As you know the Canadian investment industry is very good at separating people from their money. The biggest hidden fee we pay has been in the spotlight for a while now. It’s the management expenses of mutual funds which can eat up a quarter or more of their average returns every year.
So once you found out how much you are paying for fund management you decided it’s not worth it and you want to manage your investments directly using index funds, ETFs, or individual stocks.
Now you’re paying a lot less in management fees. But you still be running right into another fee without knowing it. This one is hidden even deeper. Like a mutual fund’s fees it is collected behind the scenes so it looks to you like nothing has happened.
Unlike fund management fees it isn’t required to be disclosed in a way that makes it easy to find. And unlike paying a high fee for a brilliant fund manager (as rare as they are) it has absolutely no possible benefits at all for you since there is literally no difference in what you are getting for the fee.
Every broker does it differently. If this problem is affecting you, it’s important to consider it when choosing a broker and find one that will make it easy to pay less fees. Later on you’ll see which brokers have been good and bad in my experience.
What is this secretive fee? I’m talking about the currency exchange charges that are applied every time you buy or sell a stock or fund in a currency other than Canadian dollars.
How it happens
When you’re studying how to manage your own investments it doesn’t take long to find someone recommending a US-based index fund or stocks that are located outside of Canada. And this is for a good reason. Canada’s small market doesn’t always provide the best choices, or even enough to build a full portfolio.
There is one catch though. When you’re trading in a market outside of Canada you need to use another currency. Foreign stocks and ETFs, and even a few Canadian-based ones, are priced in US Dollars, Euros, or another currency. You have to buy and sell them in that currency. As any experienced traveler will know, the cost to do this can vary a lot. Most brokerages will conveniently do the conversion for you so you just deposit your cash and buy the fund or stock you want.
When they do they will usually charge a hidden fee of 1 – 2% of the total amount. And some of them find creative ways to apply this fee more than once. If you sell a US fund and then buy a different US fund you might pay the fee twice in one day. That adds up quickly. Good decisions can become a bad move once this fee is applied.
The same story happens with dividends from foreign stocks. When you receive the dividend you can be charged the fee to convert it to Canadian dollars, and then charged the same fee again when you use it to buy more shares outside of Canada.
This fee is buried deep so most investors never see it. You just get a worse currency exchange rate so you end up buying a few less shares, and you lose out on the compounding gains of those extra shares forever.
Banks and brokers charge these high fees because most investors don’t notice and wouldn’t know what alternatives they can use. But now there are a few ways that you can do the conversion yourself at a lower cost and avoid these high fees.
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How to avoid it
Some people might say that they will only buy Canadian stocks and funds to avoid this fee. This can work in some situations. But for a really diversified portfolio it limits your options.
And the lowest ETF fees you can get are outside of Canada. Even some of the cheapest Canadian ETFs have costs that are 3 or 4 times the fees charged by their US equivalents.
Here are all the common ways that investors avoid this unnecessary expense. All of these tips are for US Dollars since they are by far the second most important currency for Canadian investors. Some will work with other currencies too.
These tips show you how to avoid doing currency conversions, since you can’t be charged for them if you don’t do them. Next week I’ll show you how you can do the conversion yourself for a much lower fee.
1. Use Canadian ETFs or funds. The Canadian ETF market used to be limited to only a few indexes and most ETFs used currency hedging which is costly and often adds no value. Fortunately iShares, Vanguard, and BMO have added several new ETFs in the last two years that give investors access to new indexes and remove the currency hedging.
For example you might choose VUN, a Canadian ETF, to invest in the US market using Canadian dollars instead of VTI which is an ETF that trades in US dollars. The two ETFs hold the same stocks but when you buy VUN you aren’t paying currency conversion fees. You could also use XEF, a Canadian ETF for international stocks, instead of VXUS in the US market (note that XEF does not include emerging markets like VXUS so it’s not identical).
Because these funds trade in Canadian dollars you don’t pay currency conversion fees yourself. The fund managers do the work of converting the cash. For large ETF providers the price they pay for currency conversions is very low.
The management fees for these ETFs are typically higher than the US equivalent. But some of them come close, and it can be worth paying a bit more to avoid the large cost of hidden currency exchange fees.
The good thing is that you can do this with any broker. Since these ETFs trade on the Canadian market in Canadian dollars they work the same way for everyone.
2. Use a broker that doesn’t charge hidden currency conversion fees. Based on the reputation of Canadian banking this might sound like it’s impossible. But customers of CIBC Investor’s Edge are currently reporting that it will let you buy US stocks using Canadian dollars and not charge any extra fees. (I have not used CIBC Investors’ Edge myself)
There is still the exchange rate to consider. Right now $1000 in Canadian cash will only buy you about $900 of US ETFs and there is no way around that. But if you use another broker and pay the full currency conversion fee you’ll end up with a bit less.
