Why I Quit The Smith Maneuver

by Mike Holman

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Almost 3 years ago I started up a Smith Maneuver leveraged investing plan which involved borrowing money using an investment loan (home equity line of credit) to invest in dividend stocks.  I wrote extensively about this process (see list at the bottom of page).  Over time I have seen this account go through some unbelievable volatility, have almost no dividend increases and watched interest rates plummet which meant that the account was quite profitable on a net cash flow basis.

Last week I decided to sell all the stocks in the leveraged investment account and pay off the line of credit loan.  I had been debating for a while if I should continue the leveraged plan and since it was at a point where there was a small capital gain, it made the decision very easy from a psychological point of view.

Why did I end the Smith Maneuver plan?

A lot of things had changed for me in the 3 years since I started the plan.  My opinion of leveraged investing hasn’t really changed but I didn’t feel that it was a good fit for my situation anymore.

Extra risk. When I started the plan I wanted some extra risk.  The problem is that as time went on and it became apparent that we were going to be a single income family and my company had several rounds of layoffs in the past year – my appetite for that extra risk diminished.

Another issue concerning risk is that when I started the plan, my portfolio was 80% equities and 20% bonds.  It didn’t occur to me until much later that adding leverage to a portfolio that isn’t 100% equities doensn’t make any sense.  All I had to do to increase risk was to decrease the percentage of bonds in my portfolio.  If your portfolio is 100% equities and you still want to add some risk then using leverage is a good tool for that.

Hassle - Having a leveraged investment account means doing a bit of work.  You have to open the account, buy stocks, transfer money, keep track of purchases for ACB values.  Transfer dividends out of the account to help pay the interest.  You also have to account for the earned dividends and interest payments when you file your taxes.  This isn’t a huge amount of work but again, my life has changed in the last few years – one more child plus a home business which takes time means that I’m a lot less inclined to want to do extra financial activities unless there is a clear benefit.

Motivation - Another thing that changed was my motivation – at this point in time we have a decent standard of living.  It’s likely that I’ll be able to retire at a reasonable age with an adequate income so the question is – why bother with extra risk?  Extra money is nice but if there is a downside then it’s not worth it for me.

Would I recommend doing or not doing leveraged investing?

My opinion on borrowing to invest hasn’t changed much – I think it is a valid tool to increase your portfolio risk as well as make extra purchases when the market is down.  Just be prepared for a bit of extra work.  Handling volatility is something that I have no problem with but if you have a hard time watching your unleveraged portfolio go down in value then be prepared for the fact that watching a leveraged portfolio go down is much more difficult.

The original leveraged investing plan

This post lays out the grand plan for leveraged investing.  I had a chuckle seeing Frugal Trader’s comment about my projected borrowing costs of 6% – he suggested increasing that estimate a bit.  As it turned out the borrowing costs were much lower than both of us anticipated.

The risks of leveraged investing were discussed in great detail.
Here is one risk which I found amusing

Future growth rate of dividends: If this doesn’t happen then the plan will fail. Not much I can do here other than to try to pick good companies with proven histories of both paying dividends and increasing them. Based on the last 10 years this looks like a slam dunk. But as William Bernstein wrote in Four Pillars of Investing “Ignore the last ten years” when looking at trends. I’ll have to ignore William on this one.

Lesson learned – Don’t ever ignore William Bernstein!

Interest rate exposure.  This is the risk I was most worried about and ironically it was a non-factor since interest went down and stayed down.  This is still a risk factor for the future however.

Conclusion

I’m glad I did the leveraged investing plan, it was quite interesting and I learned a lot.  My advice to anyone thinking about it is to start small and make sure you are comfortable with all the different aspects of leveraged investing before you go in deeper.

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{ 25 comments… read them below or add one }

1 The Financial Blogger

I am actually considering going back in the market through leveraging in January.

