a financial planner or a mortgage broker.

The Smith Manoeuvre is a riskier strategy, because you are borrowing to invest. You also need to make sure you are the right temperament to be able to stick with it long term and that you don't make a mistake (such as taking monthly income from the investments) that can mess up the tax deductibility of your investment credit line. You will also need a sound investment strategy. For these reasons, it is generally best to use a financial planner and make the Smith Manoeuvre part of your long term financial plan.

When you are charged a fee, it is probably because you are working with a mortgage broker or a marketing company. A financial planner will not normally charge you to setup the Smith Manoeuvre, because he can make money from the investments you buy.


There are many ways to setup the Smith Manoeuvre. The right setup depends on your long term goals, how aggressively you want to build wealth, and your risk tolerance.

If you have no more than the 20% down, then there are 2 main strategies available to you - the "Plain Jane" Smith Manoeuvre and the Rempel Maximum. With the Plain Jane, you just reinvest from your credit line the amount of principal you pay down on the mortgage with each mortgage payment. You start with zero investments and invest every 2 weeks. With the Rempel Maximum, you get a separate investment loan and use this principal portion to make the payments on the leverage loan. You invest a lump sum from the investment loan where you don't have to use your cash flow to make the interest payments.

The Plain Jane is the less risky of the 2 and still has significant long term benefits from regular investing over many years combined with the dollar cost averaging benefit. The Rempel Maximum is more aggressive, but has significantly more long term potential because you start with a lump sum.



Ed

[edrempel]

Yeah, its my view that with the SM, you really don't want to have so little equity in the house that you're going to be caught in a funding trap when it comes time to renew your mortgage during a housing downturn.

You could definitely start the process of getting the SM going with only 20% down, but it would be my suggestion that you do not use anywhere near the maximum amount of leverage possible.

Hi Mark,

It sounds like you are expecting a real estate crash? The funding trap you are referring to would likely only be a problem if your home drops in value plus you want to move or refinance. Normally, the banks will do a straight renewal in which you only negotiate the rate and term. With a straight renewal, they normally do not do an appraisal or credit check, which means they would not reduce your credit limit if your home has declined in value.

Back in the early 90s when real estate in Toronto dropped by 30%, in all the cases I was aware of, the banks did not reduce the credit limit on secured credit lines, unless you want to refinance or sell. As long as your mortgage was in good standing, you could just renew it on the due date.

For example, let's say you own a home worth $500,000. The banks will lend you up to 80%, or $400,000. You can start the Smith Manoeuvre at that point, which means your mortgage plus investment credit line generally add up to about $400,000. Then let's say real estate crashes by 20%, so your home is only worth $400,000 when your mortgage comes due. That means that the bank would only lend you $320,000 if you want to refinance in some way, but you can still do a simple renewal and just negotiate a new rate and term and renew - maintaining your credit limit of $400,000.

If you want to sell, you may not be able to fully pay off the mortgage and credit line from the house proceeds. However, you still have the investments. You have not lost your equity by doing the Smith Manoeuvre - you have invested your equity. You could sell a bit in order to make sure you can cover the shortfall on selling your house, if you really need to sell.

In short, as long as you are not refinancing or selling your home, and if you have made all the payments on your mortgage, based on our experience in the early 90s and what our mortgage contacts tell us, you should be able to do a simple renewal and keep your credit limit, even if your home has declined in value.




Ed

[Germack]

If house prices crashes line of credits will be adjusted (see USA) and you might be in deep trouble if you are heavily leveraged.

In the nineties the amount of money borrowed via LOCs was low, so the risk to the banks was also kind of low, so I guess they did not mind renewing the LOCs at the same conditions.

However, since around 2000 money borrowed via LOCs exploded. If the collateral falls in value (House) it will be very risky for the banks this time due to the huge amount of money borrowed forcing them to reduce the LOCs.
http://www.theeconomicanalyst.com/sites/default/files/u3/lines_of_credit.jpg

Leveraging is only for a very small percentage of investors and you are probably not one of them. The only one getting rich using this strategy will be Ed Remple or your financial advisor.

[Mark77]

Leveraging is only for a very small percentage of investors and you are probably not one of them. The only one getting rich using this strategy will be Ed Remple or your financial advisor.

Yeah no kidding, in a housing market downturn situation, I'd make darn sure your bank doesn't know about your SM assets. Because if they do, and if you're underwater equity-wise, the bank will very likely lean on you heavily to redeem the assets to bring the loan back into equity on a renewal.

This is one of the instances where consolidating all of your banking at one bank may very well be a bad idea.

However, in the 1990s, doing the SM was a way that one was able to hedge out house price decreases, as the stock market rose as the housing market was falling in Canada.

[sharp21]

Hi Sharp 21,

I don''t fully understand your question. What does the readvanceable have to do with CCA? You can claim CCA and still borrow against the property to invest at the same time.

Claiming CCA on a rental is a tax deferral that makes sense in most cases, especially if you plan to hold it for a long time. You get a tax deduction for the CCA (only to the extent that you have taxable net rent income after expenses), which you have to "recapture" when you sell the property. The recapture is fully taxable when you sell. This does not affect your capital gain.

For example, you buy a property for $100,000. Let's say you claim $50,000 CCA every year over 20 years. Then you sell the property for $150,000. You will have a $50,000 recapture plus a $50,000 capital gain. The total income added to your income is $75,000, since the capital gain is only 50% taxable.

The result is that you paid less tax for 20 years and then paid more in the last year. Because of the time value of money, you would normally be ahead. However, depending on your tax bracket today and how high your tax bracket would get when you sell and add $75,000 to your income, you may or may not be ahead.

Make sure your rental is 100% a rental and not a portion of your home. You cannot claim principal residence deduction on the property if you claimed CCA at the same time.



Ed

Thanks Ed.

My taxable income today is likely higher than it will be in 20years so it would probably be a better idea to write off CCA.

However, I plan on selling this property in 5-6 years, in order to keep my fleet new. As it won't be paid off I'd rather not get hit with the recapture so I'll just pay the tax.

Especially as I can pay it off with the tax deductible investment loan...

S.

