Canadian Capitalist » Smith Manoeuvre

Smith Manoeuvre: Who Profits?

Canadian Capitalist — Tue, 17 Jun 2008 00:37:13 +0000

The siren song is irresistible: “Make your mortgage tax deductible” or “Want to beat the tax man?” — is that a trick question? Who doesn’t? This is also accompanied by a warning — “Don’t try this at home. This stuff is so complicated that you need our help to do it”.

While there is no question that the tax issues involved in implementing the Smith Manoeuvre are complicated and potentially require the services of a tax accountant to make sure that everything is set up right, it is worth asking if the warning isn’t a little self serving. If a homeowner simply builds equity in their home, no trailer fees or sales commissions are generated for the advisor. But, the home owner implementing the manoeuvre with actively managed funds, while compensating her advisor handsomely, faces long odds of making any profit.

How so? There is a striking consensus among pundits that future equity returns are going to be rather modest and real returns from stocks can be expected to be in the neighbourhood of 4% to 5%. We’ll split the difference and say that the risk premium — i.e. the extra return obtained when you invest in stocks instead of T-bills — is 4.5%. Let’s further assume that the real return on risk-free assets such as T-bills is going to be 0% (a very conservative assumption but we’ll give the Manoeuvre all the benefit it can get).

From the 4.5% excess return that stocks can be expected to provide, we’ll have to deduct the costs of the SM. First, there is the line of credit provided by our friendly bank at a 1.75% premium over the risk-free rate. That leaves us with a 2.5% premium of implementing the SM, which may not be too bad if a homeowner can handle the risk and negative behaviours that come with leveraged investing, especially when the portfolio grows to a significant size.

But, sadly, there is more. The average mutual fund in Canada has a MER of 2.5%. It is a good bet that the average mutual fund will produce, well, average gross returns. Net out the MER and the intrepid investor implementing the Smith Manoeuvre using an average mutual fund sold through an advisor will be left with a return of — drum roll, please — 0%.

It’s true that we haven’t accounted for the tax arbitrage between the deduction from income of interest paid and the capital gains tax rate on investment income. However, consider that (a) part of the investment income comes from dividends, which is taxed on an ongoing basis (b) mutual funds generate turnover that results in a tax bill and (c) capital gains tax is levied on the nominal, not real, gains. Does the tiny return justify the extra risk assumed in implementing the Smith Manoeuvre? I’d argue that there are less risky, old-fashioned alternatives such as simply paying down the mortgage.

So, who benefits from the Smith Manoeuvre? The bank made money on the loan. The advisor made money on commissions and trailers. The homeowner? Well, I suppose, as the old saw goes, two out of three ain’t so bad.

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Smith Manoeuvre Warning

Canadian Capitalist — Mon, 17 Mar 2008 02:48:36 +0000

I’ve written many posts about the investment pitfalls of the Smith Manoeuvre but not being a tax expert, I’ve skipped over the other risks involved in implementing the strategy. A column in the weekend’s Toronto Star quotes a tax specialist warning against the “dark side of the Smith Manoeuvre”:

According to White [the tax specialist], the “significant flaw” in the scheme is when the primary purpose of using it [the Smith Manoeuvre] is to make a home mortgage tax deductible, it leaves the homeowner vulnerable to attack by Canada Revenue Agency.

The column ends with some sensible advice:

Always obtain tax advice from a qualified person, such as an accountant or tax lawyer, who is not selling or promoting anything, and to whom the client’s interests come first.

If the tax adviser stands to make a commission selling participation in a scheme like the Smith Manoeuvre, he or she is in an obvious conflict of interest and the advice can hardly be said to be impartial.

I understand the comments are a bit speculative on what the CRA might do in the future but it is scary to think that there might be an adverse ruling in the future.

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DIY Smith Manoeuvre, Part 4

Canadian Capitalist — Mon, 17 Dec 2007 03:22:26 +0000

This is the fourth part in a series on implementing a do-it-yourself Smith Manoeuvre. You may also want to check out Part 1, Part 2 and Part 3 of the series.

Now that you are regularly withdrawing funds from the loan portion of your readvanceable mortgage and investing the proceeds in equities, there is only one step left: taxes. You should keep track of the interest paid on the investment loan, calculate the total interest expenses for the financial year and report it in Schedule 4 and Line 221 of your T1 General.

