Currency risk: hedged or unhedged ETF?
If you invest in a global fund from euros (or pounds, or any non-dollar currency), much of your money is in other currencies, mainly dollars. Even if the fund trades in your currency, the exchange rate affects your return. Hedged ETFs remove most of that effect at a cost. Is it worth it?
- The ETF's trading currency does not matter: what matters is the currency of the assets it holds.
- A world index typically has around two thirds in US dollars.
- If the dollar falls against your currency, your return drops, and vice versa.
- Hedging costs roughly the interest rate differential between the two currencies.
- For long-term equities, investors usually do not hedge; for foreign bonds, hedging is the norm.
Where the risk comes from
An MSCI World ETF trading in euros still owns shares priced in dollars, yen or pounds. If US shares rise 10% in dollars but the dollar falls 10% against the euro, your gain in euros is roughly zero.
The trading currency only determines the currency in which you see the price; the currency risk comes from the assets inside.
An example
You invest €10,000 in a global fund with 70% in dollars. In one year, the shares rise 8% in their own currencies and the dollar falls 10% against the euro:
What hedging costs
A hedged ETF uses forward contracts to lock in the exchange rate each month. Its approximate cost is the difference between the interest rates of the two currencies: if dollar rates are above your currency's, hedging costs you; if below, it can even add a little.
Hedged ETFs also tend to have a slightly higher TER and fewer, smaller share classes.
Equities: usually unhedged
Over long horizons, currency effects on equities tend to even out, and many global companies already earn revenue in several currencies. The dollar also tends to strengthen in crises, which cushions the fall of an unhedged portfolio held in euros.
That is why, for long-term equity holdings, investors usually do not hedge: lower cost and more diversification.
Bonds: usually hedged
Bonds are different. Their return is low and stable, and currency swings can exceed the bond's own return. An unhedged global bond fund behaves almost like a currency bet.
If you want foreign bonds to stabilise your portfolio, the version hedged to your currency is the usual choice. See bonds and Treasury bills.
Frequently asked questions
What is a currency-hedged ETF?
An ETF that uses derivatives to neutralise the exchange rate effect between the currency of its assets and the currency of the share class.
Does the dollar affect me if my ETF trades in euros?
Yes. What matters is the currency of the shares inside the fund, not the currency it trades in.
How much does currency hedging cost?
Roughly the interest rate difference between the two currencies, plus a slightly higher TER in many cases.
Should I hedge my global index fund?
For long-term equities, investors usually do not. For foreign bonds or short horizons, hedging makes more sense.