[edrempel]

Yeah no kidding, in a housing market downturn situation, I'd make darn sure your bank doesn't know about your SM assets. Because if they do, and if you're underwater equity-wise, the bank will very likely lean on you heavily to redeem the assets to bring the loan back into equity on a renewal.

This is one of the instances where consolidating all of your banking at one bank may very well be a bad idea.

However, in the 1990s, doing the SM was a way that one was able to hedge out house price decreases, as the stock market rose as the housing market was falling in Canada.

Hi Mark,

We have specifically asked our bank contacts what they will do if real estate crashes 20% or 30%. They all said the bank would do the same as they did in the 1990s - as long as you are making your payments and are not refinancing, they would just leave the credit limit the same.

The same principal applies to unsecured credit lines. If you qualify for a $30,000 unsecured credit line, the bank normally does not take it away from you if your financial situation or income decline. As long as the credit line is in good standing and you are not refinancing it, banks tend to leave the limit.

If there is a real estate crash and you have leveraged up to 80% of your home's value, you might have trouble refinancing or moving your readvanceable mortgage to a new bank, but we do not anticipate any trouble renewing your mortgage or keeping your credit limit.


Ed

[edrempel]

Hi Everyone,

If you are thinking at the Smith Manoeuvre, a good time to start is when the markets are very cheap, like today. We have not had P/Es under 12 combined with low interest rates since the early 1950s.

There is a lot of negative news, but there is always negative news when the markets are cheap. Plus, we think that NONE of the major items feared in the news will happen. "Fear of a False Factor is Favourable"

If you stay focused on the long term, the markets have always gone up over 15-year periods, and the worst ever 25-year period is 5%/year (more than tripling your money).




Ed

[Mark77]

http://www.leaderpost.com/business/fp/money/Smith+Manoeuvre+alive+well/5503228/story.html


While the creator of the eponymous Smith Manoeuvre, Fraser Smith, is sadly no longer with us, the tax-savings movement he spawned is very much alive and well in Canada.

Born in 1938, Smith died of cancer on Sept. 25 at age 74.

[edrempel]

Hi Mark,

Yes, we owe him a lot. He started a movement that has made a lot of difference in the lives of a lot of people.

I wrote a tribute to him: http://www.milliondollarjourney.com/a-tribute-to-fraser-smith.htm .




Ed

[jlow86]

I am looking to start the Smith Manoeuvre and I bank with TD. Anybody use the TD HELOC? How does one set it up?

[bradatkins]

Hey -

I've been reading about the Smith Manoeuvre for almost a year now.

I seem to go in spurts where I'm 90% certain I'm going to do it, then I back off.

I sat with my financial advisor a couple of nights ago, to discuss it again.

There's something that's bugging me about it, and I'm not sure what. Maybe nerves?

I asked my CFP if it's so good, why isn't everyone doing it? He said two reasons:

1) You need to be somewhat aggressive to want to do this (which I am)
2) You need to be a long term investor, and long term resident in your house for the future (which I am)

I then proceeded to ask him how many clients he has done this, and he said 2. He's with IG by the way.

I currently pretty much max out my RRSP's every year through company and personal contributions and the company does not have a DB plan.

My home is currently valued at 250K, was purchased for 137K 8 years ago, and I have somewhere around 100K left to pay.

Does anyone have any suggestions as to what's making me uncertain about pulling the trigger? Maybe the risk, maybe the inexperience of my CFP. I'm not sure.

Any feedback is appreciated.

Thanks,
Brad

[kerdon]

Hey -

I've been reading about the Smith Manoeuvre for almost a year now.

I seem to go in spurts where I'm 90% certain I'm going to do it, then I back off.

I sat with my financial advisor a couple of nights ago, to discuss it again.

There's something that's bugging me about it, and I'm not sure what. Maybe nerves?

I asked my CFP if it's so good, why isn't everyone doing it? He said two reasons:

1) You need to be somewhat aggressive to want to do this (which I am)
2) You need to be a long term investor, and long term resident in your house for the future (which I am)

I then proceeded to ask him how many clients he has done this, and he said 2. He's with IG by the way.

I currently pretty much max out my RRSP's every year through company and personal contributions and the company does not have a DB plan.

My home is currently valued at 250K, was purchased for 137K 8 years ago, and I have somewhere around 100K left to pay.

Does anyone have any suggestions as to what's making me uncertain about pulling the trigger? Maybe the risk, maybe the inexperience of my CFP. I'm not sure.

Any feedback is appreciated.

Thanks,
Brad


I'd be nervous about dealing with your IG rep who has only done it for 2 people. Is he doing it himself???
He will likely ask you to be a long term investor, sell you IG only funds, and DSC the heck out of you, and you'll be locked up for 5-7 years. He'll then say let's rebalance 10% each year. That portion is the amount you are able to unlock from DSC and he will front load the mutual fund and collect a 1% trailer. On a 100k its a nice 5200 pay day for him.
Your MERs will be in the 2.6% range.

Personally I do the SM myself, I use a fee based account, @ 1.1%, and use direct securities. As its much easier to track dividends. Remember if the funds he chooses return you ANY return of capital, you can't claim the portion of interest. Just a FYI

[bradatkins]

I'd be nervous about dealing with your IG rep who has only done it for 2 people. Is he doing it himself???
He will likely ask you to be a long term investor, sell you IG only funds, and DSC the heck out of you, and you'll be locked up for 5-7 years. He'll then say let's rebalance 10% each year. That portion is the amount you are able to unlock from DSC and he will front load the mutual fund and collect a 1% trailer. On a 100k its a nice 5200 pay day for him.
Your MERs will be in the 2.6% range.

Personally I do the SM myself, I use a fee based account, @ 1.1%, and use direct securities. As its much easier to track dividends. Remember if the funds he chooses return you ANY return of capital, you can't claim the portion of interest. Just a FYI

So I guess there's two things that bug me:

1) Lack of confidence in my CFP
2) Lack of detailed understanding/knowledge to do the investing portion myself.

Does anyone do this through a CFP?

[cannon_fodder]

Sometimes there are uncommon ideas with uncommonly good results. If many people are not aggressive nor financially literate, then it is understandable that not a lot of people do this.

