Smith Manoeuvre in the News

SM Here’s a story from Wednesday’s Toronto Star on the Smith Manoeuvre.  It’s very cursory but it does underline the point that the Smith Manoeuvre is not for everyone.

Taking the other side is Peter Majthenyi, one of Canada’s top mortgage agents by volume, and a Mortgage Architects planner.  Peter calls the Smith Manoeuvre his “core business.”  In the story above he cites one example where the strategy can save/make a homeowner (with home equity) $13,000 a year plus capital gains.

Where do we stand?  Well, we talk about the Smith Manoeuvre a lot on CMT and other sites–generally in terms of which mortgage is best for it.

Is it a good investment strategy?  That question is best left to a financial advisor–who is far more qualified to judge this based on an individual’s circumstances.  From the results we’ve seen, however, the Smith Manoeuvre can be a potent technique for the right kind of risk tolerant investor.

All that said, there is sometimes too much hype about it.

Adrian Mastracci, one of the straightest-talking financial advisors you’ll meet, makes a point worth noting.  If your mortgage rate is 6%, and you’re in a 40% tax bracket, simply pre-paying your principle gives you the equivalent of a 10% pre-tax return–with zero risk, zero required skill, and zero hassle!

This approach may possibly net you a lower return long-term, but it’s nonetheless compelling when you consider the Smith Manoeuvre’s uncertainties (link2), initial setup, and monthly maintenance.

If you want to learn more, find a financial advisor expert in the Smith Manoeuvre.  Before wasting time, determine if the Smith Manoeuvre is truly even right for you.  If you need a referral, just email us.

  1. Hello MT,
    Regarding the Toronto Star story.
    I have to disagree with Peter Majtheni on the 7% yield on “blue-chip stocks” I talked to Dynamic and Aim Trimark who handle over 60 Billion in assets and the only thing they see is income trusts! If Peter has names of these blue chip stocks which yield 7% and can grow they would like to buy! For example BMO’s stock dividend is about 4.2% one of the highest of the big banks and the stock has gone nowhere of the last 6 months!
    I think that he may be talking about ROC funds (return of capital) if that is the case please talk to a trusted Chartered Accountant or read my blogs about this topic. The clients may be getting into a real tax problem when they borrow to invest in these funds!
    regards,
    Brian Poncelet,CFP

  2. Hello Mt,
    I wanted to talk about risks with repect to the Smith Manouever. If you use your tax refunds (assuming you are in a 40% tax bracket) and put this against your mortgage once a year, your break even rate of return is about 4%! Thats right if your investments only get 4% over the course of time you will still “convert” your mortgage to a fully TAX DEDUCTIBLE mortgage years sooner. Without changing your current mortgage payments.
    When you borrow to invest there is risk. However if you are comfortable with balanced funds (cash,bonds, stocks) then you can invest in corportate class funds switch between other funds and pay little or no taxes until you sell your investments then you have to pay capital gains taxes.
    Why balanced funds? Remember 2002 & 2003? the TSX was down about -14% each year!! Some balanced funds “lost” less than 5% for the two years combined!! If you have any balanced funds and are comfortable with the down side then pick up Faser Smiths book and judge for your self to see if it makes sense for yourself.
    regards,
    Brian Poncelet, CFP

  3. To respond to the concerns expressed above, take a look at the Stone Dividend Growth Class fund at this link.
    http://www.globefund.com/servlet/Page/document/v5/data/fund?style=na_eq&id=17566&gf_uid=globeandmail.gf.02220972164
    This is one of the funds we have used when implementing the Smith Manouever. Why? You are borrowing for the purpose of earning income from your investment. Every holding must pay a dividend to be considered for the fund. The fund has paid a distribution quarterly. So it is onside with the tax act. It also has a total return over the past year of better than 15% per year.
    What people have to understand with dividends, is that good companies keep raising them over time, so if you initiate your BMO investment today ($61.42 closing price Oct 22, 2007) gets you a yield of 4.6%. However BMO was at $40 5 years ago, so your yield on that price is 7% today. The increasing dividend drives the stock price higher, leading to capital gains.
    Another example Power Financial was about $17 5 years ago, and closed at $41.12 today. The yield as of today’s close is 2.9% but the yield on a hypothetical $17 purchase 5 years ago is 6.8% today. Plus the stock has more than doubled in price.
    Back to Stone Dividend Growth Class, a $10,000 investment 5 years ago is valued at about $21,800 today, so you can achieve about the same net result with a mutual fund with the added benefits of active management and diversification, plus you can invest in small increments which is part of the Smith Manouever strategy.
    Disclaimer:
    This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please be sure to see me for individual financial advice based on your personal circumstances. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Using borrowed money to finance the purchase of securities involves greater risk than using cash resources only. Assante Capital Management Ltd. – Member CIPF.

