What Are Currency Hedged ETFs?
Currency-hedged ETFs are exchange-traded funds created to minimize the risks of fluctuating exchange rates in ETFs that have foreign holdings.
Many investment companies offer two versions of the same ETF with one version including a currency hedge. The latter ETF has the same holdings as the former, but it also includes derivatives purchased to protect–or hedge–against currency risk. The protections come at a cost, however, and hedged ETFs may have higher fees than non-hedged ETFs.
Recommended: ETF Trading 101: How Exchange Traded Funds Work
Why Do Investors Use Currency-Hedged ETFs?
Since currency values fluctuate, exchange rates can affect the total return on an asset. While ETFs provide investors with a significant diversification, they don’t offer any protection against the investment risk created by foreign exchange rates. So purchasing an ETF focused on overseas markets creates an additional layer of volatility within the investment.
Currency shifts can boost or diminish returns on international investments — but they almost always make them more uncertain. If the local currency loses value against the ETF’s currency (in this case the dollar), that can offset returns for the dollar-based investor, even if the assets that make up the security’s returns go up in their own currency.
Since many ETF investors are not interested in forex trading, they can minimize their currency risk by purchasing a currency-hedged ETF, which can smooth out volatility related to foreign exchange rates.
Currency-hedged ETFs may have a slightly higher expense ratio than non-hedged ETFs, due to the cost of the futures contracts as well as potential expenses associated with the tools and people who develop the hedged currency strategy.
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How Do Exchange Rates Impact Investment Returns?
While a strong dollar may be good when you’re buying assets in a foreign currency, it can hurt returns on assets denominated in a foreign currency. Over the past decade, the strong dollar has meant that hedged portfolios tend to outperform those that weren’t hedged.
Here’s an example: If the dollar-to-foreign-currency conversion rate is 1 to 2, as in one dollar buys you two units of the foreign currency, and you buy 100 shares of a stock at 5 foreign currency units per share, it will cost you $250, or 500 foreign currency units. Now, let’s say those shares double, so that 100 shares are worth 1,000 foreign currency units instead of 500 and your investment is now worth $500, compared to the $250 you spent initially.
But if the dollar strengthened so that the conversion rate went from 2 foreign currency units per dollar to 4 foreign currency units per dollar, those 100 shares are still worth 1,000 foreign currency units but for a US investor, their $250 investment would have shown no gain. While this is an extreme currency fluctuation, it illustrates the reason that some investors might purchase currency-hedged ETFs.
How Does Currency Hedging Work?
Investors use two methods to hedge against currency risk: static hedging and dynamic hedging.
Static Hedging
Static hedging is the most basic kind of hedging. An ETF that uses static hedging has one strategy that it executes, regardless of market conditions. An ETF using this strategy would buy contracts in the future market that lock in a currency’s value relative to the dollar or set parameters around it.
The contract is an agreement to buy a currency at a future price, which has the same effect of cancelling out currency gains or losses if they move from the currency’s current value against the dollar.
Dynamic Hedging
Dynamic hedging may incorporate multiple strategies or change strategies as market conditions change. Dynamic hedging is not always in effect, instead the hedge is “put on” based on the judgment of the ETF manager. Sometimes this judgment reflects an algorithm or series of rules that looks at market conditions for determining when to buy and sell financial instruments that hedge currency exposure.
For example, an ETF might have a rules-based system that looks at the trend of a currency’s value against the dollar, the interest rates in both countries, and the overall value of that currency (namely if it’s more expensive than the dollar). Those data points and, specifically, how they change over time, would determine whether and how much to hedge the ETF at any given time
The Takeaway
Currency-hedged ETFs are one way to get exposure to foreign markets and protection against the currency risks that come with that type of investment, but they may cost more than non-hedged ETFs. It’s important for investors to understand how they work, as they start to build their own investment strategy and learn how to pick ETFs to include (if any) in their portfolio.
If you’re ready to start putting that strategy into action, a great place to start is the SoFi Invest investing platform, which offers personalized investment advice, a range of ETFs, and automated investing.
Photo credit: iStock/Delmaine Donson
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