Key takeaways
- Unhedged foreign funds combine asset returns with currency returns.
- A hedge rolls forward contracts; its cost reflects the interest-rate gap between currencies.
- Hedging can add or subtract carry depending on which rate is higher.
- It is more common for bonds than for long-horizon equity investing.
- Check the share class currency, charges and tracking, not just the word hedged.
When you buy a fund that holds foreign shares or bonds, you take two bets at once: one on the assets and one on the currency they are priced in. A currency-hedged ETF tries to cancel the second bet. Whether that is useful depends on what you hold, how long you hold it and what the hedge costs.
Two sources of return
Imagine you live where the home currency is the euro and buy a fund of overseas shares priced in another currency. Your result is the shares' return in their own currency, combined with how that currency moved against the euro. An 8% gain in the shares can turn into 2.6% if the foreign currency falls 5%, or into 13.4% if it rises 5%.
| Foreign shares return | Foreign currency vs home | Your unhedged result (approx.) |
|---|---|---|
| +8% | Falls 5% | +2.6% |
| +8% | Unchanged | +8.0% |
| +8% | Rises 5% | +13.4% |
| -10% | Falls 5% | -14.5% |
These figures are illustrative arithmetic: multiply the two growth factors together. They show that currency can add to a good year, subtract from it, or deepen a loss.
How the hedge works
A hedged ETF usually sells the foreign currency forward, using forward contracts, in an amount matching the fund's holdings. If the foreign currency falls, the loss on the holdings' currency value is offset by a gain on the forwards, and vice versa. Most funds renew the contracts every month.
The cost is an interest-rate gap, not a fixed fee
The price of a forward contract reflects the difference between interest rates in the two currencies. As a rough guide, a hedged investor earns about the local return plus the difference between home and foreign short-term interest rates, minus the fund's charges and trading costs.
- If home rates are lower than foreign rates, hedging tends to cost roughly that gap each year.
- If home rates are higher than foreign rates, hedging tends to add roughly that gap.
- If rates are similar, the carry is small and the main cost is the fund's own fee and trading.
An illustration: suppose short-term rates are 4% at home and 1% abroad. A hedge would tend to add about three points a year to the hedged result. Reverse the rates and it would tend to cost about three points. The gap is not free money; in theory currencies adjust to offset it over time, but in any single year that adjustment can go either way.
Illustrative only: shows the approximate sign and size of the interest-rate gap, before fund charges.
When hedging tends to help
- Bonds. Bond returns are modest and steady, so currency swings can dominate the result. Many investors in foreign government or corporate bonds hedge to keep the bond's behaviour.
- Shorter horizons. If you will need the money in a few years, a currency fall near the end could hurt you.
- Spending in the home currency. If your liabilities are in one currency, reducing the foreign exchange noise may suit you.
When it may not be worth it
- Long horizons in equities. Over decades, currency moves have tended to wash out, while the hedge carries costs and tracking differences all the way.
- Natural diversification. Foreign currencies sometimes rise when shares fall, so leaving them unhedged can cushion a bad equity year. That relationship is not reliable.
- High carry cost. When home rates are well below foreign rates, the drag can be significant.
Imperfections to know about
A hedged fund is not a perfect shield. Forwards are reset monthly, so in between, value changes cause a small mismatch. Large currency moves create gains or losses on the contracts that need cash or sales to settle. The fund's charge is typically higher than for the unhedged version. Tracking the hedged index may show a small residual difference.
Choosing between hedged and unhedged
A practical decision path
- Identify your currency exposure. Check the share class currency, the fund's base currency and the currencies of the assets inside.Tip: Many funds offer several share classes of the same strategy.
- Name the asset type. Hedging bonds is common. For equities the debate is open and horizon matters.
- Set your horizon. Short horizons make currency swings more decisive; long ones tend to dilute them.
- Check the cost. Compare the fund's charge, trading costs and the current interest-rate gap.
- Compare the tracking history. See how the hedged and unhedged versions behaved in turbulent years.
Frequently asked questions
Does hedging always cost money?
No. The carry can be positive or negative depending on interest rates, and fund charges and trading costs apply either way.
Is hedging the same as insurance?
Not really. Insurance pays out only in bad outcomes. A hedge removes both gains and losses from currency movements.
Can I hedge myself?
In principle, using currency forwards or futures, but for retail investors the contracts, margin and rolling make it complex. Hedged share classes do the work for you.