  4. Hi John,
    You made some good examples…but unless Peter Majthei has bought “blue-chip stocks” five years ago for his clients, where is the 7% dividend yield today?
    Are you using the Stone dividend fund for distibution against the mortgage? If so what is the distibution monthly or yearly etc.?
    regards,
    Brian

  5. I’ll have to agree strongly with Adrian on how attractive simply paying down the mortgage is. Yes, you “only” get a 5% after-tax return in the form of savings, but where can you get that kind of guaranteed returns?
    The SM people mine past data to show how good you could have had with fund X. But nobody gets to earn past returns. The true test of leveraged investments in the stock market is when we are in a true bear market. Try telling your client that markets always come back when they are losing money they borrowed from the bank.
    Oh, and by the way, are you sure you can leverage and invest in balanced funds and still get a tax break? The CRA explicitly states that a tax deduction will only be allowed when there is a reasonable expectation of profit. With the bond/fixed income portion of a balanced fund there is no such expectation.

  6. Brian,
    It is important that investors be informed that past performance is no guarantee of future returns. The composite return on large company dividend paying stocks such as those in the fund I mention is a combination of dividends paid out and or reinvested and share price appreciation that reflects the rising fortunes of those companies.
    The Bear market discussion is appropriate to have with clients prior to their employing the strategy. Nothing goes straight up, not housing, not companies, not gold, not commodities, and not interest rates. Neither have any of these asset classes gone down forever. In the words of the immortal JP Morgan when asked about his thoughts on the future direction of the stock market, he replied “It will fluctuate” John Templeton when asked when is the best time to invest: “When you have the money.” Check the 53 year record of the Templeton Growth Fund.
    Bottom line, is you can’t enter into this strategy with much certitude in the short term, but odds move in your favor when you take the longer view. Fraser Smith talks of a 10% rate of return from stocks.
    A quick filter of funds on Globefund with records of =or>10% turned up 31 funds, many of which I am using today. This is not bad, considering there were not many funds aroudn 20 years ago, and many have disappeared thru merger etc.
    This strategy is not guaranteed. Is it likely to work if you stick with the plan. I think so. Especially since application of Smith Manoeuver implies dollar cost averaging, buying a little more every month. This will smooth out the bumps in the ride.
    Please read theDisclaimer:
    This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please be sure to see me for individual financial advice based on your personal circumstances. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Using borrowed money to finance the purchase of securities involves greater risk than using cash resources only. Assante Capital Management Ltd. – Member CIPF.

  7. In response to CC, I’m not a tax expert, but isn’t the criterea “borrowing for the purpose of earning income”? Bonds produce income so would qualify. Long term bonds can also produce capital gains as interest rates move down, so there is also an expectation of earning a profit.
    Disclaimer
    This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please be sure to see me for individual financial advice based on your personal circumstances. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Using borrowed money to finance the purchase of securities involves greater risk than using cash resources only. Assante Capital Management Ltd. – Member CIPF.

