Smith Manoeuvre

[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.

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).