Reducing the Cost of Currency Exchange

Yesterday’s post looked at whether US-listed ETFs are really a good deal for RRSP investors. Although ETFs from Vanguard and other American providers have dramatically lower annual fees, Canadians may face hefty currency exchange fees when trading them.

Most discount brokerages in Canada do not allow you to hold US dollars in a registered account, which means that using US-listed ETFs can involve paying a currency exchange fee when you buy, again when you sell, and every time you receive a dividend.

I’ve created a spreadsheet that helps investors compare the cost of Canadian and US-listed ETFs. With the headwind caused by a 1.5% currency exchange fee (in line with what many brokerages charge), it turns out that it would take many years for US-listed funds to pay off: in my test run, a Canadian investing $5,000 annually in an RRSP would need more than 11 years to see the benefit.

If you plan to use US-listed ETFs in your Couch Potato portfolio, consider these strategies to dramatically lower your costs:

Use a brokerage that allows you to hold US dollars inside an RRSP. The only three online brokerages that do this are Questrade, QTrade (a $50 annual fee applies) and RBC Direct Investing. They allow you to link your RRSP to a US-dollar bank account and move funds into your investment account without an exchange fee, and then you can buy and sell US-listed ETFs in American dollars. Being able to hold US dollars also avoids exchange fees when you collect dividends.

Don’t resign yourself to paying 1.5%. You can probably live with a high currency exchange fee if you’re only collecting a hundred bucks a year in US dividends in your RRSP. But if you’re regularly exchanging currency inside your investment accounts, you really need to find a better deal. Many brokerages don’t publish their currency spreads because they would rather you not know how much they’re gouging you. One exception is Questrade, which charges just 0.5%. (Does anyone know of other discount brokerages that can compete with that? Please share your experiences below.)

Learn how to wash your trades. If your brokerage does not allow you to hold US dollars, it may allow you to “wash your trade.” This technique allows you to sell a US-listed stock or ETF and temporarily park the proceeds in a US-dollar money market fund. Then you can buy a different US stock or ETF with those dollars and avoiding paying a currency exchange fee twice. For more information, see these posts from Michael James and Canadian Capitalist, then call your brokerage for instructions.

Consider “Norbert’s gambit.” My spreadsheet assumed that our investor would eventually sell his entire position in the US-listed ETF after a couple of decades, at which point it would be worth six figures. In reality, paying anything like 1.5% when exchanging a large sum like this is insane. If you’re looking to exchange a large amount of US dollars (say, $10,000 or more) consider the innovative method popularized by Norbert Schlenker of Libra Investment Management. Nicknamed Norbert’s gambit, this involves buying a highly liquid interlisted stock (that is, one that listed on the TSX and a US exchange) in one currency and then having your brokerage “journal it over” to the other currency before selling it. (Your trading account must allow you to hold both US and Canadian dollars.) This isn’t for the novice: read this these trhreads on Financial Webring and Canadian Money Forum first, then call your brokerage and ask about the specifics.

Hold your US-listed ETFs in a taxable account. If you can’t tax-shelter all of your investments, the usual advice is to put your Canadian equities in a taxable account, since the capital gains and Canadian dividends get the most favourable tax treatment. However, some investors may find it makes sense to hold their US-listed ETFs (or dividend-paying stocks) in a taxable account. Yes, you will pay a 15% withholding tax on the dividends, but this may be recoverable, the capital gains are still taxed favourably, and you get the benefit of generating income in US dollars, which you can use for travel or making online purchases.