  8. Hello CC,
    Thank-you John, for pointing out the part about bonds producing an income and being tax deductible if set up right.
    Please go to CRA’s website type in IT533 (interest deductibity and related issues) Go to section 31 it says “Where an investment (e.g., interest-bearing intstruement or preferred shares) carries a stated interest or dividend rate, the purpose of earning incometest will be met”
    Later in section 31 it says “These comments are also generally applicable to investments in mutual fund trusts and mutual fund corporations.”
    Hope this helps CC.
    regards,
    Brian

  9. Hello CC,
    I wanted to talk about your comments about Adrian paying down the mortgage. In the globe & mail (feb 8,2005) Adrian “suggests you try to put some money into your RRSPs and pay down your mortgage with your tax refund”
    Why not use the money and put this against the mortgage? Adrian has wisely figured out that taxe refunds make this work better than paying down the mortgage only! Thats the beauty of the Smith Manoeuver use tax refunds to help pay down debt.
    Also, CC the power of dividends is
    widely known, but here is some information you can check out yourself.
    “From 1871 through 2003, 97 percent of the total after inflation accumulation from stocks comes from reinvesting dividends. Only 3 percent comes from capital gains”
    The future for investors – Professor of finance Wharton University of Pennsylvanna – Jermey Siegel
    So the best bet is take the 4-5% yield from BMO (and other good companies or funds) buy more stock with your dividends and over time you will make more money that holding just the stock!
    regards,
    Brian

  10. Brian:
    I did leave a comment but my browser crashed and I wasn’t motivated to type another comment.
    Thanks for the clarification about interest deductibility. It does appear that a balanced fund would qualify now but I am not sure if CRA won’t challenge it in the future. Think about it. Why would CRA allow taxpayers to borrow at 6.25% to earn 4.25%?
    The tax deduction is already accounted for in guesstimating that the effective cost of capital in leveraged investing is 4%. You can’t count it again. Investors better hope that they can earn 4% after-tax future returns simply to break even with the SM. Maybe they will; maybe not. It’s not a bet I am personally willing to make.

  11. Hi CC,
    Your comment about “why would CRA allow taxpayers to borrow at 6.25% to earn 4.25%” is a good one. CRA will allow any one to make bad investments they may tell you what you are doing is nuts after they do an audit!!
    The stuff about getting more than 4% to break even proves my point! Assume you have a well balanced fund that has cash, bonds, stocks like banks energy etc. If we can’t get 4% over the long term you better be prepared for a major depression worse than the 1930s!
    If you assume our taxes don’t go down, and you use the tax refunds to pay down the mortgage you will have made your mortgage fully tax deductible years sooner!
    CC I think the reason you may be concerned about the rate of return (and I may be wrong) is you may have had a bad experience maybe some dot com stocks or Nortel etc.
    If you own some bank stocks (which I think you might) and are confident that you will make at least 4% you may want to review the SM again.
    regards,
    Brian Poncelet, CFP

  12. I’ve just started surfing around most any discussion I can find about Smith Manoeuvre and it is fun to see how the same people show up just about everywhere…the grumpy people with the bruised egos who are fighting to find flaws with SM but can only do so if they ignore how it actually works or make vague references to how “risky” it is (when in fact it is much less risk than what people typically do to try to end up with a house they own and the ability to retire on more than cat food money). And of course the smiling Smith people who for the most part patiently try to wade through the ego trips and defensiveness to help out those who don’t want to see the evidence right in front of them. But to be fair most mainstream media articles come across pretty much the same – the facts are not properly understood and perhaps because the writer doesn’t really understand it, they too tend to make vague references about “risk.” Then again with that full page ad about hurrying up to maximize your RRSP on the ajacent page it ain’t too surprising.

  13. “grumpy people with the bruised egos” sounds like a comment from someone with a vested interest in selling the Smith Manoeuvre. Ditto on your characterization of the “smiling SMith people.”
    Are you a financial planner perhaps?

  14. Brian: I have a 80% allocation to equities, so I’m hardly a conservative investor. But the point I am trying to make is that investing your own savings and borrowing to invest are completely different. It is very easy to visualize a long period of modest returns; in fact, a recent book made a convincing argument for very modest equity returns for the next 12-15 years. Modest returns for a very long time has happened in the past and could happen again even when there is nothing wrong with the economy.