I have stopped my Smith Manoeuvre back in May 2009 since we started to live on a single income household. Like you, my appetite for risk had diminished back then ;-)

However, I have missed a great opportunity between May and today. I am considering going back with a few trades since I am done with my MBA and I have more time to trade.

Interest rate won’t probably rise significantly for another 2 years so there is plenty of room. And if they ever rise faster, this would mean that the economy is going well… which means that your investment will as well ;-)

2 Alexandra

I have one leveraged investment loan for $100,000 and my husband has the same (actually his is 98,000 for some reason), which we got about two years ago. The value of these investments have been volitile to say the least – right now we are sitting at just 12K below the original value. It was hard to keep my head on when the value plummeted last year, but I am staying the course and will see this plan through. I think we’ll end up doing quite well, despite major setbacks.

3 2 Cents

Congratulations on your decision. You made a well-reasoned case both for increasing risk and for knowing when it just isn’t right for you. I think you are getting out at a good time, as I believe we have yet to discover all the cockroaches. I do not believe this is a good environment to increase risk, as there are just too many uncertainties. The rules of the game are not clear and keep changing. Just being in the stock market at this point seems to me to be quite a risk.

4 Four Pillars

Rob – That is quite interesting about Siegel’s research. I can’t disagree with his theory but sometimes reality and theory don’t always match up perfectly for each individual.

FB – My leveraged account was very profitable because of low interest rates. I don’t think rates will stay low forever but I don’t know when they will go up – could be next year, could be 8 years from now.

Alexandra – So you guys have “his” and “hers” investment loans? :)

Yes, it is tough to watch a leveraged portfolio sit underwater. I think if you are committed to the plan for the long term then it will work out for you. You guys also borrowed a lot more than I did which is good. I think if you are going to do it then it’s not that worthwhile for a smaller amount.

In my case I didn’t want to increase the loan amount (to make it more worthwhile) and that’s one of the reasons I ended it.

5 Jess

I haven’t tried leverage loan yet.

Isn’t the interest is tax deductable?

I’m planning on doing a leverage loan next year and invest it on a mutual funds instead. I’ll let my Distribution pays for it.

6 Jess

Off topic:

Are you guys going to change your strategy because of HST? If yes, what would it be?

7 Locke

I still believe in the Smith Maneouvre/leverage formula via dividend growth stocks. More so now than before since yields are above credit line rates.

But being in the financial industry, I totally understand how much people misinterpret their tolerance for volatility and that family situations change. The whole recession put into the perspective, that if I lose my job and markets are down I’d be upside down. As it stands right now, I’m 50% leveraged via 0% balance transfer that I’ll transfer to a credit line

8 Jerry Hung

Like Real Estate, it is not for everyone, and even for those who are doing it, they aren’t applicable all the time either

I am happy with my leverage, in fact I’m kicking myself for NOT buying more during the downturn since I could’ve afforded the risks, but one can never win from market timing, so I’m just glad my leveraged section has covered my unleveraged losses :)

There are higher priorities in life, and owning a PF blog doesn’t mean you have to do EVERY trick in the book

Plus, leverage with SM is still not as leverage as a mortgage ($10 asset for $2 you put in), maybe you should look into RE too then, be careful of the bubble though? ;-p

9 Michael James

At least you didn’t collapse your leveraged account 9 months ago at the market bottom. It must be painful for anyone who lost his nerve in March.

10 Thicken My Wallet

Since leveraged investing is much like running a business in that you are using mostly other people’s money, your point about hassle is a good one. Running any business is a lot of hard work. I am sure the book-keeping alone was quite a lot of work. Congrats on doing it for so long.

11 Four Pillars

Jess – Yes, the interest on investment loans is tax-deductible.

Jerry – Yes, I wish I had bought more in the downturn. I did however buy steadily last fall and in January which ended up being a good move.

Michael James – Yes, maybe we should ask Derek Foster about that? :)

TMW – I found the hassle factor decreased significantly after the first year once I learned how to organize things and do the taxes. My point wasn’t that it was too much work but rather that the “hassle” wasn’t something that I had thought of before starting the plan.