When your tax return is processed and a refund is issued, you should use the refund to pay down your mortgage and take out a loan and invest it to get the full benefit of the Smith Manoeuvre.

Notes:

I’ve said this before and I’ll say it again: Check with your accountant before implementing the SM. I’ve personally never borrowed money, invested it in index funds and claimed a tax deduction of the interest expense. So, check with your accountant or tax advisor.

Despite the complexity, SM is simply a leveraging strategy. As you may know, leverage cuts both ways. There is no guarantee that even over the very long term, equities will return more than the interest you pay on the loan. That’s the risk of implementing the SM. Don’t believe anyone who tells you otherwise.

In the interests of full disclosure, I have no intention of implementing the SM. I simply pay down the mortgage and am happy with guaranteed, risk-free, after-tax return of roughly 5%.

An adverse tax ruling is a risk with the SM and even if interest deductions are currently allowed, they may not be in the future. For example, in the 2004 Quebec budget, interest deduction was limited to the amount of interest income in that year.

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DIY Smith Manoeuvre, Part 3

Canadian Capitalist — Thu, 13 Dec 2007 00:20:46 +0000

This is the third part in a series on implementing a do-it-yourself Smith Manoeuvre. You may also want to check out Part 1 and Part 2 of the series.

Now that you have a readvanceable mortgage, the investing part is really simple. Open a separate investment account with one of the low-cost mutual fund providers. TD Mutual funds is my favourite but CIBC Mutual funds (if you qualify for their MER rebate) and Altamira are competitive options.

First, decide on the portion you want to allocate to Canadian equities. There are many schools of thought on how much should be allocated to Canadian equities. Dan Solin, author of The Smartest Investment Book You’ll Ever Read, suggests allocating 20% to Canadian stocks. You could pick slightly more or slightly less but it’s important to stick to the allocation and not chase performance. Next, simply split the rest of allocation between US equities and those of developed markets. A sample allocation would be 20% Canadian equities, 40% US equities, and 40% developed market equities.

Now, select the fund you are going to use to capture the respective equity allocation. If you choose to invest with TD mutual funds, you would invest 20% in TD Canadian Index (TDB900), 40% in TD US Index (TDB902) and 40% in TD International Index (TDB911).

After the first mortgage payment and every payment thereafter, transfer an amount equal to the principal portion of your mortgage payment from the investment loan account into the mutual fund account and invest in the three funds based on your initial allocation target. Also, when you pre-pay your mortgage (as you would when you receive a tax refund after filing your return), you would borrow an amount equal to your principal repayment and invest the proceeds.

You will notice that there is no allocation to fixed income. This is deliberate due to two reasons: (1) It makes no sense to borrow and invest in bonds (2) Since the investment account is taxable, interest income from bonds is taxed at your marginal rate (3) I’m not convinced that investing in bonds withstands the “reasonable expectation of profit” test and (4) Regular investing automatically takes advantage of market fluctuations. If you do go this route, make sure that you have enough bonds in your registered accounts to achieve your target allocation to bonds across all your portfolios.

While I am not a fan of SM, I think the low-cost, tax-efficient, portfolio discussed in this post increases your odds of success. If you do decide to implement the SM, don’t forget to check with your accountant that your process will withstand scrutiny from the CRA.

[Update: You may want to check out the excellent points made by Jason in the comments section. Jason points out that you can reduce some of the risks of SM by not borrowing the entire principal payment portion back. Another option would be to decide how much of your home equity you want leveraged and figure out your investment loan based on that. For example, let's say that your home is worth $300K and you decide to eventually leverage 50% of your home's equity. If your mortgage is $150K, you'll to borrow back the entire principal payment amount to reach your target. If instead your mortgage is $240K, you'll borrow 62.5% of your principal payment.

Though I belong in the camp that currency hedging isn't worth the cost and over the long run, currency fluctuations even out, not everyone will be comfortable with the wild swings in currency. If you belong in that camp, you may want to choose the currency-neutral versions of the US Index Fund (TDB 904) and International Index Fund (TDB 905) instead.]

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DIY Smith Manoeuvre, Part 1

Canadian Capitalist — Mon, 10 Dec 2007 22:16:04 +0000

In a traditional mortgage, a little bit of the loan principal is paid down with every mortgage payment. The Smith Manoeuvre (SM) leverages the fact that interest expense on an investment loan is tax deductible (but interest on a mortgage isn’t) by taking out an investment loan equal to the principal payment portion of every mortgage payment and investing the proceeds in the equity market. In theory, equity returns will beat the tax deductible interest payments on the loan and over the long-term you’ll come out ahead with the SM than just paying down the mortgage.

