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How Currency-Hedged ETFs Work

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How Currency-Hedged ETFs Work

Author: Greg McFarlane
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How Currency-Hedged ETFs Work
Cultura/Stefano Gilera / Getty Images

Fact checked by Timothy LiReviewed by Charles Potters

When you invest in foreign companies, not only are you betting on the success of that asset, but you’re also making a bet about the fluctuations of the foreign currency market. A currency-hedged ETF is an exchange-traded fund that tracks the values of overseas securities, without exposing the investors to excess currency risk. It does this by holding forward contracts for the base currency as part of its portfolio, which gives a payoff if the currency price increases.

Key Takeaways

  • A currency-hedged ETF provides exposure to foreign equities while reducing exposure to exchange rate risk.
  • Currency-hedged ETFs work by holding currency-forward contracts that provide a payout if the exchange rate moves against the investor.
  • Currency-hedged ETFs may be a good investment in countries that are susceptible to high inflation, or even hyperinflation.

Foreign Exchange, Domestic Dealings

Take BlackRock’s (BLK) iShares, which assembles and maintains over 800 ETFs; one of the largest rosters in the industry. Those funds include several currency-hedged ones, each denominated in a particular currency (or basket) and packaged to American investors, or at least to investors who normally transact in U.S. dollars.

But why would an investor hedge ETF investments? Aren’t ETFs broad enough to avoid uniformity in the first place? ETFs offer diversification, but a standard ETF that invests in foreign markets won’t do a thing to protect you against currency fluctuations.

Currency-hedged ETFs protect you against exchange rate hits. Or, if you’re a glass-half-full kind of person, help you take advantage of potential gains in other currencies vis-à-vis the U.S. dollar. A strong dollar can hurt your international exposure, as it takes correspondingly more Swiss francs or Norwegian kroner to equal the purchasing power of a greenback.

Never Worry About Hyperinflation Again

The concept is simple. In some cases, a currency-hedged ETF can be nothing more than an existing ETF—same components, same proportions, same expense ratio—but denominated in something other than U.S. dollars.

The fundamental difference is that the currency-hedged ETF contains positions in currency forwards, which are essentially futures contracts on currencies. Forwards allow you to lock in the price of a currency today, regardless of eventual fluctuations. Currency forwards don’t fit the strict definition of futures contracts, because they don’t trade on exchanges.

Hedge a Little or a Lot

Generalizing, currency-hedged ETFs come in two varieties: single-currency and multiple-currency. Single-currency-hedged ETFs are the more common of the two.

Take iShares’ MSCI Japan ETF (EWJ), for instance. The unhedged ETF had a one-year return of 24.31% as of March 31, 2024, while the hedged version of the fund returned 48.37%. Not coincidentally, the U.S. dollar gained 9.8% versus the yen over approximately the same period.

In retrospect, if you had to buy one or the other, the hedged fund seems like the obvious choice; the yen depreciated significantly in 2023.

Important

Make sure to pay attention to the expense ratio of ETFs, which is the cost you’re paying to invest in them. Expense ratios reduce your returns so it’s important to take them into consideration when comparing ETFs.

If one firm’s yen-denominated hedged ETF outpaces its non-hedged counterpart, it’s reasonable to assume that other yen-denominated ETFs will, too. Take WisdomTree Investment’s Japan-hedged equity fund (DXJ).

Its holdings as of Dec. 31, 2023, are your standard Japanese multinationals: Toyota, Mitsubishi UFJ Financial, Mizuho, and Nintendo, for example. In 2023, the fund’s net asset value (NAV) increased 35.6%. If you’d invested in a non-hedged fund of a similar constitution, your returns would be less due to the drop in the yen’s value in 2023.

As for multiple-currency-hedging ETFs, in practice, they focus either on a particular region (e.g. Europe, emerging markets), or a certain size of the company (e.g. small-cap). Should the involved currencies fall enough against the U.S. dollar, the composition of the funds becomes less important.

In fact, if the appropriate currencies are in play, a small-cap non-hedged ETF assembled by an adept manager can end up being worth considerably less to your portfolio than a currency-hedged ETF of ordinary composition.

How Many Currency-Hedged ETFs Are There?

There are 29 currency-hedged equities ETFs traded in the U.S. as listed on VettaVi’s ETF Database as of April 5, 2024. The individual assets managed by these funds range from $6.4 billion to $10 million.

Are Currency-Hedged ETFs a Good Investment?

The effectiveness of currency-hedged ETFs may vary, depending on global economic conditions and exchange rate fluctuations. According to Morningstar, the costs of holding trading currency-forward contracts can reduce the tax efficiency of these ETFs. They also have higher management fees to account for the additional costs of executing the hedging strategy.

What Are the Drawbacks of Currency-Hedged ETFs?

Currency-hedged ETFs reduce their exposure to exchange rate risk by investing in currency forward contracts, in addition to the usual basket of foreign securities. These contracts must be traded frequently, increasing the management costs and tax liabilities of the fund.

The Bottom Line

You’re not going to get rich off predicting movements between and among currencies. Well, you could, but you’d have to start with an awfully large leveraged bankroll. On the other hand, if you are looking at currency-hedged ETFs as a way to stave off real-dollar losses, you have plenty of options.

With more such ETFs available to the individual investor, and firms thus forced to compete on price, there’s never been a better time to not only expose yourself to international markets but reduce price movement risks while doing so.

Read the original article on Investopedia.

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