What does it mean to hedge currency?
Investing in international equities on an unhedged basis involves taking on additional exposure in the form of foreign currency and exchange rate movements.
Exchange rate movements can negatively or positively impact your returns.
Currency hedging your investments is a way to limit this impact.
How to hedge currency risk
Currency hedged ETFs are designed to hedge currency risk. The ETF issuer typically does this by entering forward foreign exchange contracts (or similar instruments) with a third party, enabling the buyer to set an exchange rate at a certain price for a certain period.
This means that when there is a loss in the value of the underlying ETF holdings that is attributable to currency movements, the forward contract is expected to provide an offsetting gain, and vice versa.
What is the difference between hedged and unhedged ETFs?
The objective of hedging is to minimise the influence of currency movements on your investment returns, which should instead be determined primarily by movements in the value of the underlying investment.
Investing in an unhedged international ETF means your investments will be affected by changes in the value of the Australian dollar. Investing in a hedged international ETF seeks to minimise the impact of these currency fluctuations.
For example, the HNDQ Nasdaq 100 Currency Hedged ETF obtains its investment exposure by investing in the NDQ Nasdaq 100 ETF , with the foreign currency exposure hedged back to AUD.
When the AUD is rising in value against foreign currency, a hedged ETF would be expected to outperform an unhedged ETF with the same underlying investment exposure. Conversely, when the AUD is falling, the unhedged ETF would be expected to outperform the hedged ETF.
What sort of investors might consider a currency-hedged ETF?
What factors can affect currency movements?
- Differences in interest rates
- One country’s higher interest rate may attract flows of money from other countries, in turn strengthening the home currency
- A country’s current account deficit
- A country spending more of its currency on importing products than what it receives from its exports may tend to face a declining currency
- Government debt
- A country with high levels of debt is likely to see its currency decline as foreign investors look to sell their bonds in the open market
- Political stability
- A country with more stability is seen as less risky for foreign investors, which entices capital away from other countries. This will potentially increase a ‘stable’ country’s exchange rate.