However, if you include how many people just simply borrowed from a HELOC to invest in the stock market, then it wouldn't surprise me to see the number of people is higher doing this than the SM. The former is kind of a "one shot" jump start that may coincide with a particular low in the markets. SM typically is done as a long term, trickle investing strategy.

If you feel competent enough to buy index ETFs or index mutual funds or maybe a balanced collection of blue chip dividend paying companies for your RRSP or TFSA, then what makes this so different?

[liorsyncro]

The key concepts when borrowing to invest are:

1) Making sure the cost of borrowing is tax-deductible (investing in qualified investments)
2) Making sure the choice of investments is tax-efficient
3) Making sure that you're using the right mortgage/LOC product for this strategy
3) You must remain diversified and ensure that there are proper risk mitigation strategies in place (for example, borrowing $50,000 to buy $50,000 of TD Bank stock is not a wise strategy)

While any financial planner can put this strategy to work, we've done these with a fee-only planner specializing in low-cost investing (ETFs and individual stocks). Kerdon mentioned good reasons why fee-based advisers are better for this strategy than your typical mutual fund salesperson. The mortgage and LOC should be discussed with a mortgage adviser and NOT the financial planner. Some financial planners out there are somewhat picky with the kind of LOC they want to the client to get. It's important to make sure that the planner and mortgage adviser are on the same track and that you're not getting conflicting advice.

Contrary to popular belief, you don't need to be an "aggressive" investor to do this; you need to be responsible, yes, and be comfortable with leverage. This means you have little "bad" debt (i.e. high balance on credit cards, high interest loans, etc.) and a steady source of income. This strategy works best for individuals with a long investment horizon.

[liorsyncro]

Hi Everyone,

If you are thinking at the Smith Manoeuvre, a good time to start is when the markets are very cheap, like today. We have not had P/Es under 12 combined with low interest rates since the early 1950s.

There is a lot of negative news, but there is always negative news when the markets are cheap. Plus, we think that NONE of the major items feared in the news will happen. "Fear of a False Factor is Favourable"

If you stay focused on the long term, the markets have always gone up over 15-year periods, and the worst ever 25-year period is 5%/year (more than tripling your money).




Ed
+1 I posted about this on my blog. For the right individual, today's valuations can be a very attractive proposition especially high quality stocks. There may be additional losses as the whole Europe debt fiasco continues to unravel but there are dozens of companies out there trading at very attractive multiples. Look up the November issue of Moneysense for a partial list of Canadian stocks.

[Mark77]

The key concepts when borrowing to invest are:

1) Making sure the cost of borrowing is tax-deductible (investing in qualified investments)
2) Making sure the choice of investments is tax-efficient
3) Making sure that you're using the right mortgage/LOC product for this strategy
4) You must remain diversified and ensure that there are proper risk mitigation strategies in place (for example, borrowing $50,000 to buy $50,000 of TD Bank stock is not a wise strategy)


5) Make sure you're not fully reliant on a single lender or source of collateral (ie: if you buy stocks, make sure they can be borrowed against just in case the ability to use your house for credit is diminished).

6) Don't use 100% of your possible/available resources/credit limits; this can lead to the lenders believing you are under stress and engaging in predatory behaviour.

7) Don't invest in products that are highly correlated with your real estate. ie: REITs, or a second "investment property" are big no-no for SM investors. SM investors also should generally not invest in mortgages or fixed income securities.

[bradatkins]

...
If you feel competent enough to buy index ETFs or index mutual funds or maybe a balanced collection of blue chip dividend paying companies for your RRSP or TFSA, then what makes this so different?

I think you hit the nail on the head. I'm not very investment savy. I think what I'm looking for is for "someone" to give me the flowchart of the SM, and advise me what to buy.

I'm a process oriented type person, so if I need to do X every month, no problems, but determining what X is, is the question. Something like this: http://wiki.errorok.com/images/2/2a/Smflow.png

I guess my expectations of my CFP were that he would lay everything out on the table. ie get a HELOC, setup seperate bank account, purchase investments, take monthly dividend and pay HELOC, etc, etc. That doesn't seem to be the case.

[Chasem]

I'm not sure if I should go ahead with the SM right now. It's not that I don't want to, but I'd have to break my current mortgage contract and sign with another bank, as my bank does not offer a readvanceable mortgage.

Our mortgage is currently $600,000 and we are paying a variable of Prime - .85 or 2.15%, 5 year term, 35 year amortization period.

If we break our mortgage, we would have pay an estimated $3000 in interest penalty (3 months worth).

Also, the best variable rate right now is Prime - .45 or 2.55% for a 5 year term. So if we jump onto this higher variable rate for the remainder of our term (roughly a bit more than 4 years), we have pay an estimated extra $11,000 in interest. The total additional interest and penalty is $14,000. Ouch. :mad:

Instead, I was thinking that I could set up an initial HELOC at $100,000 this year and then increase it on a yearly basis, rather than a biweekly/monthly basis. I intend to put $22,000 in prepayment on top of our regular mortgage payment every year, along with whatever dividends are earned into the principal. That then gets converted into the HELOC. Then when the time comes to renew our mortgage, I would sign up for a readvancable one then.

I am not sure if this would be cost-efficient though as I have never set up a HELOC before and do not know if there would be fees associated with increasing the HELOC every time, but I presume it would be nowhere near as much as $14,000.

Thoughts?

[Mark77]

I'm not sure if I should go ahead with the SM right now. It's not that I don't want to, but I'd have to break my current mortgage contract and sign with another bank, as my bank does not offer a readvanceable mortgage.

Thoughts?

Almost sounds like you're in a situation where if you have to get the loan re-done, the extra interest you would be paying would actually exceed the value of the tax deduction. Instead, you might want to look into simply using some of your prepayment money to buy stocks in a TFSA (or RRSP if you're not maxxing them out).

A 35-year amortization period instantly raises a bunch of red flags -- why did you select that in the first place? Not that you made a bad choice (I mean, if you could get such an amortization period and not pay an interest rate premium -- then that was good dealing on your part!), but too much leverage can be very dangerous when doing the SM as well. I'm suspecting your house is in the $700-$800k range -- and that's probably "ground zero" for a Canadian housing market collapse as units that expensive have a very limited market to be bought up as distressed assets in the future.

