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DIY Smith Manoeuvre, Part 3

December 12th, 2007 ·

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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30 responses so far ↓

  • 1 Cross the River // Dec 12, 2007 at 9:12 pm

    Salutations,

    I’m still trying to figure out how only paying interest on the line of credit might affect your credit score. Or does it not?

    As for the investing part, it’s too bad that when it comes down to choosing an account, the ones with the lowest trading fees charge a lot for mutual funds and the ones that let you get mutual funds for free (well, certain conditions apply), usually have higher trading costs. GRRR!

    Also, great posts, very concise.

    CtR

  • 2 0xCC // Dec 12, 2007 at 9:22 pm

    The main reason for not investing in bonds with the SM is because you are almost guaranteed to lose money. As you mentioned interest on the bonds is taxed at your marginal rate. The tax deduction on the interest you are paying on the money you are borrowing to invest is also at your marginal rate. So those things balance out. Except for one major point, unless the bond market is doing something really strange the interest you pay on the money you are borrowing will probably be at least 1.5% higher on the interest rate you will get on the bonds.

  • 3 Cross the River // Dec 12, 2007 at 9:53 pm

    I might just have figured it out.

    One account for stocks (like Questrade or something) and one account for mutual funds (TD) as long as you have a minimum in it not to pay annual fees.

    Does it make sense?

    I’d still like to know for the credit issue.

    Thanks

    CtR

  • 4 MillionDollarJourney // Dec 12, 2007 at 11:04 pm

    CTR, it depends on the readvancable product that you use. I’ve read that the first line matrix mortgage does not report the HELOC to the credit agencies, thus no effect on your credit sores.

  • 5 Jason B // Dec 12, 2007 at 11:12 pm

    > A sample allocation would be 20% Canadian equities, 30% US equities, and 30% developed market equities.

    This only adds up to 80%.

    What about currency exposure? If 80% of your investments are in non-Canadian dollar securities, the plan may prove to be psychologically difficult if currency fluctuations are not in your favour. All it would take is a quick rise in the Canadian dollar to make you feel like the SM is failing you. I would consider currency hedging for that reason… A reduction in volatility may help one’s chances of success in the plan, and it keeps your mortgage debt denominated in the same currency as your investments.

    Also, why is it that everyone who mentions the SM assume that 100% of the equity built up should be reborrowed? If you’re going to view your home as a source of investment cash, evaluate your risk tolerance the way your do with earned money. The difference with using home equity is instead of investing in fixed income, you just don’t reborrow - you leave the equity in your home. I think it’d be a lot easier for me to stay disciplined if I borrowed 50 cents for every dollar of repaid principal.

  • 6 DIY Smith Manoeuvre II - The Readvancable Mortgages | Million Dollar Journey // Dec 12, 2007 at 11:24 pm

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  • 7 The Financial Blogger // Dec 13, 2007 at 7:59 am

    Cross the River, if your HELOC is reported to the credit bureau and it is alway maxed out (since you are paying interest only), it will affect your credit score negatively. However, if you are making all your payment on time it should not be too bad.

    The key point would be to get another line of credit or a significant limit on a credit that you use but pay the entire balance monthly. Therefore, you debt to available credit ratio will be lower and your credit score will not be hurt too much.

    You can find other tricks to improve your credit score on my blog: http://www.thefinancialblogger.com/category/improve-your-credit-score/

    I hope this helps!

    FB.

  • 8 Canadian Capitalist // Dec 13, 2007 at 9:00 am

    Jason: Thanks for pointing out that the allocation doesn’t add up. I’ve corrected the post.

    Your points are excellent and I agree with you that it is far more prudent to borrow back 50% of equity. It goes a long way to reduce some of the SM risks. Now, why didn’t I think of that? TD also currency neutral versions of their index fund that are slightly more expensive. I feel that the extra fees are not worth it over the long term but others might feel different. So, it is useful to state that in the post.

