If you’re thinking about investing into exchange traded funds, or ETFs, then you might not realize there are two choices for you to consider: hedged ETFs and unhedged ETFs.
ETFs are a way for some investors to diversify their portfolio. It’s a way to get some exposure to foreign markets without dealing with the other hassles that typically come when investing internationally.
Although currency fluctuations are always part of the equation and mostly unavoidable, currency hedging is a way to reduce the effect of fluctuations with the exchange rate. Choosing funds that use hedging will protect against currency downsides, but it also comes at the risk of not benefitting from a currency upside.
Unhedged ETFs do not provide this type of protection. That means your portfolio gains from beneficial currency changes while carrying the risk of a steeper downside from detrimental currency changes.
How do you decide which option is best for your needs?
What Are Hedged Investments?
Your fund manager will use a strategy to offset the impact of currency fluctuations to maintain the overall value of the investment. The goal with a hedged ETF is to have your value be shifted by the changes in the equity you’ve purchased for your portfolio only.
A hedged investment is a good option for investors who are wanting to generate steady returns without high levels of risk. Although the returns for hedged ETFs are typically smaller, there is a better guarantee that you’ll get something.
When a foreign currency is appreciated in value against your domestic currency, hedged ETFs will usually outperform unhedged ETFs.
That means a hedged investment is often a matter of timing. One might compare it to the chance to lock-in a fixed-rate for a home loan at a very low percentage. If you invest during times of abnormal extremes, then the hedged ETF gives you some protection against future fluctuations that could be harmful to your overall investment.
What Are Unhedged Investments?
With an unhedged investment, you are fully exposed as an investor to currency fluctuations at all times. The fund manager will not actively attempt to offset any changes that are caused by currency value shifts. Although this creates a higher risk for the investment to decrease in overall value, a depreciating foreign currency against your domestic currency could cause your investment to increase in value as well.
Investors who aren’t trying to create a steady stream of income or returns often find that unhedged ETFs are a solid choice to consider. That is especially true for investors who are looking to build equity from their initial investment over a long time period.
Pros and Cons of Hedged and Unhedged Investments
There are some pros and cons of ETFs, both hedged and unhedged, that are important to remember before deciding on which option is right for your portfolio.
Pro: ETFs provide you with more liquidity. You can sell holdings without much difficulty, then retrieve funds from that sale without much effort.
Pro: ETFs are highly volatile. Instead of embodying one stock in a specific sector, they include multiple stocks. That can limit your risk of substantial loss compared to one-stock equity, yet still give you an element of risk when the ETFs are tied to specific sectors.
Pro: You can use market orders for ETFs, including stop-loss and limit orders. That means you can trade ETFs as if they were stocks. You can even short ETFs.
Con: There are commissions and trading fees which must be considered when handling hedged or unhedged ETFs. If you are trading frequently, then the costs of trading will begin to erode the returns you’re able to achieve.
Con: It limits diversification in some ways because you’re focused on one primary industry. There are ETFs which are widely diversified to offset this potential negative, but it is important to remember that most exchange traded funds must be held for the long-term to produce profits.
Con: You may not be aware of the index that is being tied to the ETF. Some ETFs use untested indexes. Even though ETFs are a low-cost, diversified investment tool that offers some tax efficiencies, there can be enough unknowns involved that make any investment risky compared to other options available to you.
The reality of a hedged ETF is that the process isn’t precise. The fund manager is using techniques and tools that are designed to offset the risks which come with currency fluctuations. That is not a guarantee that you’ll see the outcomes you want. It is simply a risk reduction.
Hedged ETFs utilize an instrument called a “currency forward” to update their contracts. It is a process that is usually done monthly. That means the daily currency fluctuations are not tracked by the fund manager. If the exchange rate shifts suddenly or in a large amount, then the hedging process may be ineffective for you.
On the other hand, the risks of using an unhedged ETF are somewhat similar on the opposite end of the spectrum. You’ll get to take advantage of the swift changes that can happen in currency fluctuations, but it may be a large negative swing that impacts your finances for months, if not years, to come.
Both ETFs have the ability to erode your long-term returns. Unhedged funds do tend to track indexes with more regularity, which means you’ll have more information about your investments to consider. More data is always a good thing when evaluating short- and long-term trends.
On the other hand, hedged funds create a foundation for steady returns that can produce investment income.
Hedged vs Unhedged ETFs: Which is Better?
There is some evidence to suggest that over 10-year or 20-year investment periods, currency fluctuations tend to balance themselves out. In such a situation, an investor may not feel the need to hedge their investments or incorporate hedged ETFs into their portfolio.
There is also evidence to suggest that hedged ETFs and funds will outperform unhedged ETFs and funds over time. When evaluating long-term performance for your investments, this issue is something that you’ll want to keep in mind.
For the average investor, the decision to invest into hedged ETFs or unhedged ETFs is dependent upon personal goals and circumstances. Before making any investment that changes the structure of your portfolio, it is highly recommended that professional financial advice be obtained. That way, you can compare your ETF investment options with someone familiar with the risks and advantages of hedged vs unhedged ETFs to make a good decision.