"Guerilla capitalization" of interest is one of the key distinctions and selling features of the Smith Manoeuvre. This makes the Smith Manoeuvre unique from a simple borrow-to-invest strategy.
All loans come with interest costs. Your Smith Manoeuvre HELOC is a two part loan. Portion 1 is your regular mortgage; you will make monthly, or bi-weekly, payments which combine interest owing and a portion of principal repayment. This will reduce the amount owing in Portion 1 over time. Most mortgages today are designed to be paid off over 25 or 30 years.
Portion 2 of your HELOC is a different animal. As a revolving investment loan worth up to 65% of your home's value, you never have to pay off the loan. Unlike your traditional mortgage, if you borrow $300,000 in a HELOC structure now, you can still owe that same $300,000 years down the road.
The only thing you are required to do is pay the interest owing each month. On the investment loan portion 100% of the interest is tax deductible. That means it comes straight off your taxable income as an expense.
You will get a statement for your HELOC accounts each month. This statement will clearly show the outstanding principal of the mortgage in Portion 1, the next payment owing on Portion 1, the outstanding loan balance in Portion 2, the available credit in Portion 2, and the next interest payment owing on Portion 2.
To pay the interest bill on Portion 2, you will "guerilla capitalize" the loan so that the interest payments don't come from your regular income. This is why you don't need the dividends from your Smith Manoeuvre investments to cover the interest costs on your investment loan.
You will take the interest owing out of Portion 2 of the HELOC and transfer to your Smith Manoeuvre chequing account. Then, before the payment due date, you will pay the interest bill by making a payment from the Smith Manoeuvre chequing account back to Portion 2 of the HELOC.
On the first day of each month, Mrs. Jones can log into her bank account and view her monthly HELOC statement.
This day, on May 1, Mrs. Jones sees that she must make a regular payment of $1,450 on her mortgage (Portion 1) on May 31.
Mrs. Jones currently has a $250,000 outstanding credit balance on Portion 2 of the loan and must also make a $534 interest payment by May 31.
She normally can save an extra $550 each month which she uses to top-up her regular mortgage payment penalty-free for a total mortgage payment of $2,000.
She also sees that her $2,000 mortgage payment made on April 30 was cleared, so she paid down $550 in principal from her normal top-up, plus another $400 which was the embedded principal portion of the minimum $1,450 payment.
Mrs. Jones can also see that she has $950 available to borrow in Portion 2 of the HELOC as it is an automatic readvanceable loan.
She needs $534 to pay the interest bill on the investment portion of the HELOC, so Mrs. Jones transfers $410 to her Smith Manoeuvre investment account and quickly buys more ETF units with that money.
Then she schedules a payment of $534 to her Smith Manoeuvre chequing account for May 22.
On May 25, Mrs. Jones logs into her Smith Manoeuvre chequing account and sees the $534 sitting there. She schedules a payment of $534 to Portion 2 of the HELOC to "pay" her interest bill there by May 31.
While it takes a few steps, this is how to "guerilla capitalize" the interest on your HELOC investment loan. As you could see in the example, at no point was any outside money used to pay the interest bill. The interest accrued on that temporary $534 loan from the HELOC to pay the interest is negligible.
When making your regular Smith Manoeuvre investment account contribution, always leave enough money there to pay the anticipated interest owing. That money just bounces back and forth between the HELOC and chequing account every few weeks, slowly growing as the size of the investment loan increases.
If the interest on an investment loan is tax deductible, the interest on the interest will also be tax deductible. That's why this strategy will not affect the deductibility of your investment loan.
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Let's look at the factors that identify good advisers: compensation structure, encouragement of complacency, corrupt practices, and over-complication of investment choices.
Compensation is super important. After all, if you want to look at incentives this is the first stop. Let me be clear though, do not expect anyone to work for free. Good advisers should earn a good living and you should willingly pay them fairly for their services.
In the adviser world, the two main compensation structures cannot be more disparate: clear asset-based compensation that you pay or murky kickback compensation that the funds pay (and you pay indirectly). Always choose an adviser with compensation arrangements you fully understand.
Good advisers charge a transparent fee for managing your money and providing other personal finance advice. It usually starts at 1% of invested assets and can drop to 0.5% of assets for large accounts. The higher your assets, the lower the percentage.
Good advisers will not make any money other than this fee. No bonuses, kickback schemes, referral schemes, or Cayman Island vacations paid for by the fund companies they recommend. Any extra money they earn should be passed directly to you.
Other advisers earn money from commissions, sales charges, bonuses, etc. Usually you have no clue how they are paid and they often don't make a big point of volunteering that information in a clear manner. The less you know and the quicker you pass by that information, the happier they are.
Here's how it works with these other guys. You invest in a fund or insurance product with them and they take 3-5% right off the top in sales fees. Then they get another 0.5-1.0% in annual commissions.
They get an extra bonus if they sell products over $xxx from one fund company. They get other fees and commissions selling you loans and insurance products. They get referral bonuses from people they refer you to.
It's one big murky system and unfortunately it's the most common form of compensation. The largest advisory firms in Canada work this way because it's lucrative for them; stay far away!
All too often clients with advisers are way too complacent with their investments. Almost stupidly, they trust everything their adviser does... until a market crash that is.
Good advisers take the time to explain everything to you and should answer all questions you have in a way that you easily understand. No industry jargon or doctor's office latin. They should be clear and reassuring, but blunt and honest.
Good advisers will freely admit they can't control the market and neither can you or anyone else. The only thing they can do is structure your portfolio so that in most situations it will meet your needs: your risk tolerance, volatility tolerance, income needs, tax efficiency, and return expectations.
They should encourage you to stick to the strategy you developed together regardless of current market performance. Unless something drastically changed in your situation (not the market).
