How (and when) to hedge your investments? All you need to know about ETF Currency Risk

To hedge or not to hedge? Review of ETF Currency Risk

Key takeaways

  • If you live in Europe or UK investing in a globally diversified portfolio means you are getting significant exposure to foreign currency, typically USD since roughly half of World Equities are in the US
  • US Investors face ETF Currency Risk with International Equities
  • Changes in exchange rates between currencies will affect your returns
  • You have the option to buy Equity and Bond ETFs that have a currency hedge but it may not always be the best solution
  • The hedge is a form of insurance that cancels out the loss you experience from a falling overseas currency. Sadly, the contract also cancels any win you experience from rising overseas currencies too.
  • Your time horizon matters. Your vulnerability to exchange rate volatility increases if you need to sell your investments in the short run
  • You need to make a distinction between Equities and Bonds in your portfolio – both have very different goals
  • Don’t hedge Equities unless your time horizon is relatively short. Longer-term investors may potentially benefit from foreign currency exposure. However, academic research shows that exchange rate fluctuations have little impact on equity returns over very long time horizons 
  • Hedge Bonds. Bonds provide the portfolio stability that diversifies and counters equity volatility. To control portfolio risk, it is prudent to hedge the international Bond exposure of your portfolio since FX is responsible for most of International Bond Volatility

Currency Returns are a lottery in the short term

In the short term currency can have a major impact on returns

  • Given the major impact of currencies (FX) on portfolio returns it can be extremely  tempting to try to influence the returns by timing the exposure to a currency 
  • But remember, currency markets are among the largest, most efficient and competitive. Most investors have neither the speed nor any edge to outpeform in the long term
Difference in one year returns due only to currency for a UK Investor that bought a hedged vs unhedged S&P 500 ETF
ETF currency risk - S&P 500 in GBP - One-year trailing annualized return difference between hedged and unhedged ETF UK Investors Bogleheads
Illustrative difference in GBP denominated SPTR Index returns. Source: Bankerowheels.com

Adopt a currency risk position that aligns with your goals

  • Your time horizon matters. Exchange rate fluctuations can be violent – as the Brexit vote aftermath has shown 
  • In the short run you may consider hedging ETF Currency Risk for both Equities and Bonds depending on your risk tolerance
  • The rest of this guide focuses on long term impact
  • In the long run your risk tolerance will determine the Bond/Equity allocation and with it the need for Hedging

How to build a Long Term Portfolio?

I have created a model portfolio for Long Term Investors. While this takes a view of a US Investor the same asset allocation applies for European or UK Investors

Bond ETFs should be hedged

Most European and UK Investors will get exposure to International Government Bonds

Typical Country Allocation in International Government Bond ETFs
BND UCITS equivalent for European and Uk Investors
FTSE World Government Bond Index. Source: FTSE, Bankeronwheels.com
  • When international bonds are left unhedged in a portfolio the volatility of the currency can offset the diversification benefits 
  • For European Investors hedging significantly reduces the volatility of International Bonds – look at the smooth red line representing a Hedged ETF vs. the volatile orange unhedged ETF
  • I have added an FX Index which is mostly tied to USD and JPY for European Investors and explains most of the difference between hedged un unhedged returns
European Investors - Hedged vs Unhedged International Bond ETF Returns
ETF currency risk - FTSE world government bond developed countries index hedged vs unheged EUR - european index investors bogleheads
Hedged vs Unhedged FTSE World Government Bond Developed Countries Index Total Returns in EUR. FX was estimated based on current country breakdown of non-EUR Bonds. Source: Bankerowheels.com
  • The same conclusions hold for UK Investors
  • I have added an FX Index which is tied to USD JPY and EUR for UK Investors 
  • Given the recent volatility of GBP given Brexit/COVID-19 Risks hedging makes even more sense 
  • If you wonder why UK investors enjoyed a better return than European Investors it’s because UK Interest Rates were generally higher – hedging will make the return similar to your local Bonds
UK Investors - Hedged vs Unhedged International Bond ETF Returns
ETF currency risk - FTSE world government bond developed countries index hedged vs unheged GBP - UK index investors bogleheads
Hedged vs Unhedged FTSE World Government Bond Developed Countries Index Total Returns in GBP. FX was estimated based on current country breakdown of non-UK Bonds. Tracking error and fees may affect results. Source: Bankerowheels.com

How to choose a European or International Bond ETF?

I have complied a list of recommended Bond ETFs which will help you decide whether to opt for your country Bond ETF or an International Bond ETF. You will also understand the difference between Blend Bond ETFs vs Government ETFs

Equity ETF should most likely be unhedged

  • As an investor in International Equity ETFs you will be mainly exposed to the USD (for US Investors it will be the JPY and EUR)
  • FX is not an income producing asset – it adds no value. Vanguard research demonstrates that the effect of currencies in the long run (20+ years) is marginal 
  • In the short / medium term currencies can add or remove volatility and this may change over time (and makes it very tricky to predict)
  • Currency hedging in an International ETF has costs – Hedging often involves derivative instruments which all have bid–ask spreads driven by short-term market conditions, other transaction costs, and additional operational risks. Many currency-hedged ETFs are 0.1% to 0.3% more expensive per year than their unhedged counterparts
  • Even if you choose a currency hedged ETF some currency risk can’t be hedged away –  quoted companies have international revenue streams (think Apple, Google or Tesla) in any case and are already exposed to currency risks by the way of doing their business

For European and UK Investors with Global Portfolios USD is the major FX Risk

Typical Global Portfolio Allocation
best international ETFs - emerging vs developed markets
Source: MSCI - MSCI All Country World Index by Country, Bankeronwheels.com

