Cut the cost of investing in foreign shares

Many investors are missing out on opportunities to profit by shunning foreign shares. Here's what you need to know about investing abroad.

While most investors have traded UK stocks online, many still think that buying foreign shares is much more difficult and expensive. Brokers are partly to blame, as they are often bad at explaining exactly what they do and are fond of piling on unnecessary costs.

But if you pick the right firm, international trading is just as easy as buying British shares and only slightly more costly.

In general, headline costs for trading international stocks are in line with UK dealing costs. Trading commissions may be a bit higher, ranging from £5-£20, but there are rarely any extra account or handling fees.

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You can't usually use discounted rates for reinvesting dividends or regular investments, but other than that, the process of buying a foreign stock is fairly similar.

However, there is one big catch: what you pay to convert sterling into foreign currency when you settle the trade.

How you are charged

To see why, you need to grasp two key points about how brokers manage international trades. The first is the way in which the trades are made.

Your broker may trade directly in the foreign market, via an overseas branch or a partner broker. Alternatively, they may buy through a British-based market-maker that deals in foreign shares.

The second is how you pay for the trade. If your broker deals directly, they may follow one of two approaches. One is to allow you to hold foreign currency in your account and settle the trade that way, or they may convert the price to sterling and make you settle in sterling.

If your broker uses a market-maker, the market-maker will quote a sterling price and you will settle in sterling.

These may sound like technical points, but they are crucial to understanding how much your broker is charging you. A number of brokers take advantage of investors' naivety to levy an excessive hidden charge that makes international trading far more expensive than it looks.

Understanding forex fees

When you turn sterling into foreign currency, you never pay the rate at which major institutions deal with each other (the interbank rate). You always pay a mark-up the only question is how much.

Where a broker allows you to convert sterling to foreign currency and hold it in your account, this charge is very clear. It varies hugely, from slightly above interbank rate at Interactive Brokers, to as much as 2% at TD Direct Investing, depending on trade size.

For brokers who automatically convert to sterling, the rate may be less apparent, but 1%-1.5% is typical.

When brokers use a market-maker, it gets more confusing. When the market-maker quotes a sterling price, it builds in some margin for itself.

One broker reckons this typically ranges from about 0.5% for trades under £10,000 to around 0.1% for those above £150,000. But some brokers have an arrangement whereby the market-maker increases the margin they charge, then rebates a proportion to the broker. This can substantially raise the forex mark-up paid by the end investor.

For example, with Hargreaves Lansdown, the forex fee may be up to 1.7%, depending on trade size, while for Selftrade it's up to 1.25%.

Forex commissions are often not clearly disclosed, yet they can have a huge impact on the total cost of trading.

Imagine you are buying £1,000 of foreign shares from a firm that charges £10 per trade and a 1.5% forex commission. The impact of the forex charge is greater than the trading commission, with your total cost of trading being £25, or 2.5% of the amount you're investing.

So scrutinise foreign dealing costs closely and find firms with low overall costs, not just low advertised commissions.

Choosing an international broker

Of course, costs only matter when the broker can buy the shares you want and access varies greatly from broker to broker. In general, brokers who use the market-maker system can access major US, Canadian and European stocks online. Some may also offer telephone trading in other markets, but it will be more expensive.

Those who invest directly may offer online trading in other parts of the world. Yet they may exclude certain smaller markets that would be covered by a market-maker-based service, because demand is too low to be cost-effective.

This makes choosing a broker largely about the trade-offs you are willing to make. It is often best to have two complementary accounts instead of looking for one to meet all your needs.

Just as with British stocks, there is no single broker who suits every investor's requirements. But the number of firms with a serious foreign-dealing service is more limited and many look increasingly uncompetitive, so it's easier to compile a shortlist.

At present, Sippdeal and iDealing seem to be among the cheapest firms that trade through market-makers (despite its name, Sippdeal offers regular accounts and Isas as well as Sipps).

Saxo Bank offers access to the widest range of markets, while Interactive Brokers is very cheap for active traders. iWeb has a relatively high forex fee, but its low trading commission could still make it a reasonable choice for small trades.