This is a great deal for CIBC customers since free currency exchanges are very difficult for individual investors to get. The policy could change in the future though so it would be best to confirm it before making trades and check in once in a while to make sure you are still getting this advantage.
Some investors prefer to avoid CIBC because they can’t hold USD cash directly in accounts such as RRSPs, which other brokers do allow (see #3 below). If you aren’t keeping a lot of cash sitting around this isn’t a problem and avoiding the fee is worth it.
3. Use a broker that allows you to hold US dollars. This may not help you when you’re buying a stock or ETF (unless you use tip #4 as well). But if you sell one US ETF to buy another, or you receive dividends and use them to buy more shares, this is one way that you can avoid paying the currency exchange fees while doing that.
With most brokers, if you sell a US ETF or get dividends from a US stock they will convert the cash to Canadian dollars because that is all they allow in your account. But a few brokers will divide your cash balance into Canadian and US dollars.
If you sell a US ETF in one of these accounts you will get US dollars. You can then use those to buy something else on the US market. This makes it easier to avoid doing a currency conversion when you don’t need to. Questrade and RBC Direct Investing are two brokers that are known for this.
You still need to make sure your account is set up so all trades happen in the currency of that security. So if you sell a US stock you will get US dollars, and if you sell a Canadian stock you will get Canadian dollars. Some brokers will allow you to force all your trades to happen in Canadian dollars, which may lead to hidden conversion fees.
I have used both Questrade and RBC Direct Investing because they offer this option.
4. Deposit USD into your brokerage account. If you already have a foreign currency from income outside of Canada or the sale of a property then it doesn’t make sense to convert it to Canadian dollars in your bank account (paying another hidden fee), move it into your brokerage account, and then pay to convert it back into US dollars.
Instead you can keep it in a US dollar bank account until you’re ready to invest it. Then if your brokerage allows you to have US dollars in your account (see #3), you can transfer directly from your bank to your broker with no conversions. Just make sure the transfer is requested in US dollars and not Canadian dollars.
Once you do this you are free to buy any stock or ETF on the US market using that cash.
5. Use wash trading if you are selling to buy something else. For brokers that don’t allow you to hold US dollars (see #3) this can be a useful way to cut out some fees. Like #3, this only helps when you are selling one US holding in order to buy another. When you do this some brokers will convert the cash to Canadian dollars and then convert it back when you buy. By doing this they charge the conversion fee twice.
But some brokers such as TD Direct Investing will allow you to “wash the trades”. This can only be done when you make both trades in one day. Sometimes you even have to make them before a certain time like 3PM EST. When you do this the broker will add up all your trades at the end of the day and adjust the amounts to remove the currency conversions.
So if you sell $10,000 of one US ETF and buy $9,500 of another the broker will make sure no currency conversion happens on that $9,500. The remaining $500 will be converted to Canadian dollars and deposited as cash. TD even lets you have the cash put in a US money market fund if you want, so there is no currency conversion happening.
This way you can use the US dollars from a sale to buy something else without paying extra fees. The broker doesn’t do this unless you ask for it. There are two ways you can do it. You can call in on the day you place the trades and ask to have it done for that day only. Or you can call in and ask to have it done automatically for all future trades. When you call you just need to tell the agent that you want “wash trading” or you want to “wash your trades” and they will understand. If they don’t you can call back later and get someone who has heard of it.
There are specific rules so before making these trades you should call and ask if it’s available, how it works, and if there is a deadline every day that you have to make the trades before, and when it will take effect if you ask to use it for all your future trades.
You can only wash trades that you place yourself. Dividends are not eligible for this. #3 is the best way to protect your US dividends from fees. But remember that dividends are typically a lot smaller than your total holdings so your first priority should be to minimize fees on the bigger trades. If you pay an extra 1% fee to re-invest a $300 dividend you’re only missing out on $3.
I have used TD in the past and avoid it now. The wash trading option helps, but with other brokers that let you have US dollars in your account you don’t even need to do that. TD has been far behind other brokers for investors who use other currencies. If that’s important to you, avoid TD and try another one like RBC Direct Investing instead.
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These are the most common ways to avoid currency conversion fees. Next week we’ll look at the two ways you can actually get lower currency conversion fees and save hundreds or thousands of dollars.
I have done nearly all of these at different times. This has allowed me to take advantage of some of the unbeatable investments available in the US market. Once you have done them a couple of times (or set up the right account) all of them are as simple as depositing a cheque in your ban account. You just need to pick which combination works for you.
While waiting for the next part, leave a comment below to let me know what you do to avoid hidden exchange fees!