Smith Manoeuvre: Is a Dividend Portfolio Required?

I get asked occasionally about investment options in the Smith Manoeuvre. Do you need to invest in a dividend strategy? What about ETFs? Can you use a trend portfolio?

The investment portfolio is an important component of the Smith Manoeuvre strategy. In order to have the HELOC loan interest qualify as a tax deductible expense (the whole point of the Smith Manoeuvre), you need a dedicated non-registered investment account where your borrowed money is invested.

This money should be carefully tracked at every step of the way to ensure full tax compliance. This means direct transfers from your HELOC to your Smith Manoeuvre investment account. Dividends from the Smith Manoeuvre investment account go to your Smith Manoeuvre chequing account. Both sides of your HELOC get paid from your Smith Manoeuvre chequing account.

These accounts are only for the Smith Manoeuvre process. No outside money, no mixing accounts to save a couple bucks on any account fees, and no taking money from your HELOC to pay for Mexico vacations or concrete countertops.

The structure is not necessarily simple, as you can see by my chart below. But the rewards are significant!

You can save thousands of dollars a year in taxes just for moving money through a few extra accounts once a month. This tax money can be used to pay off your traditional mortgage faster and boost your investment accounts.

Once you have all the accounts set up and understand the process, it should take no more than a few minutes of your time, a few times per month to complete the transactions.

Source: TheRichMoose.com

SM Investment Account

All of the component accounts of the Smith Manoeuvre are necessary for the strategy to work seamlessly.

As per the CRA's definition of income, every last dollar in your Smith Manoeuvre investment account (money borrowed from Portion 2 of the HELOC) must be invested in an asset that generates one of these types of income: Canadian dividends, foreign dividends, interest income, or certain forms of business income.

It's important to understand the distributions are not required to exceed your interest expenses. It is just some income that qualifies for your loan interest to be tax deductible.

Capital gains (distributed or embedded) or return of capital distributions do not count!

The direct application of income generating assets from your borrowed money is why your Smith Manoeuvre investment account must be kept separate from any other non-registered investments.

ETF Investing in your SM Account

It is certainly possible to invest with ETFs in your Smith Manoeuvre investment account and be tax deductible and successful.

As long as the ETFs pay dividends or interest, whether they are foreign or Canadian-based, they are likely to meet the standard for tax deductibility on your HELOC loan.

Although there are differing opinions on this, I would avoid most funds which are advertised as being tax efficient. This includes swap-based ETFs, T-series funds, or corporate class funds.

Compared with direct stock investing, ETFs may simplify the investing process and decision making, but they are likely to add some complication your tax situation. They are also likely to be less tax efficient compared with other options.

The problem with the vast majority of ETFs is that they distribute several different forms of income each year within each distribution.

Some forms of income are less desirable because they are taxed at higher rate, such as foreign dividends and interest. These are commonly found in international equity ETFs and bond ETFs.

Distributed return of capital, common with ETFs and REITs, causes you more work at tax time and can reduce the tax deductibility of your SM HELOC over time if not adjusted correctly.

Most ETFs and mutual funds are likely to be less tax efficient than investing directly in Canadian-listed stocks. That doesn't mean you should avoid all ETFs, but it does mean you should take this into consideration when planning your investment strategy.

If you invest in ETFs, you should prefer ETFs which are low cost, highly liquid, and pay a low distribution yield.

Avoid bond ETFs where the investment return is mainly in the form of distributions instead of unit price gains.

Investing with ETFs means you can employ a large variety of the strategies I talk about on this blog. That includes buy-and-hold investing with Vanguard Portfolio ETFs and my TADM strategy.

Stock Investing in your SM Account

Investing directly in publicly-listed Canadian corporations is a popular strategy for Smith Manoeuvre investors.

Directly holding Canadian stocks means you can design a very tax efficient portfolio that is very likely to meet the requirements for interest deductibility set out by the CRA.

As long as the company stock you invest in pays a tiny dividend or even states intent to pay a dividend at some point in the future, your SM HELOC interest will be tax deductible.

Directly investing in individual corporations also helps you avoid the potential distribution mix nonsense of many ETFs and REITs. Individual corporations distribute dividends, that's it.

Canadian-listed companies distribute dividends which are eligible for the dividend tax credit. This can significantly lower your tax bill on the distributed investment income, keeping your account tax efficient.

There are countless strategies you can use to invest with individual stocks. Trend investing, value investing, dividend growth, high yield dividend, Buffet moats, large cap equal weight, etc.

The keys to successful individual stock investing include: adequate diversification, systematic buying and selling, and cutting losses on positions when needed.

If your strategy kicks you out of a stock position, don't hold cash in your SM account. Instead, put the money in a more tax friendly bond fund like the FirstAsset 1-5 Year Laddered Strip Bond ETF (BXF.TO) or the BMO Discount Bond ETF (ZDB.TO).

Of the strategies I mentioned, naturally I'm a fan of trend investing. It's generally easy to track, requires little guesswork or "guesstimating", and can result in a pretty smooth ride.