Good advisers will provide you with good information that compares your investment returns with the market benchmarks on at least an annual basis. That is the MSCI ACWI Index (in Canadian dollars) for all stocks and the FTSE TMX Universe Bond Index for bonds. *Let me know if these links are changed*
If you are in a 60/40 mix of various stocks and bonds, the real benchmark comparison should be 60% MSCI ACWI and 40% TMX Universe Bond Index. Do not accept comparison to a compilation of multiple indices.
Do not be fooled by advisers recommending a complicated portfolio and then comparing to a complicated benchmark. Comparisons should always be made in the exact proportions of major asset classes that were specified in your original financial plan which they developed with you! Don't forget, complicated plans are simply your adviser believing their complicated portfolio will outperform a simple portfolio.
Bad advisers will turn to jargon when they are asked questions they don't understand. They try to appear much smarter than you through terminology. They will sound very wishy-washy on investment strategy and will promote "tinkering" with your portfolio when you aren't happy with returns.
They will also be hesitant to provide you with clear investment return information. They will rarely compare your performance to the real benchmarks.
Never trust an adviser who compares your performance to a "custom benchmark" established by the fund company. Also never accept a comparison to "comparable funds". That's slang for we picked the crap out there to make you believe we look good. Don't forget, less than 20% of actively managed funds sustainably outperform their benchmarks so there's lots of crap to choose from when picking comparable funds.
Good advisers develop investment plans with you based on your personal situation. They will be very clear about how they are diversifying and structuring your portfolio to meet your risk tolerance, tolerance for volatility, financial situation, and expected return on investment.
Once this plan is in place, good advisers will stick with it regardless of market performance. The only trading they should be doing is the initial buying in the desired proportions and the maintenance to keep the desired allocations as the market moves. This maintenance should be periodic and systematic. Once a quarter, twice a year, annually, when the allocations are off by more than 5%, or another similar standard.
Bad advisers love to play on your emotions. They over-promise returns and under-explain risk. They put you in assets based on yours or their gut instincts. Run far, far away as fast as you can if an adviser suggests you buy what they believe should "outperform". Or "is current trending upwards". Or they can "guarantee an easy X% with minimal risk".
Bad advisers also promote portfolio tinkering. Gold goes up, they put you in their 'Assertive Gold Miners Value Fund'. Oil prices crash, they suggest you move out of the 'Global Oil Opportunities Fund' and into their 'European Banks Disciplined Equity Fund'. They simply are not sticking to any plan, if there even is one to begin with. It's emotional investing, performance chasing, and you will lose in the long run.
To make matters worse, this portfolio tinkering by bad advisers is borderline criminal. Every time they move you out of a product and into another they can collect a sales charge (3-5% remember). Not only that, by the time the next fund is "hot", it's probably already overbought and won't continue climbing the same way.
Research has shown that funds which outperformed their sector over the previous five or ten years are very likely to underperform the sector benchmark in the next similar time frame.
Dalbar, a U.S. analytics company, publishes an insightful report annually on investor and adviser behaviour. Year after year Dalbar finds that mutual fund investors substantially underperform broad indices. So what are Dalbar's recommendations to advisors? Stop overpromising clients on performance, pay attention to client risk tolerance and control risk exposure, and make accurate promises in terms of probabilities.
Good advisers have you invested in products you easily understand. It should be so easy that you could do it yourself if you had the time, discipline, or confidence. Index ETFs, larger individual companies, gold bullion, farmland or timber funds, office or apartment building funds, you get the drift.
Stay away from any funds that charge more than 1% in management fees. Hell, stay away from funds that charge more than 0.50% in management fees. It's unnecessary and no, they will not perform better because their managers are "smarter". Very, very, very few investment managers are able to sustainably outperform the index.
Good advisers also limit your portfolio holdings to a reasonable number of investment products. For sure less than 20 holdings, probably less than 10. Warren Buffett's $150 billion investment portfolio owns less than 50 different stocks; the top 10 holdings account for 80% of his total portfolio. If the Oracle himself can invest $120 billion in just 10 holdings, a good adviser can definitely keep your six or seven-figure portfolio down to 10 holdings.
Bad advisers push you into complicated products that you don't understand. This includes funds with other creative names like "disciplined", "balanced", "special", "concentrated", "strategic", and so on. Fancy words that translate to underperforming, overpaid, stock-picking, not-so-magical investment managers who are probably plain greedy to boot.
Bad advisers also sell you on portfolios with an enormous number of holdings. If the portfolio proposed suggests you invest in 50, 80, or even 100 different funds, stocks, and other products, run away. It's a tell-tale sign that your adviser is massaging products into computer software programs in order to present you with implied future performance based on past performance that fits your wants and needs just right. Or he is presenting complicated portfolios to appear more valuable and knowledgeable.
Bad advisers tend to sell you into products which are very similar. I can almost guarantee the 'Opportunity Senior American Fund' will perform similar to the 'US Strategic Equity All-star Fund' over the long haul: very poorly. Don't get fooled into thinking two shitty products are actually different. Shit is shit. Period.
A Good Adviser Is...
A good adviser is honest and clear about their compensation. They encourage the use of low-cost products, like ETFs, because it doesn't impact how they get paid.
Good advisers work with you to structure a portfolio with 20 or fewer holdings which aligns with your risk tolerance and financial circumstances. They promise you realistical, or even cautious, expected long-term investment returns.
Good advisers acknowledge they cannot help you outperform the market benchmarks, but they can keep you from drastically underperforming those benchmarks.
Good advisers help you stick to the investment plan that you created together, regardless of market performance and your emotions.
A good adviser is like a good sports coach--they use their knowledge and confidence to push you farther than you could go on your own while protecting you from injury.