If you're not already maximizing the RRSP's -- do that, without question, because, at least if the market in Canada does collapse housing-wise, you will have protected a good chunk of your savings from creditors.

[Chasem]

Almost sounds like you're in a situation where if you have to get the loan re-done, the extra interest you would be paying would actually exceed the value of the tax deduction.

Yeah, this is what I figured. I did a bit of math and it seems that I will be having to fork out a few thousand overall, even after tax savings.


Instead, you might want to look into simply using some of your prepayment money to buy stocks in a TFSA (or RRSP if you're not maxxing them out).

Thanks for suggesting this. I had not contemplated using the prepayments to max out the TFSA and/or RRSPs. The question is, would I save more in mortgage interest if I make the prepayment towards the house or would I save more in taxes if I put them in a TFSA/RRSP?


A 35-year amortization period instantly raises a bunch of red flags -- why did you select that in the first place?

I actually wanted a 20 year amortization period when I first started mortgage rate shopping. After realizing that the banks gave various prepayment options, it made sense to go with a 35 year amortization period instead. Our current payments allow us to pay our mortgage off in 15 years. That is obviously what we would prefer to do if everything goes smoothly. Life is not always so smooth though. In the event that my wife or I lost our job, we wanted to be able to have a bit of breathing room with our payments until we get back on the job market. So we selected the 35 year amortization period, but pay it off like it were a 15 to 20 year amortization period.

[edrempel]

I am looking to start the Smith Manoeuvre and I bank with TD. Anybody use the TD HELOC? How does one set it up?

Hi Jlow,

The TD HELOC works well for the SM. They are usually very competitive on rates, as well, although they do not offer variable mortgages in the HELOC.

What do you want to know about setting it up?


Ed

[edrempel]

I think you hit the nail on the head. I'm not very investment savy. I think what I'm looking for is for "someone" to give me the flowchart of the SM, and advise me what to buy.

I'm a process oriented type person, so if I need to do X every month, no problems, but determining what X is, is the question. Something like this: http://wiki.errorok.com/images/2/2a/Smflow.png

I guess my expectations of my CFP were that he would lay everything out on the table. ie get a HELOC, setup seperate bank account, purchase investments, take monthly dividend and pay HELOC, etc, etc. That doesn't seem to be the case.

Hi Brad,

I'm sure that is the reason for your hesitation, Brad. In the end, the Smith Manoeuvre is a strategy of borrowing to invest, so the main factors in succeeding are your ability to have faith in the long term strategy and having an effective investment strategy.

To figure out whether the SM is right for you, you need to be the type of person that will be able to stick with the strategy through the inevitable bear markets. The investments can be done the same as your RRSPs and other investments, but I can tell you from experience doing the SM myself and with several hundred client families that quite a few people feel different with leveraged investments than non-leveraged.

This can especially true if you start out with a significant lump sum. In your case, you have $100,000 equity that you could invest right away. If you borrowed $100,000 to invest and the market went into a major bear market - let's say it is down 30% - will you be able to stick with your strategy? That would mean that your investments could be down to $70,000 while you still owe $100,000 on your credit line plus the interest you paid from the credit line. There is usually lots of negative news out to add to pessimism at that time.

That is the worst case scenario. I bring it up because it is possible and because that is how you deal with fear. If you would panic and sell or stop investing in a bear market, then this is probably not the right strategy for you. However, if you can tolerate the worst case scenario and stick with the strategy long term, then it is highly likely to be very successful for you.

From experience, we have found that clients that always have faith in the strategy and their investments long term tend to make the right decisions, and have good experiences and results with the SM. Those that are nervous about the markets or the economy, or lose faith when there is a lot of bad news tend to make the wrong choices and to have disappointing results.

The setup can vary since there are 7 different Smith Manoeuvre strategies. The right strategy depends on your objective, your risk tolerance, and how aggressively you want to build wealth.

It is always best to do the SM as part of a comprehensive, written financial plan. It should be fully a part of your life goals, which is then both the reason to do it and the reason to stick with it.

Is your MAIN goal from the SM to:

1. Build wealth and provide for your retirement.
2. Pay off your mortgage faster.
3. Provide additional income now (instead of building wealth).

The most appropriate reason is #1. #2 is possible, but questionable. Borrowing money to invest for the purpose of reducing debt means you have to think clearly about what you are doing. #3 is mainly for retirees and is only a good idea in rare circumstances.

The drawing in your post is generally accurate for most of the strategies, except for 2 things:

1. Line 8 - It is best to keep your tax deductible accounts completely separate from non-deductible accounts. If you want to make extra lump sums, you should make them directly from your main chequing and not mix it with your SM chequing (if you have one). In most cases, we find the SM chequing account unnecessary, since it is possible to invest directly from the SM credit line.
2. Line 7 - In most cases, there are NO monthly dividends. It is possible to invest for taxable dividends, but if this is your main goal, you are limiting your investment choices. You mentioned MONTHLY dividends, which sounds like the Smith/Snyder strategy that some advisors and mortgage brokers use. It involves receiving monthly non-taxable payments from investments that are considered "return of capital" (ROC). This strategies causes tax issues and reduces the deductibility of your credit line over time. The most effective SM strategies usually focus on long term growth, so there are not usually monthly dividends.

The investment strategy is key because you must have a solid strategy that you will be able to have faith in during bear markets. In our case, we focus on finding the world's best investors and investing with them. When you find them, they are normally managing mutual funds (or sometimes hedge funds). I don't mean average mutual funds, but those managed by the best stock pickers. We call them "All Star Fund Managers" (Google it). I can tell you that if you focus on finding them, there are fund managers that beat the markets by wide margins over long periods of time after all fees. Identifying them is complex, but worth it.

Most of the bloggers here are DIYers and invest differently. Personally, I don't do amateur investing, I don't pick my own stocks, I don't buy index investments or buy into the latest popular trends. The current popular trend is "dividend-paying stocks", which tend to become popular after major bear markets and fall out of favour near the end of bull markets.