It is hardly surprising that the Smith Manoeuvre is so popular now these days after more than five years of double-digit equity returns. What could be simpler than borrowing at low single digits and investing it in equities for a 20% return? Most investors understand that the Smith Manoeuvre presents an attractive arbitrage opportunity but haven’t forgotten the pain of a brutal bear market. So, financial advisors are now getting clients to implement the Smith Manoeuvre using segregated funds and other hare-brained schemes offering “principal protection”.

The key to succeeding with the SM is lowering your investment costs and hoping that the investing gods will continue to be benevolent. The SM only works when you borrow at say 4% (accounting for the tax deduction) and earn say 5% (after tax) on your investments. If experts are right about low future equity returns in the 7.5% range and your investment costs are 2.5%, your gross returns are going to be about 5%. Your after-tax returns are likely to be in the 3.5% to 4% range, hardly justifying the risks you take in equities. Note that some experts are of the opinion that equities will essentially be flat over the next 12 to 15 years. If that happens, you would wish that you had never heard of this strategy.

I have teamed up with Frugal Trader of Million Dollar Journey to develop a DIY Smith Manoeuvre with rock-bottom investing costs. In tomorrow’s post on his blog, FT will discuss his thoughts on readvanceable mortgages available to Canadians and I will continue the series with investment options and tax considerations. Please be warned that implementing the SM requires you to understand the risks involved in leveraging to invest in the equity markets and to keep up with the tax implications of the strategy.

Warning: The Smith Manoeuvre is a leveraging strategy. Leveraging to invest in the equity markets is risky. You could possibly earn less in the equity markets than your interest charges even over the long term. You should determine the appropriate amount of leverage that you will be comfortable with, so that you won’t panic and sell when markets tumble. Though I believe the information provided in this series of posts is accurate, check with your accountant that everything is kosher and you won’t have trouble with the CRA regarding the tax deductibility of interest. Handle with care, double check everything and please keep in mind that I’m just a guy with a website, not a financial advisor. In the interests of full disclosure, I should mention that I personally don’t, or have any plans to, implement the SM.

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The Smith Manoeuvre Debate

Canadian Capitalist — Mon, 29 Jan 2007 00:00:04 +0000

About one year back, I did a review of The Smith Manoeuvre (SM) book and noted that the book should have talked about the pitfalls involved with the strategy. Many financial planners have left comments disagreeing with my review (though I reviewed the book, not the strategy) and I challenged one planner to show me how a client implementing the SM will come out ahead in the worst-case scenario (this particular planner uses segregated funds, so he tells me the worst case scenario is 0% returns).

The planner’s client (let’s call him Joe) owns a house appraised at $350K and has a $260K mortgage on it. His monthly mortgage payment is $1,520. To implement the SM, the planner takes out a secured investment loan of $55K and invests the proceeds (less expenses) in segregated funds. To service the investment loan, Joe pays an interest of $275 per month.

To make an apples-to-apples comparison, I am going to assume that Joe can make an extra payment of $275 towards his mortgage principal. If Joe can find an extra $275 savings for the SM, he can find a similar amount for a mortgage pre-payment.

After five years, let’s assume that Joe’s home is still worth $350K (the home’s value doesn’t affect the outcome). If he had opted for an accelerated mortgage pay down, he would have a mortgage balance of $211K and he has a net worth of $139K. If Joe had implemented the SM instead, after five years, he would own the $350K home, an investment portfolio of $99K and a loan of $321K, leaving him with a net worth of $128K.

What about after 10 years? With mortgage pre-payments, Joe’s net worth would be (Home:$350K – Mortgage:$149K) $201K. The SM would leave him with (Home:$350K + Investments: $160K – Loan:$321K) $189K. Even after 15 years, Joe would be better off with a mortgage pre-payment (net worth of $280K) than the SM (net worth of $270K).

Now, surely over 20 years Joe would have come out ahead, right? Not really. With pre-payment Joe now owns his home free and clear. The SM also results in a mortgage-free home, but Joe now has a portfolio of $346K and an investment loan of $321K and a net worth of $375K. But, the key difference is that Joe hasn’t made a mortgage payment for 17 months, which if he had saved would have added an extra $31K to his net worth.

