Wednesday, June 2, 2010

Index Portfolios and Foreign Currency Exchange Costs

The premise behind the indexing approach to investing is to use a simple approach to get market average returns with a minimum of costs. This is usually done using index-based exchange traded funds (ETFs) or low-cost index mutual funds. Investors choose a mix of index funds and stick with it, possibly rebalancing periodically to maintain a preferred target percentage of assets in each fund. Once these decisions are made, the focus is on minimizing costs, including the cost of currency exchanges.

If a Canadian investor chooses to own both Canadian- and US-dollar funds, some amount of currency conversion will likely be necessary. All currency conversion involves spreads which are the difference between buy and sell prices. If you start with Canadian dollars, convert them to US dollars, and then convert back to Canadian dollars, you'll have less money than when you started.

The big question is how much less money will you have? For large dollar amounts traded in foreign exchange markets, the loss could be as little as 0.05%. However, average investors doing their conversions through a discount broker could pay much more. Over 2% is not unusual. These huge spreads are essentially an added fee rather than a genuine market-driven spread. Typically, these fees are quoted in terms of the cost of converting once in either direction. So, the 2% round-trip spread would be about 1% in each direction.

Unfortunately, discount brokers don't seem to compete on these foreign exchange fees. When customers show up at a bank branch to exchange physical currency notes, high fees to cover service costs are understandable, but there is little reason for currency conversion fees related to stock transactions to be so high other than a desire for additional profit.

If these fees were driven by a competitive market, it is hard to imagine that the added fee per currency conversion would be more than 0.1%. Discount brokers manage to trade shares for only $10 per trade. The additional costs due to the bid-ask spreads on stock prices are usually quite small. But for some reason currency conversion fees are much higher.

Let's look at an example. Suppose that an investor wants to rebalance a portfolio by selling about $10,000 worth of Canadian ETF shares to buy about $10,000 in a US ETF. Let's assume that the ETFs trade for $50 with 5-cent bid-ask spreads. So, 200 shares are involved in each trade. The total trading spread is $10, half of which ($5) is lost on each buy or sell. Add in the $10 commission and each trade costs $15. Let's assume that the foreign currency exchange fee is 1%.

The overall costs are as follows:

Sell Canadian ETF: $15
Convert proceeds to US dollars: $100
Buy US ETF shares: $15

The total cost is about $130 and is dominated by the foreign exchange cost.

Note that this problem is not solved by allowing US dollars to be held in a RRSP. This issue is similar, but not the same.

It is very easy for currency conversion costs to be lost in all the other activity in a trading account. They are buried in the quoted exchange rate. However, for some investors, the total fees they pay can be dominated by these currency conversion fees.

4 comments:

  1. Would it help to have a forex account alongside the trading account?

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  2. @Patrick: I've never had a forex account; so I'm not sure.

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  3. Have you considered buying a stock that trades on both NYSE/NASDAQ and TSX? I've read the strategy in a few places, but never tried it myself. I'm looking to do it once our dollar reaches parity..

    Here it goes:
    1. Buy TD stock (or RIM or RY or MFC) from TSX.
    2. Call your brokerage to "journal" your holding to US (NYSE or NASDAQ). This is the "uncertain" part, since I've never done this mayself. I hear they should be able to do this if the stock trades in both exchanges with the same "CUSID".
    3. Sell the stock in NYSE. Usually, the same stock price between TSX and NYSE/NASDAQ should follow the spot currency exchange rate (CAD-USD).
    4. Keep the money sold in the USD RSP account at your discount brokerage or do a wash-trade by instructing the brokerage.

    Pls let me know your experience.

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  4. @Diwa: Canadian Capitalist did this a week or so ago. Here is the link to his description of what he did:

    link

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