Money Bag: Smith Manoeuvre and Expected Investment Returns
Today I’m reaching into the mail bag for a new feature I’m calling the Money Bag. I’ll answer questions and address comments from readers on a wide range of money topics, myths, and perceptions about money. No question is off limits, so hit me up in the comments section or send me an email about all the money things you’re dying to know.
To start, we’ve got two questions from reader Kevin, who asked about expected future investment returns and also why I haven’t done the Smith Manoeuvre. Take it away, Kevin:
Expected Investment Returns
“I read an article in your weekly reading that spoke about how good stock market returns have been over the last few years and that we shouldn’t expect the same results going forward. The author said we should expect 4-5 percent returns going forward.
I was wondering if that is the case, why not pay off your mortgage faster instead of putting that money into an ETF portfolio.
The money put into your home would be a safer short term investment, plus the added “mortgage freedom” benefit. Then if you REALLY wanted you could borrow against the equity later when expected investment returns are higher?”
Hi Kevin, thanks for your email. I believe the best long-term investment is in the stock market, but with mortgage interest rates creeping up it certainly makes that decision more complicated.
Expected future returns are just that…projections. Nobody knows where the stock market is headed tomorrow or next week, let alone for the next two decades or more.
There’s an opportunity cost with every decision. The risk you take by putting all your extra cashflow against your mortgage is that you could miss out on better returns if markets rise higher than expected. That’s why I think it’s best to stick with a regular contribution schedule for your investments and balance that with responsible debt pay down (including mortgage).
Kevin, without knowing your age, employment situation, family situation, debt situation, and investment goals it’s impossible to say what you should do. All I know is if you base your investment strategy on market timing and looking at crystal balls, you’ll end up disappointed more often than not.
Perhaps a blended approach of additional mortgage payments along with your regular investment contributions will scratch both of those itches for the time being until something changes in your personal situation that warrants a new approach?
Smith Manoeuvre
Here’s Kevin again with a follow up reply:
“Have you looked into doing the Smith Manoeuvre yourself? Why did you decide to do it or not do it?
I’m young professional with a 100k plus salary and wife that stays at home with our new baby. I have been researching [the Smith Manoeuvre] and I’m considering doing it with index ETFs, or borrowing to buy another home.
I’d like to know why you did it or not, and hopefully gain some understanding from your experience.”
Ahh, the Smith Manoeuvre. This was all the rage back in 2007 when I started following financial blogs. It was made famous in that circle by Frugal Trader at Million Dollar Journey, among others.
The Smith Manoeuvre is a leveraged investment strategy where an investor obtains a readvanceable mortgage to borrow against their home and invest in the stock market. While turning your mortgage into a tax-deductible loan sounds appealing, it’s not without risk.
Unfortunately, I know of several bloggers and blog readers who didn’t stick with the strategy through the financial crisis in 2008/09. Looking back it was the worst time to be setting up a leveraged investment portfolio. That’s because it’s hard to stomach watching your portfolio get cut in half in just a few months. And sure, many companies kept their dividends intact, but that’s little solace for some investors who were staring at a $200,000 loan balance and a $120,000 investment portfolio.
Okay, so let’s fast forward 10 years and now we’re in an unprecedented bull market for stocks, while home valuations are also sky high in many areas. While I never advocate market timing, it just doesn’t feel like a good time to be setting up a leveraged portfolio if you’ve never lived through a crash of that magnitude and know for certain how you’d react…or how your significant other would react for that matter.
Personally, we have many competing financial priorities and I believe maxing out our RRSPs and TFSAs, plus RESPs for the kids and a little bit extra on the mortgage is good enough to meet our financial goals. If I get to the point where our mortgage is paid off and all other accounts are maxed out AND there’s still money left over, then I’d consider opening a non-registered account and looking at some different investment strategies (including the Smith Manoeuvre). But at this point I have no plans to consider this strategy anytime soon.
Finally, you mentioned indexing, which of course I’m all for, but the Smith Manoeuvre likely* works best with Canadian dividend stocks. Not only is the loan tax-deductible but there’s also the dividend tax credit to consider. The point is to have the dividends pay the interest, and while index funds pay distributions they are likely too small to cover the loan interest.
*Note: I’m not a Smith Manoeuvre expert at all
Final thoughts
I hope you enjoyed the first edition of the Money Bag. Please feel free to share your thoughts on expected returns or the Smith Manoeuvre with me and Kevin in the comments section. We’d love to hear a different perspective.
And send me an email with your money questions and I might include it in a future Money Bag segment.
Hi Rob. I am trying to find a ETF to follow-high paying US dividend stocks. I am retired and looking to replace several mutual funds (just finished reading Larry’ book) I am looking at XHD with a 2.7% yield- .007 cents monthly. For a ETF that follows high paying US dividend stocks
Not much income to show for this investment
Can you recommend a couple of high dividend ETF’s US and international
Like said I’m looking for income
Hi Dan, that’s the trouble with the dividend ETFs, you’ll be hard pressed to find one that pays higher than 3 percent or so.