The point of this exercise is not to show that the SM doesn’t work but that it entails taking a small risk, not any risk at all as many planners claim. You should also note that this particular SM example involves a higher leverage and would become risky if a severe real estate downturn should occur. Also, while segregated funds may give you peace of mind, it also comes with a higher price tag. If you are earning 8% in the markets and giving up 3% in expenses, you would probably just break even with the SM. I’ll close with a comment made by David Trahair, author of Smoke and Mirrors, in a recent Toronto Star column: “It’s a high-risk strategy because you’re betting the farm that some investment adviser can do better than you can. You have a guaranteed return from getting rid of the mortgage.”

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The Smith Manoeuvre Revisited

Canadian Capitalist — Tue, 26 Sep 2006 03:43:12 +0000

There is a fair bit of discussion going on about The Smith Manoeuvre (SM) in Jonathan Chevreau’s columns in The Financial Post and on his Wealthy Boomer Blog. To recap, the SM involves two parts: in the first part the mortgage is paid down as fast as possible and in the second part a loan equal to the principal payment of the monthly mortgage is taken to invest in the stock market. Note that interest on an investment loan is tax deductible whereas mortgage interest is not.

In his column that kicked off the discussion, Mr. Chevreau endorses the first half of the SM but warns against the pitfalls of leverage involved in the second half. Here’s how Mr. Smith responds to Mr. Chevreau’s criticism:

My only regret is that we do not agree on the importance of simultaneous management of assets and debt early in life. That’s what a well-run business does, and it is certainly what wealthy people do, which is why they are wealthy.

An individual or a household is not really comparable to a business as has been pointed out in this blog post. I also disagree that we should do something simply because wealthy people do it. I doubt that there is a causal link between leveraging and wealth and what wealthy people do after they have accumulated assets is immaterial to the argument.

Personally, I want to keep things simple. Sock away the maximum possible in a RRSP and pay down the mortgage with the rest of the savings. The way I see it, I can earn a guaranteed, risk-free, after-tax return of 5.25% (our mortgage interest rate) by paying down the mortgage, which I think is pretty darn good.

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Book Review: The Smith Manoeuvre

Canadian Capitalist — Tue, 04 Apr 2006 03:08:02 +0000

The author, Fraser Smith, is a Vancouver-based financial planner, who devised the eponymous strategy to take advantage of the fact that while the interest paid on a mortgage for a personal residence is not tax-deductible, any interest on a loan taken out to make investments (in mutual funds or stocks or a private business) is deductible. The key to the Smith Manoeuvre (SM) is a readvanceable mortgage in which the lender is willing to advance a loan equal to the mortgage principal that is repaid with every payment.

The biggest problem with the book is that Mr. Smith never really explains the risks involved with his strategy. He claims that the manoeuvre is no more risky than a mortgage on a personal residence because the leverage involved is the same. True enough, but there are two key pitfalls to his strategy:

A mortgage is a loan that is amortized over many years (25 years is the standard). Over this period of time, the principal balance will decline steadily. In the SM the principal balance remains the same.
People are irrational. They will be willing to buy a home with a huge loan and even if housing prices decline, they probably won’t sell and rent immediately and will do their best to meet the mortgage payments. Taking out a huge loan and investing in the market is a completely different cup of tea. In a market correction or worse-yet, a bear market, they are going to panic and sell not having the stomach to take further losses.

Incredibly, Mr. Smith suggests the opposite. He suggests that people might be better off capitalizing the interest on their investment loans, which is really a fancy term for adding the interest due on a loan to the principal owing. Great, now we have compounding working against us!

I also found the book difficult to follow and the author has the tendency to rant instead of sticking to the topic. It doesn’t help that every few pages he wants the reader to purchase the $mithman Calculator (retails for $39.95), a software program to evaluate his strategy under various assumptions.

The vast majority of Canadians can safely skip the book and the fancy calculator and simply max out their RRSPs (remember, interest on loans to fund your RRSP is not deductible) and pay down their mortgage as fast as they can. Once their personal balance sheet shows very little debt, they can take out a secured loan (if they have the patience and stomach to make leveraging work) to make taxable investments.

That said, people who are lucky enough to have very stable jobs (and a predictable cash flow) and are willing and able to stomach the risks involved in a leveraged investment strategy might find the book useful.

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