You can choose whichever strategy makes sense to you (or get advice). The key point, though, is that you do need to have a solid investment strategy that you believe in and that you will be able to maintain faith in right through the next bear market.

I hope that is helpful, Brad.


Ed

[bradatkins]

Hi Brad,

This can especially true if you start out with a significant lump sum. In your case, you have $100,000 equity that you could invest right away. If you borrowed $100,000 to invest and the market went into a major bear market - let's say it is down 30% - will you be able to stick with your strategy? That would mean that your investments could be down to $70,000 while you still owe $100,000 on your credit line plus the interest you paid from the credit line. There is usually lots of negative news out to add to pessimism at that time.


This I can handle, it typically stings for a few days (ie when I get a quarterly statement and I'm down 17K, which has happened) I'm not too happy for a few days, but then get over it without doing anything irrational. No one likes to lose money (even in the short term). But I'm fairly young (31) so I have time on my side.

And to be perfectly honest, would I take all the equity out and leverage it right away? Probably not. I'd take at least the difference of what I owe minus what I bought it for (currently owe 89K, bought for 137K). Run that for a while (say 1 year) once I understand, then I can move forward with more.



Is your MAIN goal from the SM to:

1. Build wealth and provide for your retirement.
2. Pay off your mortgage faster.
3. Provide additional income now (instead of building wealth).


My goal is #1. I have in my past moved jobs, and given up company pension plans, as I do not have faith in them. No one is looking out for #1 (my family) other then my family. I want to ensure we have a secure future.



Most of the bloggers here are DIYers and invest differently. Personally, I don't do amateur investing, I don't pick my own stocks, I don't buy index investments or buy into the latest popular trends. The current popular trend is "dividend-paying stocks", which tend to become popular after major bear markets and fall out of favour near the end of bull markets.


Right, I'm less then an amateur investor. I'm good at a lot of things, and investing isn't one of them. I don't plan/want to be good at it either.

So to sum it up, I think I need the following to be comfortable:

1) Someone who knows what steps I need to take to do this properly
2) Someone who is an 'all star fund manager'

I've read pretty much everything I can find of yours, be it from your website or million dollar journey. I've signed up for your next webinar (hopefully it's soon :) )

So my question is, does a person like yourself do #1 and "hook people up" with the all star fund managers?

Thanks for sharing your knowledge.

Brad

[kerdon]

This I can handle, it typically stings for a few days (ie when I get a quarterly statement and I'm down 17K, which has happened) I'm not too happy for a few days, but then get over it without doing anything irrational. No one likes to lose money (even in the short term). But I'm fairly young (31) so I have time on my side.

And to be perfectly honest, would I take all the equity out and leverage it right away? Probably not. I'd take at least the difference of what I owe minus what I bought it for (currently owe 89K, bought for 137K). Run that for a while (say 1 year) once I understand, then I can move forward with more.



My goal is #1. I have in my past moved jobs, and given up company pension plans, as I do not have faith in them. No one is looking out for #1 (my family) other then my family. I want to ensure we have a secure future.



Right, I'm less then an amateur investor. I'm good at a lot of things, and investing isn't one of them. I don't plan/want to be good at it either.

So to sum it up, I think I need the following to be comfortable:

1) Someone who knows what steps I need to take to do this properly
2) Someone who is an 'all star fund manager'

I've read pretty much everything I can find of yours, be it from your website or million dollar journey. I've signed up for your next webinar (hopefully it's soon :) )

So my question is, does a person like yourself do #1 and "hook people up" with the all star fund managers?

Thanks for sharing your knowledge.

Brad


I would also check if our advisor is using DSC mutual funds, or fee-based? They are very different to advisor compensation.

I only run a fee based business, as my fiduciary duty is to the clients not to my pocket book.

[Chasem]

Reading back on some older posts when Pitz was still active on this thread, I see that some posters used an IB margin account. IB's interest rates are Prime -, whereas most HELOCs are Prime +.

I was thinking of setting up a combination of the two in order to blend the rates. At the amounts I am looking to invest, my rates would average to just under Prime if the HELOC is set up at Prime + 0.5%. The difference is easily 100 bps or more.

My concern is the dreaded margin call. IB's rules is that the if the market value of the portfolio drops below a certain threshold, they instantly liquidate. They don't phone, email or notify you if this is going to happen.

I assume there would have to be some proactiveness on my part to ensure that there is enough cash to cover the account in the event that value drops close to the threshold. Would I have leave a residual amount of cash in IB just to be safe? Would they pay interest on that dormant cash?

Also, has anyone here used IB as a full 100% replacement over a HELOC and care to share their thoughts on how they would handle the margin call if it were to happen.

Chasem

[Mark77]

My concern is the dreaded margin call. IB's rules is that the if the market value of the portfolio drops below a certain threshold, they instantly liquidate. They don't phone, email or notify you if this is going to happen.


At least they will liquidate you rapidly. Unlike other brokers, who might leave the market to keep going down, and then, all of the sudden, liquidate you a few days later.




I assume there would have to be some proactiveness on my part to ensure that there is enough cash to cover the account in the event that value drops close to the threshold. Would I have leave a residual amount of cash in IB just to be safe? Would they pay interest on that dormant cash?


Obviously you wouldn't want to be anywhere near the threshold for receiving a margin call, as it takes ~3 days to transfer cash into IB. If you have a $300k house, $200k paid off, and are inveseting $100k with the SM -- you might consider borrowing $50k of the cash from IB (ie: 2:1 leverage), and the other $50k from the HELOC. If the IB account goes down, putting you closer to the danger zone, simply make a transfer from the HELOC into IB. You'll never get your interests costs down fully to the IB rate, but you will be saving some.



Also, has anyone here used IB as a full 100% replacement over a HELOC and care to share their thoughts on how they would handle the margin call if it were to happen.


They liquidate enough stock to get your account back into compliance. If its a temporary bottom in the market, then merely repurchase the position the next day once things come back up. Sure, you'll have lost a bit of money in the friction, but the extra returns of leverage should, over time, compensate for that.

Ideally, you wouldn't leverage yourself so much as to get into a situation where there would be a deficiency in your margin/performance bond, versus what is required for your positions. The key here is to be conservative. Just because you have a HELOC + margin account, which, really, is a lot of rope that you can hang yourself with -- doesn't mean that you can/should use much of it.