Over the long term Equity Portfolios shouldn't be hedged

EUROPEAN VIEW - Hedged vs Unhedged S&P 500 ETF Returns

ETF currency risk - S&P 500 hedged vs unhedged returns for European Index Investors in EUR ETFs bogleheads
Hedged vs Unhedged SPTR Index in EUR. Tracking error and fees may affect results. Source: Bankerowheels.com
  • While past performance does not guarantee similar future returns hedging the USD would have had counterproductive effects in the past
  • Unhedged returns were substantially higher – a 100 EUR portfolio in S&P 500 would have grown to c. 430 EUR in over 15 years if left unhedged vs. 250 EUR hedged
  • USD exposure was ‘part of the game’ when allocating your savings to US Equities

UK VIEW - Hedged vs Unhedged S&P 500 ETF Returns

ETF currency risk - S&P 500 hedged vs unhedged returns for UK Index Investors in GBP ETFs bogleheads
Hedged vs Unhedged SPTR Index in GBP. Tracking error and fees may affect results. Source: Bankerowheels.com
  • The same conclusions broadly hold for UK Investors investing in the US

US VIEW - Hedged vs Unhedged Developed Markets (ex-US ) Returns

ETF currency risk - us investor perspective MSCI EAFE hedged and unhedged returns
MSCI EAFE Hedged and Unhedged Net Total Returns.
  • As you may have expected the US Investors were worse off leaving their International Exposures unhedged during the recent periods
  • However, a study by Brandes Institute concludes that hedging have been detrimental for US Investors over the long run. Data covering a period of floating exchange rates (1973-2006) showed that hedging programs have been costing US Investors 1.8% annually
  • This is even more important for Emerging Markets where currency hedging could be detrimental. According to GMO (see exhibit 3) hedging Emerging Markets Currency Risk would have been a “spectacularly bad idea for the period 1995-2015″ 
  • We should also not forget that US investors have unique circumstances since the USD represents approximately 50% of all equity and fixed income issuance, and depending on the strategic asset allocation, a majority of a U.S. investor’s exposure may already be held in one currency and diversification benefits are to be considered
  • In conclusion, in the long run currency effect will become insignificant. Based on research, foreign currencies added to volatility but to a marginal degree over the long term

How to choose an International Equity ETF?

I have listed recommended unhedged International Equity ETFs from the perspectives of US, European and UK Investors. The guide also gives you insights on benchmarks that these ETFs track, how to break down your investments of Developed vs Emerging countries and how to make sense of sometimes confusing naming conventions 

USD still benefits from 'Flight to safety'

The USD provided European and UK Investors a natural 'hedge' during COVID-19 Sell-Off and 2008 Global Financial Crisis

  • The correlation between USD and S&P 500 was not stable from the perspective of European and UK Investors
  • Flight to quality meant that during sell-offs the EUR/GBP losses related to holding US Assets were lower
  • USD still benefits from flight to quality advantage which based on historical trends is another reason supporting keeping your US Assets unhedged
  • Below is a chart that illustrates this trend (it looks back 3 years) – remember that 2011 was the peak of European Debt Crisis

Stronger USD protected International Investors holding US Assets during market stress

36-months trailing correlations of S&P 500 and USD vs EUR/GBP
ETF currency risk - S&P 500 and EUR GBP correlation - ETFs European and UK Index Investors - Bogleheads
Three year trailing correlations. Source: Bankerowheels.com

Overall Guidelines

currency fx hedging rules for international investors

Your time horizon matters – Your vulnerability to exchange rate volatility increases if you need to sell your investments in the short run and this is a key driver for your decision

In the Long run, the academic literature suggestion is to hedge Bonds and likely keep Equities unhedged

 

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All information found here, including any ideas, opinions, views, predictions, forecasts, commentaries or suggestions expressed or implied herein, are for informational, entertainment or educational purposes only. The information provided on Bankeronwheels.com is general in nature only and does not constitute personal financial advice

Before acting on any information contained on Bankeronwheels.com you should consider the appropriateness of the information having regard to your objectives, financial situation and needs, and seek professional advice where appropriate

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Stay safe & healthy, 

Raph

 

FAQ

If you live in Europe or UK investing in a globally diversified portfolio means you are getting significant exposure to foreign currency, typically USD since roughly half of World Equities are in the US
US Investors face ETF Currency Risk with International Equities

Academic literature does not confirm benefits of hedging in the long term. Don’t hedge Equities unless your time horizon is relatively short. Longer-term investors may potentially benefit from foreign currency exposure. Academic research shows that exchange rate fluctuations have little impact on equity returns over very long time horizons

Academic research advises to hedge Bonds. Bonds provide the portfolio stability that diversifies and counters equity volatility. To control portfolio risk, it is prudent to hedge the international Bond exposure of your portfolio since currency risk is responsible for most of International Bond Volatility

While this not guaranteed to occur in the future, the USD provided European and UK Investors a natural ‘hedge’ during COVID-19 Sell-Off and 2008 Global Financial Crisis. USD benefits from flight to quality advantage which based on historical trends is another reason supporting keeping your US Assets unhedged

Yes, Your time horizon matters – Your vulnerability to exchange rate volatility increases if you need to sell your investments in the short run and this is a key driver for your decision
In the Long run, the academic literature suggestion is to hedge Bonds and likely keep Equities unhedged

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Johan
Johan
3 months ago

Great resource! Thanks so much

Ashish
Ashish
3 months ago

Just found out your blog. It is actually quite informative and refreshing . Loved it . I will be a regular here.