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
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
- Because of benefits in diversification without incurring lower returns most European and UK Investors choose to buy International Bond ETFs instead of only focusing on their home country/area Bonds to hedge the Equity portion of their portfolios
- Investors in International Bond ETFs are exposed to essentially three major currencies: USD, Japanese Yen and (for UK Investors) the EUR
Typical Country Allocation in International Government Bond ETFs
- 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
- 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
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
Over the long term Equity Portfolios shouldn't be hedged
EUROPEAN VIEW - Hedged vs Unhedged S&P 500 ETF Returns
- 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
- The same conclusions broadly hold for UK Investors investing in the US
US VIEW - Hedged vs Unhedged Developed Markets (ex-US ) 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
Overall Guidelines
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
Popular Guides
My fundamental reviews of Equity ETFs and Asset Allocation include:
- Investor Checklist - Ready to Invest? Have a look at the checklist before buying ETFs
- How to build a Long Term Portfolio for Financial Independence - Guide to creating a Smart & Simple Long Term Portfolios with ETFs
- All you need to know about International ETFs - including Developed vs Emerging Markets, Small vs Mid/Large Caps and country allocations with List of Best ETFs
- The Simplest Equity Portfolio - Comparison of Best Total World Equity Index Trackers
- How to pick the perfect ETF? - Investing in Europe is not quite the same experience as in the US but this guide will solve all your issues. Spoiler - don't use TER! (applies to US Investors as well)
- Which Assets do I need in my Portfolio? - Clean up your portfolio from assets you don't need. High Performance and low maintenance Asset Allocation Strategies
- How do I benefit from a market crash? - In the long run no crash (including Japanese style) can derail you if you do it right
- How to Invest for Short Term goals? - Medium Term Investing is more risky than long term portfolio - pay attention to the right asset classes
My fundamental reviews include:
- Spectacular Market Crashes - how much can you lose? How long will it take to recover? How to take advantage of the next recession
- What if my Broker goes Bust? How to choose a Broker that is safe
- What is the best rebalancing method? How to increase returns and reduce risk by rebalancing your portfolio
- What about currency risk? Should I hedge my Portfolio? - Hedge or not to hedge? Guide to hedging currency risk in your Equity and Bond ETFs
- Should you buy Gold? - Is it necessary to have an asset that generates no yield? What really drives Gold price?
- International and European Bond ETFS - For Long Term International Investors Bonds are key to protect their Equity Portfolios
- US Bond ETF Guide - Comprehensive Review of Blend Bond Funds, Treasuries, Corporates, High Yield, Inflation Linked, Muni ETFs
- Top 3 Corporate Bond ETFs - If you want to increase income buy these ETFs to invest alongside the FED [for US Investors only]
DISCLAIMER
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. Read the full disclaimer.
HAVE A QUESTION ABOUT INVESTING?
Drop it below or if you enjoyed my work and found it useful please do leave a comment or share it with someone that may benefit from it – I am grateful for your feedback
Note that this website is non-revenue generating. In addition to time I dedicate to this, I pay for hosting and software to provide you with the analysis
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
Great resource! Thanks so much
Just found out your blog. It is actually quite informative and refreshing . Loved it . I will be a regular here.
Does it make sense for investor with international equity portfolio to use international bonds ETFs when she cannot hedge to local currency (there are not such ETFs)?
Hi Natalia
That’s a tricky one indeed. I’d probably stick with a mix of local bonds and cash depending on level of interest rates in the country.
Raph
Thank you! In my country we have 10 yrs TIPS for individuals which pays 1% plus CPI, with capitalized interests and tax at the end so probably I will buy them. Guess that they will not hedge my international equities!
Hi Natalia – whether you would buy your local bonds or international bonds hedged to your currency would, conceptually, have broadly the same effect from a return perspective, as you can see from the Vanguard Research I mentioned here.
Please have a look at figure 7 that will help illustrate the concepts.
The key difference relates to diversification benefits (you have default risk of one (in this case – your) government vs. default risk of a number of developed countries.
Many thanks 🙂
Thank you for the amazing resource – you are answering my doubts and questions that many US-centric blogs ignore. I have a question about hedging from the European perspective: you write that the major fx risk is in the USD. But isn’t it beneficial to hedge when investing in World ETFs (esp. developing markets), given that there are other currencies involved?
Thanks, Anna – Hope all is well! Just to clarify, the main risk is USD because of the weight US Markets carry in the overall Equity markets. Of course, you do face other currency risks related to countries in the EM/DM ETFs. Is you buy an Emerging Market ETF, currency risk does come with it. It is useful to understand that flows into Emerging Markets go in hand with their performance because investors do need to buy the local currency to have exposure to those markets and hedging would remove part of the upside. The academic literature I came across… Read more »