[edrempel]

I'm not sure if I should go ahead with the SM right now. It's not that I don't want to, but I'd have to break my current mortgage contract and sign with another bank, as my bank does not offer a readvanceable mortgage.

Our mortgage is currently $600,000 and we are paying a variable of Prime - .85 or 2.15%, 5 year term, 35 year amortization period.

If we break our mortgage, we would have pay an estimated $3000 in interest penalty (3 months worth).

Also, the best variable rate right now is Prime - .45 or 2.55% for a 5 year term. So if we jump onto this higher variable rate for the remainder of our term (roughly a bit more than 4 years), we have pay an estimated extra $11,000 in interest. The total additional interest and penalty is $14,000. Ouch. :mad:

Instead, I was thinking that I could set up an initial HELOC at $100,000 this year and then increase it on a yearly basis, rather than a biweekly/monthly basis. I intend to put $22,000 in prepayment on top of our regular mortgage payment every year, along with whatever dividends are earned into the principal. That then gets converted into the HELOC. Then when the time comes to renew our mortgage, I would sign up for a readvancable one then.

I am not sure if this would be cost-efficient though as I have never set up a HELOC before and do not know if there would be fees associated with increasing the HELOC every time, but I presume it would be nowhere near as much as $14,000.

Thoughts?

Hi Chasem,

It is probably not worth it to break your mortgage to start the SM, however, the figuring this out is a bit more complex. Refinancing to get a readvanceable means that you pay both a penalty and higher interest, but it does mean that you have access to the principal portion of all your mortgage payments and prepayments for the next 5 years to invest. If you include an expected benefit of that, it may look different.

I assume you started your mortgage about 2 months ago when rates briefly hit prime -.85%? We have done this Mortgage Breaking Scenario a lot and sometimes it is surprising what can be worth it when there are 5 years left in the mortgage.

As Mark pointed out, there are other options to access the equity. Since your mortgage rate is so very low and you cannot readvance it, you are probably better off not making any prepayments for 5 years. Keep the payment at the minimum and use your cash flow to invest instead. It should not be hard to find investments that would be expected to make more than 2.15% after tax.

If you have more credit available in your home (which it sounds like you do), you can get a HELOC for the difference between your mortgage and 80% of your home value. This would mean the HELOC is a 2nd mortgage, so it will probably be at a bit higher rate - say prime +1%. This would allow you to invest that amount, if you are the right type of person for the Smith Manoeuvre.

You can also make your cash flow positive, if necessary, by leaving some room in the credit line so that you can capitalize your interest payments.

You could also apply for an increase in your HELOC every year or 2, as your mortgage gets smaller. Legal and appraisal fees to setup and increase HELOCs are negotiable. We have found that we can often negotiate them to zero, if the increase in the HELOC is significant enough and if you are going to invest it. The bank may absorb the fees if they know they will be getting interest from you.

You have a few decent options. It is not obvious without knowing your entire situation which option is best, or even if the SM is appropriate for you. I hope I didn't just confuse you more.



Ed

[edrempel]

Thanks for suggesting this. I had not contemplated using the prepayments to max out the TFSA and/or RRSPs. The question is, would I save more in mortgage interest if I make the prepayment towards the house or would I save more in taxes if I put them in a TFSA/RRSP?

Hi Chasem,

That is not actually the right question. You are comparing the total benefit of making a mortgage prepayment to the tax savings portion of the benefit only from investing the same amount in a TFSA or RRSP. If you invest in a TFSA or RRSP, it is reasonable to expect that there would be investment benefits in addition to the tax savings.

Better would be to estimate a reasonable total expected benefit from each strategy.

First, you would have to figure out which is better for you - TFSA or RRSP. This depends on your marginal tax bracket now and what you expect it to be after you retire.



Ed

[edrempel]

Reading back on some older posts when Pitz was still active on this thread, I see that some posters used an IB margin account. IB's interest rates are Prime -, whereas most HELOCs are Prime +.

I was thinking of setting up a combination of the two in order to blend the rates. At the amounts I am looking to invest, my rates would average to just under Prime if the HELOC is set up at Prime + 0.5%. The difference is easily 100 bps or more.

My concern is the dreaded margin call. IB's rules is that the if the market value of the portfolio drops below a certain threshold, they instantly liquidate. They don't phone, email or notify you if this is going to happen.

I assume there would have to be some proactiveness on my part to ensure that there is enough cash to cover the account in the event that value drops close to the threshold. Would I have leave a residual amount of cash in IB just to be safe? Would they pay interest on that dormant cash?

Also, has anyone here used IB as a full 100% replacement over a HELOC and care to share their thoughts on how they would handle the margin call if it were to happen.

Chasem

Hi Chasem,

With any leveraged investment strategy, you must have a way to handle all margin calls. Margin calls are the big fear. You have to make sure that you will never be forced to sell at a market bottom.

I would recommend using only a HELOC and not using a margin account at all. That way, you will never be subject to a margin call. You may pay a bit more interest, but this means that you can confidently invest whatever amount you want. With a margin call account, you should always keep huge amounts of cash or available credit to protect you against a margin call.

Mark is right that if you are only going to leverage a small amount of your available equity, then perhaps you would be able to write a cheque on the day of a market crash to cover the margin call. You may also be able to buy the investment back, but markets tend to be very volatile at market bottoms. It could easily be 5-10% higher before you can buy it back.

We essentially always use only HELOCs or No Margin Call Loans, so that there is never a risk of a margin call. Being able to confidently invest as much as you want is a much more important factor.

For example:

Option 1: Borrow $50,000 to invest at prime, as in your example, and keep $50-100,000 available credit to protect you.
Option 2: Borrow $100,000 to invest at prime +.5% with no risk of margin call.

Which is better? If you are a long term investor, the determining factor is the amount of dollars invested long term. The interest rate is really only a minor detail. Any margin call at all will likely lose you many times more than the interest savings anyway.

In short, I would recommend using only your HELOC, or other investment loan with no chance of a margin call.