  • 9 Canadian Capitalist // Dec 13, 2007 at 9:31 am

    Jason: I’ve updated the post based on your input. I think instead of deciding what percentage of a principal portion should be borrowed back, it is better to focus on how much of the home equity should be used for leverage. Thanks for your comments.

  • 10 FourPillars // Dec 13, 2007 at 9:54 am

    Jason - I couldn’t agree more with your comment. This is why in my leveraging plan I only borrow an amount that I am comfortable with.
    For the record - the SM is defined as reborrowing the entire principal payment each month - I really think this “rule” is designed to maximize revenue for the advisor not the client which is why doing it yourself and customizing to suit is the best way to do leveraged investments.

    Mike

  • 11 Leslie S // Dec 13, 2007 at 10:11 am

    Would like to clarify what you mean. You mention opening a mutual fund account and then speak of investing in equities in the different markets (CDN & US); are you suggesting buying individual stocks? If so, why the mutual fund account rather than a discount broker account? For instance, many mutual funds–even ones with a name that suggests it’s a CDN equity fund, often have US & Intl exposure. It’s rare to find a pure equity CDN equity or pure US equity mutual fund.

  • 12 Canadian Capitalist // Dec 13, 2007 at 10:28 am

    Leslie: All the funds I mention in the post are index funds. Since they are index funds they provide “pure” exposure to stocks in different markets. I didn’t mention a brokerage account because small amounts are invested regularly and buying ETFs will not be cost effective.

  • 13 Alex // Dec 13, 2007 at 12:22 pm

    CC - I am no expert by any means and I’m not currently implementing the SM (but I am seriously exploring it). I might be mistaken, but the rule that must be met for tax deductibility is “reasonable expectation of INCOME” not “reasonable expectation of PROFIT”. I believe you have to invest with the expectation of income, that’s why most SM discussions involve investments like dividend paying stocks/funds, income trusts, rental properties or personal businesses. You have to be very careful in deciding what to invest in order to deduct the interest. I’m not sure if run-of-the-mill equity index funds would qualify (or at least you would have a harder time justifying the deduction). It would be best to consult a tax expert.

  • 14 Cross the River // Dec 13, 2007 at 12:24 pm

    Thank you for the quick replies Gents.

    Also, Jason makes a good point about the 50 cents a dollar.

    CtR

  • 15 Canadian Capitalist // Dec 13, 2007 at 1:35 pm

    Alex: I’m not an expert either but it seems to me that index funds satisfy the “expectation of income” because they pay dividends in the range of 2%. Still, it is best to check with an accountant.

    Interest deductibility and other issues from CRA

  • 16 Todd // Dec 13, 2007 at 2:00 pm

    Using Interactivebrokers to purchase ETFs might make sense (penny per share, $1 minimum) for this.

  • 17 Ashamansony // Dec 13, 2007 at 2:25 pm

    Like Alex, I’m interested in implemneting SM, but I do have my doubts whether or not CRA would approve of an index fund.

    Perhaps I could get some clarification. In order to get the best tax preferential, would not my investments have to be in Canada. For example invest in cdn equities, cdn dividends, real estate in Canada etc. If I had an Int’l index fund, or divident fund with an international component, would I still get a tax refund?

    Secondly, while I’m leaning towards dividends, I’ve noticed that many of the funds on the market include as a component bonds, which we all seem to agree or taxed at our marginal rate. Can any one suggest a dividend fund that is most tax efficient?

  • 18 ThickenMyWallet // Dec 13, 2007 at 4:09 pm

    Although the post is entitled “DIY Smith Manoeuvre”, I would never undertake the SM without seeing an accountant. The tax issues are too complicated to address unless you deal with it day to day.

    The IT Bulletin cited is not binding on CRA. In many instances, CRA will over-ride their own bulletins if they think they have a case (the bulletin is also from 2003 and there has been 4 years of case law since then). Use much discretion when reading an IT Bulletin.

  • 19 Cross the River // Dec 14, 2007 at 11:28 am

    ThickenmyWallet,

    Said like a true lawyer (in a good sense).