  15. Hi CC,
    That’s a point worth noting. While a long-term perspective usually evens out performance blips, investing isn’t totally foolproof. There have been some very long lulls in the market over the years. 1934-1950 and 1966-1982 come to mind.
    If there’s any chance a homeowner will need the equity she’s paid off within 5-10 years, the SM becomes a bit of a gamble because the value of the portfolio will be more uncertain with this shorter timeframe.
    Rob, Co-Ed. CMT

  16. Hi CC,
    I’d like to to know what book your read let me know and I will share my views on it.
    If you have a 80% allocation to equities I will assume you are making better than 4% am I right?
    Lets look at the past..if you have things that pay you dividends or income like say banks stocks like BMO (since 1832) or government of Canada (since 1867) do you think they will be around for the next 50 years? If so invest! If not then become a monk!
    Remember you will get crappy returns. But, as long as we have high taxes the SM makes sense. If the new conservative government drops our taxes by 15% or so I will have to rethink the SM.
    Ps. Rob those periods of time you mentioned does not factor reinvested dividends. If you factor that in…even in those periods the returns were over 4%!
    Yes, you are right if a client needs the equity in his house in less than say five years then the SM is not for him! But unless he needs the equity to buy another house …get a car loan, it’s probably cheaper than a line of credit! Plus if he has not built up enough credit over the five years he has bigger problems!
    Please read the book “The Future for Investors” by Professor Jeremy Siegel
    His quote “From 1871 through 2003, 97 percent of the total after- inflation accumulation from stocks comes from reinvesting dividends. Only 3 percent comes from capital gains”
    During this time you had Two World Wars, a Great Depression and so forth!

  17. Brian: Ok, two recent books are The Little Book of Common Sense Investing by John Bogle and Active Value Investing by Vitaliy Katsenelson. It doesn’t take much of a stretch to imagine low future returns.
    Of course, we got great returns in the past (I did too, thank you). But investors don’t get to earn past returns; only future returns. Nothing is more dangerous than investing by looking only in the rear-view mirror. And yes, I am talking about total returns, including dividends.
    And the great returns on equities in Siegel’s book? Turns out, the equity returns for the 19th century excluded a great many stocks that went bust. Adjusting for survivor bias, equities earned 1%-2% less.
    BTW, why are you trying to change the topic from leveraged investing to investing? I never said don’t invest, just pointing out that leveraged investing even over the long term is no sure thing. For that matter investing isn’t a sure thing either, but it beats the alternative of being in cash and having inflation and taxes surely eat up your savings.
    The math is simple. With SM you are hoping that you can earn 5% (before taxes) just to break even. Maybe you will, maybe not. I’m just not willing to bet borrowed money on the outcome.

  18. Brian: Ok, two recent books are The Little Book of Common Sense Investing by John Bogle and Active Value Investing by Vitaliy Katsenelson. It doesn’t take much of a stretch to imagine low future returns.
    Of course, we got great returns in the past (I did too, thank you). But investors don’t get to earn past returns; only future returns. Nothing is more dangerous than investing by looking only in the rear-view mirror. And yes, I am talking about total returns, including dividends.
    And the great returns on equities in Siegel’s book? Turns out, the equity returns for the 19th century excluded a great many stocks that went bust. Adjusting for survivor bias, equities earned 1%-2% less.
    BTW, why are you trying to change the topic from leveraged investing to investing? I never said don’t invest, just pointing out that leveraged investing even over the long term is no sure thing. For that matter investing isn’t a sure thing either, but it beats the alternative of being in cash and having inflation and taxes surely eat up your savings.
    The math is simple. With SM you are hoping that you can earn 5% (before taxes) just to break even. Maybe you will, maybe not. I’m just not willing to bet borrowed money on the outcome.

  19. Hello CC,
    Lets assume you are in a 40% tax bracket or better. If not forget about the SM. How the SM works best is take the tax refund that you would not normally get and put this against the mortgage once a year.
    Lets assume you have a $200,000 mortgage @6% and amortized over 25 years. The HELOC is 6.25%. The rate of return is 4% and you are in a 40% tax bracket. At the end of 25 years you will still be ahead of the game (not by much) but the mortage will have been “converted” fully tax deductible by 21.5 years.
    So for the next 3.5 years that person will have enjoyed tax refunds of about $6,100 per year!
    The question is are you confident in getting 4% or better? If not don’t do it. If you read my comments about funds am talking about funds that have stocks, cash & bonds.
    regards,
    Brian

  20. Brian: What does my “confidence” have to do with future returns? The question you should be asking is: are you willing to stick with the program even if there is a slight chance that you may not come out ahead, especially when markets are down for a few years?

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