Good analogy comparing to a business – it’s a very small business but it’s still a business.

12 MDJ

Great post Mike and thanks for the mention. I went back to the old comment and had a chuckle myself! Prime @ 6% seems really high these days!

13 Dave

I love my leverage loan. I have one through my bank and secured the investments at their brokerage at prime plus 1%. By setting up my portfolio on a DRIP strategy I re-purchased right through the bad times, automatically dollar cost averaging.

14 Jordan

Hey Mike I want to push back on your comment that it doesn’t make any sense to own bonds if you are using leverage. Yesterday I would have thought the same thing (plus I hate owing money), but after just reading a very interesting article from the investment firm Bridgewater I am questioning that idea. Check it out:

http://invivoanalytics.com/wp-content/downloads/DALIO_PMPT2007update.pdf

The “All weather beta strategy” suggests that you can maximize your portfolio’s beta & sharpe ratio (lower risk or higher returns) by leveraging asset classes including bonds. Any asset class that is expected to earn more then the risk free rate, and less then the equity premium. The idea being that by fixing your portfolio for a specific expected return (10% in their article) with leverage you are getting more diversification by having lower asset class correlation, which reduces your portfolio’s risk.

Ignoring the 2nd part of the article “alpha strategy”, what are your thoughts? If you believe this really offers lower risk, and with interest rates as low as they are then logically even if you are risk adverse this is still a better strategy right? It seems to be better then the efficient frontier.

Jordan

(btw thank you for allowing the comment editing, I’d sound like an idiot in my original response)

15 Michael James

Jordan: Most analyses of leverage assume that you can borrow at the risk-free rate of short-term government debt. With this assumption, optimal leveraged portfolios do in fact use bonds. However, this conclusion is very sensitive to the interest rate charged on the leverage debt. I can’t borrow at this risk-free rate. If you bump up the interest rate by 1%, then the optimal amount of leverage drops significantly, and the percentage of bonds to own drops as well. The interest rate charged doesn’t have to get very high before bonds disappear and it stops making sense to borrow.

16 Jordan

Hey Michael, thanks that’s part of the equation I wasn’t getting. In the real world we can’t follow the model exactly. But as long as the interest rate charged is less then the expect asset’s long term return it should still work right? It seems according to the article I mentioned that even if the individual asset’s benefit over expense is low shouldn’t it still have a positive overall benefit from the increased diverisification and apparently higher Sharpe ratio? Like the expression “the whole is greater than the sum of its parts” ?

I’ve read interactive brokers has some of the lowest margin rates (1.74% right now) so it’s still profitable compared to bond yield. When considering bond ETFs would you be comparing the interest rate to the “Yield to Maturity” or “Weighted Average Coupon”?

Cheers

17 Michael James

Jordan: The asset’s expected long-term return has to exceed the borrowing interest rate by enough to overcome the volatility losses due to compounding. I’m sceptical that bonds have a reasonable role to play in leveraged portfolios unless the investor is able to get an unusually good interest rate or is making aggressive assumptions about bond returns.

18 Andrew

Great discussion. My plan is to leverage invest in dividend paying stocks via a HELOC (free and clear). The math on the companies I have researched works well, with two companies out of eight having to cease dividends before the dividends cannot pay off the loan.
My question is this:
As I have surplus dividends, I wish to DRIP them within the account (ie. I will DRIP 2 out of 8 companies which is roughly the surplus), and transfer the remaining dividends out to pay the loan. Does this affect the tax situation? (DRIPS are far more cost effective than transferring out the excess and reinvesting, so hopefully this does not mess up the tax considerations)
Thanks,
Andrew

19 Mike

Andrew, if you want to reinvest the dividends then that is fine. However it will change the acb of the stocks you own so it will be a bit of extra book-keeping for you to do.

