Hedged vs. Unhedged ETFs: Navigating Currency Fluctuations for New Investors

Investing in global sectors, industries, and companies such as Alphabet Inc. (Google), Eli Lily and Company, Apple Inc., or Nvidia Corporation offers more opportunities but it also means you could be exposed to currency fluctuations.

An investor contemplating investment in a global equity ASX ETF could encounter a non-currency-hedged and a currency-hedged designated ETF. We explain the differences and some pointers to consider.

What is a foreign exchange hedge?

Companies that have transactions in foreign currencies can eliminate or “hedge” the foreign exchange risk that the currency might move unfavourably against their home currency.

Simply put, currency hedging means an ASX ETF fund manager that purchases stocks in the US might want to shield investor returns from changes in currency exchange rates, focusing solely on the foreign stock market’s performance.

The ETF partners with a third party, like a bank, to use financial contracts to lock in the exchange rate.

The contracts typically lock in a pre-determined exchange rate at which the manager can buy or sell the foreign currency at a future date. This shifts or transfers the foreign exchange risk from ETF investors to the bank for the hedge but it does not completely remove the risk.

There is a cost to the ETF of setting up a hedge that adds to annual fees. Additionally, the ETF forgoes any upside if the movement in the exchange rate is favourable to it.

For newer investors, here is a ‘primer’ or summary of the difference when considering a choice of a non-currency hedged versus currency-hedged global ASX equity ETF.

Non-Currency Hedged Equity ETFs

  • Riding the Currency Waves: Your global ETF’s investment performance mirrors both the foreign stock market’s ups and downs and currency fluctuations.
  • A strong foreign market can be dampened by a weakening home currency, and vice versa. This can be exciting, potentially amplifying gains or magnifying losses.
  • Potential for Currency Boosts: If you believe the foreign currency will strengthen against your home currency, non-hedged ETFs can offer a bonus return on top of the stock market performance.
  • Lower Fees: Often cheaper than their hedged counterparts, as there is no additional cost for currency management.

Currency-Hedged Equity ETFs

  • Smoother Sailing, Less Volatility. The ETF partners with a third party, like a bank, to use derivatives (financial contracts) to lock in the exchange rate.
  • This shields your returns from the impact of currency fluctuations, focusing solely on the foreign stock market’s performance.
  • Predictable Performance: Hedging provides peace of mind by eliminating currency-driven ups and downs, offering a more stable investment experience.
  • Missed Currency Opportunities: If the foreign currency strengthens against your home currency, you miss out on that additional return.
  • Higher Expense Ratios: The cost of hedging adds to the expense ratio, resulting in slightly higher fees.

Risk Tolerance

If you can handle currency volatility, the potential upside of an unhedged ETF is tempting. But if stability and lower risk are your priority, hedged ETFs provide a smoother ride.

Market Outlook

If you are an experienced investor and able to forecast currency appreciation or depreciation you could align your choice with your expectations.

For the less experienced investor, predicting currency fluctuations is akin to a crystal ball and not for the faint of heart.

Investment Horizon

Advisors couch the choice of a currency-hedged or unhedged global ETF in these types of terms. Short-term investors might favour hedging to avoid short-term currency swings. Long-term investors often embrace unhedged options for potential currency tailwinds.

Diversification is key. Consider both types of ETFs in your portfolio that could spread your risk and capitalize on different market scenarios.

Remember

The information is educational only and should not be considered financial advice. Always consult a qualified financial advisor before making investment decisions.

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