Hedged Vs Unhedged Etfs: Which Investment Option Is Better?

Exchange-traded funds (ETFs) are an effective way to diversify investments and gain exposure to overseas markets. However, international investing brings the risk of currency fluctuations, which can impact the value of investments and returns. Currency hedging can help mitigate this risk by reducing the effect of exchange rate fluctuations. A hedged ETF provides exposure to foreign equities while reducing exposure to exchange rate risk. On the other hand, an unhedged ETF is fully exposed to the potential for currency fluctuations. The decision to invest in a hedged or unhedged ETF depends on factors such as investment goals, risk tolerance, time horizon, and financial situation.

Currency hedging vs unhedging

Currency hedging is a strategy employed by exchange-traded funds (ETFs) to protect against currency fluctuations, which can impact the value of investments and returns. When investing in global ETFs, you are investing in the local currency of that market, such as the US dollar or Euro. This exposes investors to the risk of exchange rate fluctuations, which can affect the value of their investments.

A currency-hedged ETF seeks to mitigate this risk by locking in the exchange rate at a certain price, protecting investors from potential losses due to currency movements. On the other hand, an unhedged ETF is fully exposed to currency fluctuations and does not employ any strategies to offset this risk.

In a currency-hedged ETF, the ETF issuer converts the underlying assets from their home currency to the investor's local currency, locking in the exchange rate. For example, an Australian investor interested in investing in US assets would purchase a currency-hedged ETF that has converted the US dollar-denominated assets to Australian dollars. This protects the investor from losses if the Australian dollar strengthens against the US dollar, as the value of their foreign investments remains the same.

Additionally, currency-hedged ETFs hold currency forward contracts, which are essentially futures contracts on currencies. These contracts provide a payout if the exchange rate moves against the investor, further protecting them from currency fluctuations.

Who is currency hedging good for?

Currency hedging can be beneficial for investors who want to reduce the risk of currency fluctuations affecting their investments. It is a good option for those seeking smaller but steady returns without exposure to the additional risk of currency movements. It is also useful for investors who need a steady and stable income, such as those in retirement.

However, the downside of currency hedging is that investors cannot benefit from positive currency fluctuations. If the local currency depreciates against the foreign currency, the investor will not see a gain in the value of their investment due to the currency change.

Who is an unhedged ETF good for?

Unhedged ETFs are suitable for investors who are not relying on their investments to generate a steady income and are comfortable with the risk of currency fluctuations. These investors may be planning to hold their investments for the long term, as currency fluctuations tend to balance out over longer periods. Additionally, unhedged ETFs provide better protection against a fall in the local currency and tend to perform well during market corrections.

The decision to invest in a hedged or unhedged ETF depends on your investment goals, risk tolerance, time horizon, and financial situation. There is no one-size-fits-all answer, and both options have their advantages and disadvantages. It is essential to carefully consider your circumstances and, if necessary, seek professional advice before making any investment decisions.

Pros and cons of each

Pros and cons of hedged ETFs

A hedged ETF allows an investor to track the base performance of the index, sector, or asset class without worrying about currency fluctuations. For example, a Canadian investor could purchase a Canadian dollar-hedged ETF that focuses on US equities. The ETF will rise or fall based on the performance of the equity and/or bond holdings, and the investor will not be exposed to the risk of currency fluctuations.

The downside of a hedged ETF is that if the Canadian dollar declines relative to the US dollar, the investor will not benefit from this positive currency fluctuation. Hedged ETFs also have higher management fees to account for the additional costs of executing the hedging strategy.

Pros and cons of unhedged ETFs

An unhedged ETF is fully exposed to the potential for currency fluctuations. The benefit of this is that if the Canadian dollar depreciates against the US dollar, the investment will be worth more, as the investor will receive more Canadian dollars upon selling it.

The downside of an unhedged ETF is that if the Canadian dollar strengthens against the US dollar, the investment will be worth less, as the investor will receive fewer Canadian dollars upon selling.

Overall comparison

Hedged ETFs are a good option for those looking to generate smaller but steady returns, without exposure to additional risks caused by currency fluctuations. Unhedged ETFs, on the other hand, allow investors to benefit from positive currency fluctuations but carry the risk of negative currency price changes.

The decision to choose a hedged or unhedged ETF depends on the investor's goals, risk tolerance, time horizon, and overall financial situation.

How currency-hedged ETFs work

Currency-hedged ETFs are designed to protect investors from currency risk. They are a simple, cheap, and effective way for small investors to access currency management techniques that were once only available to major financial institutions. Currency risk negatively affects investors when their home currency strengthens against a foreign currency, reducing the value of their assets held in that foreign currency. Currency-hedged ETFs are useful because they remove the uncertainty of exchange rate fluctuations.