20 The Rat

Just finished reading up on your series and this conclusion three years later. Nice work. Your reasons for departing from the plan when you did were both valid and timely, in my view. Plus, you made a capital gain which is commendable. This series is a great resource and that alone provides value!

Cheers
The Rat

21 Eclectic Investor

Okay, I seem to be late into the party but that’s never stopped my from commenting/questioning …. LOL

+1 on the risk factor in terms of layoffs and family. I’m a firm believer in making sure whatever passes the “sleep” test.

I’m not sure I get the point about bonds – unless you mean bonds within the leveraged portfolio? In any case, my view of leverage is not about risk but about using other people’s money effectively to achieve my goals (i.e. pay off mortgage faster/accumulate more shares).

Of course it helps to have other assets so that if the leveraged account goes 100% south, it will be disappointing but won’t break you. Then too, if you are cherry picking bargain between Nov 2008 and Dec 2009 – it’s not too hard to deal with leveraged stocks that have to drop 100% before loss start creeping into the picture. Then too interest costs of 3% where the dividend income to cost is between 8% to 30% helps.

I also don’t see the “hassle” as being that big. Maybe it’s my selection of investments – Canadian dividend paying companies and one split share. Regardless, pretty much everything mentioned except transfer dividends to pay loan and reporting interest on the tax return are a function of investing – not the leveraged investment. I’ve had lots of stocks I’ve had to calculate the ACB for that I paid for – the annoying ones were where the company was bought out resulting in a final ACB and capital gain/loss to report.

Glad you learned a lot and I’d extent the conclusion about starting small to include the novice investor learning their strategy.

Cheers

22 Mike Holman

Regarding bonds – my premise is that adding leverage is adding risk. If you want to add risk, it would seem to make sense to start with your non-leveraged portfolio and reduce any non-equity exposure.

If your portfolio is 100% and you want more risk, then start leveraging.

That’s the way I look at it.

Reporting interest on the tax return is not a function of investing – you only do it when you are borrowing to invest.

I probably over-emphasized the “hassle factor” – you’re right, it’s not a big deal.

23 Eclectic Investor

@ Mike:

Re: Bonds … leverage is risk and start with non-leveraged portfolio by reducing non-equity

Hmmm … I’ll have to think about it. It helps but I’m not sure I’ve digested it yet.

Re: reporting interest is not a function of investing

Hmmm … maybe my sentence wasn’t clear. I meant to convey that of all items mentioned were investment tasks, with two exceptions:
1) dividends transfer to pay the loan
and
2) reporting interest on the tax return.

BTW, in my case, as the investments changed or buyouts happened, some of the tasks such as ACB has to be completed more often than I’d planned on.

As for the “hassle factor” – for those who dive into the comments, I think the comments/responses put this task in a clearer perspective. Of course, for me at least, when I didn’t plan on it and am scrambling – it is a hassle! One that is easily dealt with when understood.

Cheers

24 cannon_fodder

Three years ago (summer 2008) we knew we wanted to renew our mortgage and take a readvanceable one. We secured a BMO Readiline at P-0.75% with an attached HELOC at Prime.

Fast forward three years later (although the period from September 2008 to May 2009 was often gruelling and did NOT fly by): our mortgage is eliminated; our HELOC is close to maxed (as a result we are $250k more in debt than we were when we started); and our SM portfolio is over $1M. Based on our projections we would have had no mortgage, and no investment portfolio, by mid 2012.

Thus, with some good (but not great) timing, strong willpower to stay the course and some aggressive investing, the SM strategy has accomplished all of what it purports to do.

One of the differences in our implementation was to tap into the majority of our available equity and “jump start” the investment portfolio rather than invest in small amounts periodically. In our case this was critical to our success.

So, all in all, I’d have to say the one best thing we ever did for our financial independence was implementing the SM.

25 Mike Holman

Thanks for the comment, CF. Sounds like you had some great timing and a ton of courage.

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