Example

Let's look at a portfolio of ten currently popular Canadian stocks which pay dividends: Royal Bank, Manulife, Power Financial, Enbridge, ATCO, Canadian National Railway, Loblaws, Telus, Brookfield Asset Management, and Fairfax Financial.

Since 2001, if you would have run a 10-month simple moving average screen on these stocks, trading no more than once a month, you would have seen fantastic results.

The portfolio would have a maximum drawdown of 11 percent and a compound return over 10 percent per year.

To achieve that same level of risk in a Canadian Couch Potato portfolio, you would have invested in the "Conservative" model. That's just 30 percent in the stock index and 70 percent in Canadian bonds.

Your compounded return would have been around 5.5 percent per year with that approach. Still decent, but certainly not great.

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Impact of Interest Rates on the Smith Manoeuvre

By this point in the business cycle, we are solidly in a rising rate environment. Since last summer, we've jumped from essentially no interest to a little bit of interest on debt. Our interbank overnight rate is still a meagre 1.25%. That's about half the rate of inflation in Canada right now.

On the other hand, borrowing money from your bank has gotten quite a bit more expensive than it used to be. Remember, banks always earn a spread of approximately 2% on the each secured loan they issue. After all, that's how they earn billions in profits each year.

As it stands today, the popular 5-year term mortgage will cost you around 3.3%. That's a 50% jump from just 2.09% a little more than a year ago. Since last fall, bank prime rate has jumped nearly 30% from 2.7% to 3.45%. Of course the banks typically add 0.5% on top of prime rate for your revolving HELOC--the main loan of your Smith Manoeuvre strategy.

Does the jump in interest rates, combined with the continued expectation of rising rates for some time yet, make it a bad time to employ the Smith Manoeuvre?

Impact of Interest Rates vs. Taxes

Interest rates do have an impact on the profitability of the Smith Manoeuvre, that is certain. In an ideal environment, interest costs will be nothing and investment returns will be stratospheric. However, it is important to separate fantasy from reality. Over the long run, we can expect stocks to return somewhere in the range of 5 or 6% above the rate of inflation. Short-term debt on the other hand will return about 1 or 2% above the rate of inflation. That equals a nominal return of 9% or so over the past century, versus an average nominal borrowing cost of less than 5%.

The Smith Manoeuvre partially capitalized on that difference. As long as the investor can manage their risk adequately, borrowing at 5% and generating returns of 9% are a good deal for anyone. That's a long-term return of 4% on money that is not yours!

It's also important to note that you borrow at simple interest but your investments grow with compounding interest. This means the size of your loan amount is capped and the interest costs do not compound. But your investment account will grow exponentially over time.

Edited. Graph made from Ontario Securities Commission Wesbite

In the above graph, debt is capped at the red line ($300,000) while your investment portfolio compounds over the years to $1.5 million. That's the power of simple vs. compound interest. In the Smith Manoeuvre, you actually don't directly pay the interest from cash flows because the strategy utilizes "guerilla capitalization".

However, the interest to investment return difference is just one factor of the Smith Manoeuvre. The other--arguably more important--component is profiting from the provisions of our tax system. Our tax system is designed to favour investments over income and productive debt over consumer debt.

The interest expenses on money borrowed for investing using the Smith Manoeuvre is 100% deducted from your income which significantly reduces your taxes. This tax deduction has a massive impact on the effects of the Smith Manoeuvre. If you have a $300,000 Smith Manoeuvre loan and you earn $80,000 a year in Ontario, at 3% interest you save $3,000 a year on taxes. At 5% interest you will save $4,700 on income taxes. After the tax adjustment, your net interest rate after tax deductions is much lower than the posted interest rate.

Meanwhile, profits from your equity investments in your Smith Manoeuvre non-registered investment account are taxed at much lower rates than regular income and, in the case of capital gains, can be deferred for a long time. At the same $80,000 income in Ontario, Canadian dividends are taxed at 8.92% after the dividend tax credit and capital gains are just half included for tax purposes when you sell your investments at a profit. A savvy investor can realize capital gains in retirement at extremely low rates by harvesting the gains strategically.

While the best way to approach the Smith Manoeuvre with regards to your investment mix depend on your personal situation, generally speaking working individuals using the Smith Manoeuvre should try invest primarily in low-yielding Canadian stocks. Of course diversification over your broader portfolio cannot be ignored.

While rising rates might seem scary to the young Canadian, or recent new home buyer swimming in debt that totals many multiples of their annual income, interest rates in Canada are extremely cheap today. In the late '90s and early 2000s when Fraser was using this strategy commonly with his clients and then promoting the Smith Manoeuvre through his popular book, interest rates were well above 5%.

It would take a massive spike in HELOC rates for this strategy to become unprofitable for middle to higher income Canadian families. For now, if you have a lot of equity in your home and are interested in growing your wealth exponentially beyond what your home could ever provide, use the Smith Manoeuvre to save on taxes and build a big portfolio.

Read my complete step-by-step Smith Manoeuvre guide posted on this blog.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.