3. Currency conversion: the cost that never shows up as a cost

Costs 1: What you pay and can see

Of all the costs in this level, this is the only one that manages to be billed and invisible at the same time. It does not appear on a line that says 'commission'. It appears inside the exchange rate you are given, which is a perfectly legitimate number that nobody argues with because almost nobody knows what the correct number was. And it touches practically any modern portfolio, because buying American, Japanese or Swiss shares means going through it.

Where the cost hides

When you buy a share quoted in dollars, somebody has to convert your euros. That conversion has a reference price, the mid-market rate (the midpoint between what is bid and what is offered in the wholesale currency market), and you do not deal at that price: you deal at a rate shifted at your expense. The difference between the mid rate and the rate you are given is the exchange margin, and that is where the whole commission lives.

The ranges you see out there are enormous. A traditional institution may apply margins somewhere between 0.5% and 1.5%, while brokers that specialize in currency operate in the region of 0.02% to 0.25%. That is a difference of up to fifty times on the same service, and a large part of why it survives is that the client never sees the reference price.

The round-trip sum, with numbers

Suppose a mid-market rate of 1.0800 dollars per euro and a margin of 0.50% applied by your broker. You are going to invest 10,000 euros in American shares.

• At the mid rate, your 10,000 euros would be 10,800 dollars.
• With 0.50% against you, you receive 10,800 x 0.995 = 10,746 dollars. You have left 54 dollars, some 50 euros, in the conversion on the way in.
• Three years pass and the position is worth 12,000 dollars. Time to unwind it and come back to euros.
• At the mid rate, 12,000 dollars would be 11,111 euros. With the same 0.50% against you, you receive 11,056 euros. Another 55 euros left behind along the way.
• Total cost of the round trip: some 105 euros, 1.05% of the initial capital.

Set that against what it would have cost you on a margin of 0.10%: some 21 euros. The difference is 84 euros on a single trade, and neither of those two amounts will ever appear on a statement beside the word commission.

The distinction almost everybody muddles

Two things with similar names and nothing in common have to be kept carefully apart here:

• Currency risk is that the euro and the dollar move while you hold the position. It can go in your favor or against you, and over the long run its expected contribution to return is roughly nil: it is uncertainty, not cost.
• The exchange margin is a certain deduction, known in advance and always in the same direction. It has no good side.

The confusion is expensive because the noise buries the signal. The euro against the dollar moves 8% or 10% in a year without breaking sweat; next to that, a margin of 0.5% looks like dust. But the movement is random and the margin accumulates: twenty round trips over an investing lifetime add up to 20% of certain deduction, while the exchange rate will still be wherever it pleases. One is a coin toss; the other is a bill.

The drips: dividends, balances and automatic conversions

The margin on the big trade can be seen coming. What almost nobody audits is the small, repeated conversions, and that is where the minimums we met in the previous module turn up again.

Imagine your broker automatically converts into euros every dollar dividend you receive, and applies on top of that a minimum conversion fee of 2 euros. A gross dividend of 100 dollars is worth some 93 euros. The 0.5% margin would have been half a dollar; the minimum charges you 2 euros, which is 2.2% of that dividend. With twelve payments a year, that is 24 euros a year evaporating in conversions you never asked for.

Out of that comes a short list of concrete checks:

• Find out whether your account is multi-currency or auto-converting. Being able to hold a dollar balance saves converting twice when you reinvest in the same market.
• Check whether there is a minimum fee per conversion. If there is, batching conversions stops being a quirk and becomes arithmetic.
• Compare the rate you were given against the mid rate for the day. It is the only way to know what you were charged, because nobody is going to tell you.

Two legitimate ways of not paying it yourself

Two routes deserve a mention of their own. The first: buying the same market through a fund or ETF domiciled in Europe and quoted in euros. Be careful about what that does and what it does not. It does not remove currency risk: if the fund owns American shares, your outcome still depends on the dollar. What it does avoid is you paying a retail margin, because the vehicle does its converting wholesale, at margins that are not remotely comparable. You are swapping an expensive cost for a cheap one, not removing an exposure.

The second: currency-hedged share classes, which genuinely do set out to neutralize the movement of the exchange rate. They are not free either. On top of the expense of running the hedge, which usually adds between one and three tenths of a point a year, the dominant cost is the interest rate differential between the two currencies, which can run to several percentage points a year when the central banks are out of step. Hedging is not 'removing the risk': it is trading an uncertainty for a known cost, and the decision has to be made looking at that price.

And one last case, everyday and highly instructive: when you pay by card abroad and the terminal kindly offers to charge you in euros. That service applies a margin of its own, frequently far above your bank's. It is exactly the same mechanism as your broker's: whoever chooses the exchange rate chooses your commission.