Other options include CUD from iShares – https://www.blackrock.com/ca/individual/en/products/239828/ishares-sp-us-dividend-growers-index-fund-cadhedged-fund – but the yield is under 2 percent.
There are more exotic options, like this covered call ETF that claims to yield 5.49%: https://www.bmo.com/gam/ca/advisor/products/etfs?fundUrl=/fundProfile/ZWH#fundUrl=%2FfundProfile%2FZWH
I’d caution that chasing yield is a mistake and that anything above 4% is likely not sustainable or would include return of capital in its distributions.
Investing is risky enough. Why amp it up with more leverage? Most times the simplest things work. Such as make more money and save more.
Well said, Dr. MB!
This Kevin guy sounds like he is really trying to be one step ahead if possible. Maybe that’s not the right move to be greedy right now. Great post Robb!
Hi Braden, nothing wrong with looking for an edge but make sure to lock down all the basics, know yourself, and have a plan for the future before diving into a leveraged strategy.
It’s also easy to take the rise in house prices for granted, as well as the bull stock market. Especially when relatively young and you haven’t lived through the inevitable down cycles before.
My wife and I bought a home in the GTA (Pickering) in 1988, a month before we married. A year later, 1989, the house price was up about 30%, but just 6 months later the housing market had crashed back down to at or below the price we had paid in the early spring of 1988.
It was a financial and emotional roller coaster, locked in to a pretty high mortgage rate – we decided to sit tight, pay off our mortgage in a hurry (9 years), and ignore bankers (sales people) recommendations to use home equity to buy their high MER mutual funds. Once the mortgage was paid off (by the time we were 40/41) we plowed savings into investments, and enjoyed some great returns. Now 20 years later we are both retired (early), and adjusting to the ‘de-accumulation’ phase.
Hi Dan, thanks for sharing your experience. That sounds like quite the roller-coaster to live through and I’m glad you were able to manage it and come out ahead on the other side. Congrats on early retirement!
Rob
In 1996 Paul Martin had wrested rates down by some severe cuts in government spending and I felt fairly confident that we were in for a protracted period of low cost borrowing. We decided to take out a 175K investment demand loan which we put into PHN Dividend income fund with a scheduled withdrawal plan to cover loan costs.
Today the loan is long paid off and we are left with $210K and $1400/month income stream. A risk that paid off handsomely. We were always ready to liquidate if circumstances dictated though they never did. Not for everyone, but we did well.
Your comments please Rob,
I’m 74, a nice portfolio of Dividend stocks and I d have a house ()paid)that’s worth about $450.000. I have $50,000 from a sale of a rental. I have been approached to invest with friends who have the opportunity to buy a condo at the ground level, they have put in $25.000 The contract will pay me 10% interest for one year. At the end of that yearI will receive $55.000. The agreement comes from their lawyer and appears legal. I’d appreciate your views.
Thanks. Great website.
If I were 22years younger today I would likely not do the same.
We are coming off a long stretch of low rates and a ten year bull market. We can expect rates to rise and a market corrrction over the coming years… maybe not the same circumstances I faced in 1996
Hi Peter, we are thinking of doing a similar strategy. Just curious how long it took to get to this point? Was it from 1996 (22 yrs)? I’m 50 now so I timeline is important for us. Thanks in advance! Kelly
We did 20 yr demand loan paid of in 16 from investment income returning at about 8% plus considerable capital growth. But times were different when we started. Interest rates were low with likelihood of staying low for years (as was the case). We were always prepared to sell and repay without penalty at any time if investment value dropped too much. We were lucky and were able to go through the 2008 crash without fear because a lot of the loan had already been paid.
Today, markets are due for a correction and rates are rising: less promising times for this approach.
Be careful.
Hi Peter, thanks for sharing that story. If I hear you correctly you’re saying that a calculated risk coupled with a long-term plan to manage it can lead to a great outcome. No arguments there.
Let me ask you this: If you were in the same age and situation today, would you make the same move?
For a high dividend ETF, I use iShares Canadian Financial Monthly Income Fund (FIE), pays out 4 cents per unit per month, which works out to about 6.5%. Some people say this really is return of capital, but it has paid the same 4 cents per month for the last 16(?) years, ie. 192 months, which works out to $7.68 per unit and it is still at $7.30+ per unit. That’s no “return of capital” as I learned it.
Robb,
The alarm bells went off for me when Kevin talked about using the borrowed money from the Smith Manoeuvre to buy another property. It never ceases to amaze me how obsessed Canadians are with real estate, but as I think we can agree on, it is not the best path to building wealth.
Steve
Maybe I don’t understand the Smith Manouever fully, but I thought it was orthogonal to investing in tax sheltered accounts. Since you are using leverage to invest in the taxable account, it doesn’t preclude you from paying, or even maxing out, your TFSA and RRSPs. Further, the tax credit on the Smith Manouever is only a part of the advantage. It’s really leveraged investing. You could in fact take the borrowed money and put it in a TFSA or RRSP to get leveraged growth, you just wouldn’t get the tax credit. Am I missing something?