Educational Piece: Using Currency Hedging with International ETFs

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“Hi Jed, I love your emails and the effort you put into them. I would love some clarity and explanations on currency hedging and the pluses and minuses of buying hedged or unhedged ETFs.” - Warwick 

Currency hedging is a financial strategy used to protect against fluctuations in foreign exchange rates. 

• Imagine if you're an Australian investor holding an Exchange Traded Fund (ETF) that represents the companies in the US S&P 500 index. 

• Let’s say that the Australian dollar strengthens against the US dollar. 

• Even if the value of the company remains the same, when you convert your investment back to Australian dollars, you'd receive less money because the currency conversion has devalued the US dollar. 

Hedging strategies can minimise this currency risk when dealing with ETFs and other products. 

Broadly speaking, there are two types of international ETFs:

• Hedged ETFs make use of various financial instruments (like futures or options) to offset potential losses from currency movements. 

  • The goal here is to remove the impact of foreign exchange movements, so that the ETFs’ return is driven purely by the performance of the underlying assets.

  • As an investor in an ETF, you don’t have to do anything to ‘make this happen’ - it’s all handled within the ETF itself. 

• Unhedged ETFs, on the other hand, do not employ such measures. 

  • As such, they expose investors to both the performance of the underlying assets and foreign exchange rate movements.

  • Of course, this could have beneficial results. If the US dollar outperforms the Australian dollar, that could juice your returns. 

So, which is better? 

It largely depends on your outlook on the currencies involved and your risk tolerance. 

Let's unpack this by examples and delve into the advantages and drawbacks of both.

Case Study: 

For instance, let's consider the BetaShares NASDAQ 100 ETF. This allows Australian investors to track the performance of the one hundred biggest companies in the US NASDAQ index. It comes in two flavours:

1. NDQ (unhedged)

2. HNDQ (hedged)

Chart shows Betashares NASDAQ 100 ETF - NDQ (unhedged, in blue) and HNDQ (hedged, in orange).

Advantages of Hedged ETFs:

• Hedged ETFs can protect you against adverse currency movements. This can stabilise your returns.

• They're useful for investors who want to isolate the performance of the underlying assets from any currency risk. 

• If you believe that the Australian dollar will appreciate against the US dollar, a hedged ETF could be beneficial.

Disadvantages of Hedged ETFs:

• Hedging isn't free. The costs involved in maintaining hedging strategies can reduce your returns.

• If the Australian dollar depreciates against the foreign currency, hedging could limit your gains.

Advantages of Unhedged ETFs:

• Unhedged ETFs, like NDQ, offer a potential upside if the Australian dollar depreciates against the foreign currency. In short: your investment value would increase when converted back to AUD.

• They're typically less costly than hedged ETFs due to the absence of hedging-related expenses.

Disadvantages of Unhedged ETFs:

• Unhedged ETFs expose you to currency risk. 

• If the Australian dollar strengthens against the foreign currency, it can diminish your investment value.

• Currency fluctuations can introduce more volatility to your returns.

Something to consider:

If you’re investing in an international ETF, chances are it might be part of a portfolio that also includes Australian ETFs. Let’s say you’ve got a 50/50 split between Australian and International ETFs.

In this case, one school of thought would suggest that an unhedged ETF is the best option:

• If currency fluctuations hurt your international ETF, you can ‘ride it out’ by drawing from the Australian ETF if you need to cash out (which would probably be aided by the strengthening Australian dollar). 

• By eliminating hedging, you eliminate extra fees, allowing for better long-term returns.

Overall, the choice between hedged and unhedged ETFs will depend on your personal investment goals, your views on future currency movements, and your tolerance for risk.