If the inquiries crossing my desk are any indication, there is a potentially dangerous trend afoot in the investment industry.

Over the past several months, many advisors and investors have asked my opinion of a particular leveraged investment strategy. These inquiries spoke of an almost identical strategy that involves both investment and tax risk. These are risks most dealers (and advisors, for that matter) would rather avoid.

Each proposed strategy involves borrowing money to invest in mutual funds (such as T-series funds) that pay fat distributions made up mostly of return of capital; then, those cash distributions would be used to pay down either loan interest or interest and principal.

First, let’s explore the investment side. Leveraging works best — and is most suitable — for the highly taxed client with plenty of excess cash flow. There should be enough cash flow to weather extended interest rate hikes (of, say, 200 to 400 basis points) comfortably.

Using existing cash flow (instead of liquidating investments) to pay the interest allows the investments to compound uninterrupted, which is a key part of this strategy’s success.

At the end of a defined time frame — or when the investments have had strong multi-year ascents — the investments are liquidated to wipe out the loan. If all goes well, the client is left with a lot of extra jingle in his jeans.

Historically, reinvested dividends have accounted for more than half of North American stocks’ total return (see www.bernstein.com/public/story.aspx?cid=4640&nid=184).
T-series funds usually distribute some taxable income — i.e., dividends, other income and realized capital gains. But as the distribution is typically much higher than the actual income, the excess (often the bulk of the payment) is classified as RoC. Taking all of that in cash removes the compounding potential that makes this strategy so alluring.

Hence, the risk to which this strategy exposes the client will outweigh the probable small investment potential.

Let’s now turn our attention to the tax side of this. The Canada Revenue Agency and Canada’s brightest tax minds are still debating how interest deductibility laws will evolve. Today, however, the basic idea of borrowing to invest in stocks (or stock mutual funds), and deducting the interest expense remains valid.

The standard test is whether the borrowed funds are used for income-producing purposes. However, the CRA likes paper trails. And if clients sell all or part of their leveraged investments and use the proceeds for what the CRA deems to be non-income-producing purposes, part of the interest deductibility vanishes.

Taking taxable distributions is fine, tax-wise (albeit a bad investment move, in my opinion). But the RoC portion of a distribution is not taxable; the CRA treats the outright sale of investments the same as taking RoC distributions in cash. If the RoC distribution is reinvested, full deductibility is intact. Use that RoC distribution to pay down loan interest or principal, and tax laws say that less than 100% of the interest is deductible.

This introduces an accounting nightmare and the reduced likelihood of success for the client — and a potential liability for the advisor who recommended the strategy (and his or her sponsoring dealer).

Being able to deduct all the loan interest is another key part of this strategy because it lowers the after-tax return needed to succeed. Losing that is big.

Losing that while also lowering the total return potential of the investments is a losing combination for all involved. IE

Dan Hallett, CFA, CFP, is president of Dan Hallett & Associates Inc., which provides a mutual funds recommended list and investment research to financial advisors.