    Whatever a CRA reprensentative tells you, whatever the bulletins says, these things are not binding. As illogical as this may sound, saying CRA told you is not a defense in the Tax Court.

    Get professionnals to help you that way you can says, the accountant told me. At least you’d have someone to turn on if you get into trouble with CRA.

    I’ve also found that if you call two reprensentatives, you might have two differente answers.

  • 20 Vasile // Dec 14, 2007 at 12:27 pm

    Cross the River: if you call two professionals, you’ll get two different answers, too, unless the question is really trivial. But I agree it’s useful to have someone to turn to :-)

  • 21 FinancialJungle.com // Dec 14, 2007 at 6:31 pm

    >>”currency hedging isn’t worth the cost ”

    Currency hedging can be free, or at least it can be done relatively easily if you practice the SM and don’t mind going on margin.

    Say you have $100k available in HELOC to invest and you want $40k allocated to US ETF. Then borrow $60k from HELOC to buy your Canadian and International holdings, but borrow $40k from Interactive Brokers US margin to buy US ETFs. Now you’re hedged at no extra cost to you. This technique was suggested by Pitzel from the CB forum.

    The remaining $40k in HELOC acts as a cushion against margin calls.

    You can also pick the middle of the road; hedge only $20k.

  • 22 Canadian Capitalist // Dec 16, 2007 at 11:18 pm

    Thicken: I’ve made the point to check with an accountant in the introductory post but I agree that you can’t stress this point enough.

    FJ: Correct me if I am wrong, but margin loans are far more expensive than secured loans. The whole point of the SM is to earn more in equities than the interest cost. By paying more interest costs, the odds of a good outcome will be reduced.

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  • 24 venter // Dec 17, 2007 at 11:18 am

    What if you have already paid off the mortgage. I would think borrowing a portion of the capital back and investing it in Canadian dividend paying stocks (taking advantage of the taxation benefits) and using div’s to pay down the loan would work. The interest payments should be deductible under these circumstances.

  • 25 Canadian Capitalist // Dec 17, 2007 at 12:29 pm

    Yes, the interest payments should be deductible for borrowing against home equity and buying common shares, even if they don’t pay a dividend.

  • 26 Financial Jungle // Dec 18, 2007 at 1:10 pm

    >>”Correct me if I am wrong, but margin loans are far more expensive than secured loans. ”

    On the contrary, margin loans are cheaper than secured loans.

    Canadian Margin Loan: 5.75%
    Canadian Secured Loan: 6.00% (prime)
    US Margin Loan: 5.74%

    http://www.interactivebrokers.com/en/accounts/fees/interest.php?ib_entity=ca#debit –> go to tab (Interests charged)

  • 27 Canadian Capitalist // Dec 18, 2007 at 1:22 pm

    FJ: That’s interesting. Thanks. Do you personally have an account with IB? If you do, are you happy? I’m a bit hesitant to try out new brokers after my experience with Questrade.

  • 28 Canadian Capitalist // Dec 18, 2007 at 1:25 pm

    FJ: I just checked with TDW and IB’s margin interest is significantly lower. TDW’s margin interest is 6% to 7% for CDN and 7.75% to 8.25% for USD balances.

  • 29 Financial Jungle // Dec 18, 2007 at 2:07 pm

    What I’m hearing is that IB sometimes misses a few dividend deposits. I haven’t experienced that myself, or at least I haven’t examined closely enough. That reminds me to reconcile the statements soon.

    Everyone complains about the UI being too comlicated, but I think it’s great. It’s not that different from other brokerages’ interface. Then again, I’m only a simple investor. I don’t trade Forex or options.

  • 30 Todd // Dec 18, 2007 at 4:57 pm

    I have a good impression of IB. Yes the UI is complicated, but the web interface is dumbed down a bit from the custom client.

    The only things I don’t like are: 1) they don’t have RRSP. and 2) they enforce the pattern day trader rule that US brokerages enforce - but thats probably a good thing ;)

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