Ed

[edrempel]

My goal is #1. I have in my past moved jobs, and given up company pension plans, as I do not have faith in them. No one is looking out for #1 (my family) other then my family. I want to ensure we have a secure future.

Right, I'm less then an amateur investor. I'm good at a lot of things, and investing isn't one of them. I don't plan/want to be good at it either.

So to sum it up, I think I need the following to be comfortable:

1) Someone who knows what steps I need to take to do this properly
2) Someone who is an 'all star fund manager'

I've read pretty much everything I can find of yours, be it from your website or million dollar journey. I've signed up for your next webinar (hopefully it's soon :) )

So my question is, does a person like yourself do #1 and "hook people up" with the all star fund managers?

Thanks for sharing your knowledge.

Brad

Hi Brad,

Thanks. I'm glad you found my posts useful.

It's good that you are able to admit that you are not a good investor. These blogs are fully of amateurs that somehow think they can pick stocks better than the top fund managers. It's good that you can be honest with yourself about this.

I feel the same. I am both an accountant and financial planner, and I've been in the financial industry for almost 20 years. I get to meet the top fund managers regularly. I can tell you that there is no way I could pick stocks anywhere close to as well as our All Star Fund Managers.

To answer your questions:

1. We will prepare a comprehensive, written financial plan to essentially plan out the finances for what you want to do in your life. Part of the plan will be the precise way that the Smith Manoeuvre is best setup in your case. Then we'll walk you through each step of the implementation.
2. Yes. We will arrange for investments with fund managers that we consider to be All Star Fund Managers. Depending on your risk tolerance, likely they will be fund managers that manage the investments for every member of our team.

Our next webinar is next week Thursday (Nov. 24), so you won't have to wait long.




Ed

[bradatkins]

Our next webinar is next week Thursday (Nov. 24), so you won't have to wait long.


Can't wait! I've got it marked in my calendar!

[bradatkins]

Great webinar Ed and Ann!

[edrempel]

Great webinar Ed and Ann!

Thanks, Brad. It was fun to do.


Ed

[BobJJones]

Hi Ed,

Just wanted to say that I value all your posts on RFD and they have been very educational.

I just had a general question pertaining to the strategy, can one borrow against their home to purchase stocks that do not generate dividends? I am a growth investor and many of the stocks that demonstrate value to me do not pay out dividends. I actually prefer the companies NOT to pay me a dividend as I want them to retain that capital for further compounding.

Furthermore, the majority are also US based as well, thus are there any additional implications of this?

Thus my second question is, will tax-deductibility still apply in this case?

Thanks!
-Bob

[Mark77]

I just had a general question pertaining to the strategy, can one borrow against their home to purchase stocks that do not generate dividends? I am a growth investor and many of the stocks that demonstrate value to me do not pay out dividends. I actually prefer the companies NOT to pay me a dividend as I want them to retain that capital for further compounding.


Yes, absolutely. However, the investments have to be actual companies. Commodity trusts (ie: GLD, USO, SLV, among others) wouldn't qualify. But mining companies certainly would. As would Apple.



Furthermore, the majority are also US based as well, thus are there any additional implications of this?


Yes, you would be subject to IRS withholding of at least 15% (which may be re-claimable on a Canadian return), and dividends from the foreign investments are taxable fully as income, not tax-preferred dividends.

Of course, you must declare your holdings of foreign investments if they exceed the threshold set forth on the tax forms, and there is a significant penalty for late filing the declaration.



Thus my second question is, will tax-deductibility still apply in this case?


Yes.

[edrempel]

Hi Ed,

Just wanted to say that I value all your posts on RFD and they have been very educational.

I just had a general question pertaining to the strategy, can one borrow against their home to purchase stocks that do not generate dividends? I am a growth investor and many of the stocks that demonstrate value to me do not pay out dividends. I actually prefer the companies NOT to pay me a dividend as I want them to retain that capital for further compounding.

Furthermore, the majority are also US based as well, thus are there any additional implications of this?

Thus my second question is, will tax-deductibility still apply in this case?

Thanks!
-Bob

Hi Bob,

Thanks for the kind words.

The interest would still be deductible if you borrow to invest in growth stocks. CRA clarifies their view in IT-533, which explains that generally any stock market investment is acceptable, unless it's prospectus prevents it from ever paying a dividend. As long as it is reasonable to believe that a stock will eventually pay a dividend, you should be fine.

IT-533 differentiates between a growth stock (which is not paying a dividend, but probably will once it matures and growth slows) and a stock where the prospectus prevents it from paying a dividend.

CRA does not differentiate between Canadian and foreign dividends. Both are income, so receiving either means you are investing for income.

You are the first growth investor I have talked to for a while. Everyone seems to be into defensive, income-producing investments, even though the stock market is very cheap now.

We invest similarly, except we use mutual funds managed by All Star Fund Managers. Most are value style, but some are growth. They are corporate class funds, which means there should be little or no distributions or dividends over the years. We can still deduct the entire interest payment, though (even though we are not paying it from cash flow).

Receiving dividends actually reduces your long term return, because of the tax you have to pay. A tax-efficient investment allows you to compound the money you would otherwise pay in tax. Canadian dividends are taxed at lower rates, but similar to capital gains, but you can defer capital gains many years into the future.




Ed

[edrempel]

Hi Everyone,

This is a good time to start the Smith Manoeuvre. It is safer and probably more profitable if you start it when the market is as cheap as it is today.

The P/E of the S&P500 is only 11.7%. Historically, it has been about 15%, and about 20% when interest rates are as low as they are today. This makes the market 30-70% undervalued. This low value protects you by giving you a margin of safety.

The Smith Manoeuvre is a long term strategy, so the short term is not that relevant. However, it is a good idea to start with significant investments at a time when the market is so very cheap.

The market is cheap because there is a lot of fear out there today, most of it unfounded or fully priced into today's prices already.

If this is something you are thinking of at some point, you may well regret not starting at an opportune time like today.


Ed

[Mark77]

Rumour out there is that the OSFI will be reducing the maximum HELOC amounts allowed from 80% LTV to 65% LTV.