Currency-hedged ETFs and non-currency-hedged ETFs typically use the same asset allocation if they are issued by the same provider and track the same index or asset class. The key difference is that currency-hedged ETFs use forward exchange contracts to hedge against exchange rate fluctuations. The value of these forward exchange contracts corresponds to the value of the ETF's assets. If the home currency strengthens, reducing the value of foreign investments, the forward contracts should gain enough to offset those losses. Conversely, if the home currency weakens, the forward contracts will lose value and subtract from any currency gain.

Investors use two methods to hedge against currency risk: static hedging and dynamic hedging. Static hedging is the most basic form of hedging, where an ETF uses a single strategy regardless of market conditions. Dynamic hedging, on the other hand, may incorporate multiple strategies or change strategies as market conditions evolve. It is not always in effect and is typically activated based on the judgment of the ETF manager or an algorithm that analyses market conditions.

While currency-hedged ETFs offer protection against currency fluctuations, they also come with some trade-offs. Firstly, they may have slightly higher expense ratios than non-hedged ETFs due to the cost of futures contracts and other associated expenses. Secondly, no currency hedge is perfect, and there is always a slight mismatch between the estimated value of the ETF covered by the hedge and its actual market value. Finally, currency hedging involves timing risk, as the accuracy of the hedge depends on the frequency with which the forward contracts are renewed.

Hedged investments vs unhedged investments

Hedging is a strategy used by investors to reduce the impact of currency fluctuations on their investments. When investing in foreign companies, you are exposed to the risk of currency fluctuations, which can affect the value of your investment and returns. Currency hedging can help to mitigate this risk.

A hedged investment is one where the fund manager uses strategies to offset the impact of currency fluctuations. This is typically done by using currency forward contracts, which lock in the exchange rate at a certain price, protecting against currency movements. For example, if you are invested in US assets and the NZ dollar appreciates against the US dollar, your investment will be worth less when converted back to NZD. A hedged investment will protect against this loss by locking in the exchange rate.

On the other hand, an unhedged investment is fully exposed to the risk of currency fluctuations. The fund manager does not actively try to offset any gains or losses due to changes in currency values. This means that while you run the risk of your investment decreasing in value, you also have the potential to benefit from favourable currency movements. For example, if the NZ dollar depreciates against the US dollar, your investment will be worth more when converted back to NZD.

The decision to invest in a hedged or unhedged fund depends on your investment goals and risk tolerance. Hedged investments are generally a good option for those looking for steady, smaller returns without the additional risk of currency fluctuations. Unhedged investments may be more suitable for those who are not relying on their investments to generate a steady income and are willing to take on more risk for the potential of higher returns.

It is important to note that hedged investments also come with higher costs, as the frequent trading of currency forward contracts increases management costs and tax liabilities. Additionally, hedged investments may underperform unhedged investments if the currency movements are favourable. Therefore, it is crucial to consider your risk tolerance, investment time horizon, and the specific country you are investing in before deciding whether to invest in a hedged or unhedged fund.

Factors to consider when choosing

When deciding between a hedged or unhedged ETF, there are several factors to consider. Here are some key points to keep in mind:

Risk Tolerance

Hedged ETFs offer reduced risk by protecting against currency fluctuations. They are suitable for investors who want to avoid the additional risk associated with foreign currency exposure. In contrast, unhedged ETFs carry the risk of negative currency price changes but also offer the potential for gains if the currency fluctuations are favourable.

Investment Goals

If your goal is to generate smaller but steady returns without taking on too much risk, hedged ETFs might be preferable. On the other hand, if you are comfortable with the potential volatility and are seeking higher returns, an unhedged ETF could be more suitable.

Time Horizon

Consider your investment time horizon. If you are investing for the long term, currency fluctuations may balance out over time, reducing the need for hedging. However, if you are seeking stable returns in the short term, hedging may be more appropriate.

Country Risk

Evaluate the risk associated with the country you are investing in. If you are investing in a country with a volatile currency or a high inflation rate, hedging may be a prudent choice to protect your investment.

Cost Considerations

Hedged ETFs typically have higher management fees and indirect costs due to the implementation of the hedging strategy. These additional costs can impact the overall returns of the ETF.

Personal Circumstances

Take into account your personal financial situation, risk tolerance, and investment goals. Consult with a financial advisor to determine which option aligns best with your specific circumstances.

Ultimately, the decision to choose a hedged or unhedged ETF depends on a combination of these factors. There is no one-size-fits-all answer, and it's important to carefully evaluate your options before making an investment decision.

Frequently asked questions