A discussion of the potential impact on the SM may be useful. Will a lot of people, who took out HELOCs in the 65%-80% LTV range, be affected by much higher interest rates as the 65-80% LTV loans may no longer be eligible for the lowest rates?

Also, various reports have emerged of banks raising rates against "Prime", or redefining the index against which HELOCs are used (ie: a recent poster said that Laurentian Bank has raised the index on his HELOC). Is the SM not significantly less economic as the spread goes up?

[edrempel]

Rumour out there is that the OSFI will be reducing the maximum HELOC amounts allowed from 80% LTV to 65% LTV.

A discussion of the potential impact on the SM may be useful. Will a lot of people, who took out HELOCs in the 65%-80% LTV range, be affected by much higher interest rates as the 65-80% LTV loans may no longer be eligible for the lowest rates?

Also, various reports have emerged of banks raising rates against "Prime", or redefining the index against which HELOCs are used (ie: a recent poster said that Laurentian Bank has raised the index on his HELOC). Is the SM not significantly less economic as the spread goes up?

Hi Mark,

Here is a copy of a post I made on a different blog on this issue:

We will have to see what is actually implemented and how it applies. After reading it, I don't think it would affect the Smith Manoeuvre much.

Here are some specific initial thoughts:

- It is unclear whether the 65% LTV limit for the HELOC portion of a mortgage would apply to the entire readvanceable or only the revolving portion. Most have fixed portion, which is the actual mortgage. The banks may also offer additional conventional mortgages for the extra 15%, or we could make up the difference with an investment loan, if appropriate.

- Having the HELOC payment become P+I after 5 years is not an issue. We can just readvance the principal portion of the HELOC payment each month. For example, let's say your mortgage payment of $1,000/month is $500 interest and $500 principal. You can readvance the principal portion of $500. Let's say you need $200/month to pay the interest on the existing HELOC. Then you can invest the remaining $300/month. Now if they increase the payment on the HELOC portion from $200/month to $300/month, that means we are paying down $100/month principal on the HELOC in addition to the principal portion of the mortgage payment. That still leaves $300/month to invest. The P+I requirement likely will have no effect on the SM.

- For those posts above that think this will make the SM a negative cash flow, you should reread what the SM is. The SM requires no cash flow, since you can capitalize the interest payments. The Smith Manoeuvre has become a generic term used for any leverage strategy. Today, since we are possibly in an income bubble, a lot of people are leveraging into income producing investments and using them to pay the interest. This is not the SM. It is simple leverage. This simple leverage using income investments may run into negative cash flow, but this should not affect the actual Smith Manoeuvre.

- These rules, if they come into effect, should not affect existing mortgages or people already doing the SM.

- The biggest effect may be in making HELOCs harder to qualify for.

- If this results in lower real estate prices, that should not affect the limits for existing HELOCs. In the early 1990s when home prices in Toronto fell 30%, HELOC limits were not reduced even when they were more than the value of the home. It was only an issue if you want to sell or refinance.

- OSFI is not trying to shut down the SM. Their concern is unqualified home buyers buying a home that they cannot afford and people using their HELOCs to spend, similar to what happened in the US. Since SM investors are not the actual target, there should be creative solutions for us to maintain the SM for suitable clients without breaking the spirit of the new rules.

It is also reasonable to believe that banks will try to keep good qualify business, such as the SM. It is very profitable for banks, because we are talking about a HELOC that may be maintained for many decades by a client with a strong financial position. It is a competitive environment and current bank share prices include a lot of optimism in profits, so banks will have to work to make sure any new rules do not affect their profitability.

I will likely have more comments once it is clear what rules changes will happen and how they are implemented.


Ed

[Mark77]

Oh of course edrempel. But does the spectre of changes not reinforce the idea that the investments themselves purchased as the result of the Smith Manouevre should be, in and of themselves, of high enough quality that they would be eligible for freestanding credit against them?

Diversification of borrowing sources is, IMHO, just as important as diversification of investments, in terms of the overall SM. Which makes a SM with proceeds into a rental property, problematic, because that does not provide borrowing diversification (since the other part of the borrowing portfolio would be a loan against a principal residence, presumably).

[edrempel]

Oh of course edrempel. But does the spectre of changes not reinforce the idea that the investments themselves purchased as the result of the Smith Manouevre should be, in and of themselves, of high enough quality that they would be eligible for freestanding credit against them?

Diversification of borrowing sources is, IMHO, just as important as diversification of investments, in terms of the overall SM. Which makes a SM with proceeds into a rental property, problematic, because that does not provide borrowing diversification (since the other part of the borrowing portfolio would be a loan against a principal residence, presumably).

Hi Mark,

Interesting point. I guess I always took that for granted. You are right to make a point of it.

The mutual funds we invest with can all be used for an investment loan, if necessary. It would be easy to borrow against the mutual funds, instead of borrowing against your home, if there is a good reason. For example, if your home fell in value and you wanted to refinance or sell it, it is possible to pledge the funds as collateral and transfer the debt from the secured credit line to an investment loan.

An investment loan with the mutual funds as collateral would be roughly .5% higher interest rate than a secured credit line.

We have done this type of transaction only a few times, but you are right that it adds confidence to the Smith Manoeuvre knowing that this could be done if it ever becomes necessary.


Ed

[scott82]

hi i am lookin at starting a SM now is it better talk to someone about this or what
my house is worh 500k
i have 300k morg left with 4 yrs left on it at 3% but i also have HELOC as well with 105k aviable to use and i am with RBC
any help???

i heard some guys talkin about it at work

[kerdon]

hi i am lookin at starting a SM now is it better talk to someone about this or what
my house is worh 500k
i have 300k morg left with 4 yrs left on it at 3% but i also have HELOC as well with 105k aviable to use and i am with RBC
any help???

i heard some guys talkin about it at work

I think it would be advisable to talk to a professional. Just because the guys are work are talking about it doesn't mean it is right for everyone.

Beware, you do not want a mutual funds that distributed ROC Return of Capital, it will affect your tax deduction of the loan. RBC has some funds that are notorious for ROC. Managed Payout Solution, regular, enhanced, and enhanced plus. I have yet to find a RBC planner that understands ROC, they will tell you the payout is guaranteed....so be ware.