ETF Hedged or Not: Making the Right Choice for Your Investment Strategy

When faced with the decision of whether to invest in a hedged or unhedged ETF, the stakes are high. Hedged ETFs provide a layer of protection against currency fluctuations, but they come with their own set of trade-offs. In contrast, unhedged ETFs can offer greater exposure to potential gains from currency movements but also introduce additional risks. This comprehensive guide explores both types of ETFs, breaking down their advantages, disadvantages, and key considerations to help you make an informed decision that aligns with your investment goals.

At the core of this decision lies understanding the primary difference between hedged and unhedged ETFs. Hedged ETFs aim to eliminate the impact of currency fluctuations by using financial instruments such as futures contracts or forward contracts. This means that if the ETF invests in international assets, the impact of currency movements on the investment returns is minimized. For instance, if you are investing in European equities through a hedged ETF, the ETF manager will use hedging strategies to mitigate any negative effects of fluctuations in the euro against your home currency.

Conversely, unhedged ETFs allow for the natural exposure of the currency, meaning that fluctuations in the foreign currency can either amplify or reduce your returns. If the foreign currency strengthens against your home currency, your investment in an unhedged ETF may see enhanced returns. However, if the foreign currency weakens, the returns could be adversely affected. This kind of exposure can be beneficial in a rising foreign currency environment but risky if the currency moves against your position.

To illustrate, let’s consider a practical example. Suppose you are an investor based in the United States, and you are considering an ETF that tracks Japanese stocks. If you choose a hedged ETF, your returns will be largely unaffected by changes in the yen-to-dollar exchange rate. On the other hand, an unhedged ETF will directly reflect the performance of the yen against the dollar, potentially leading to higher returns if the yen appreciates or lower returns if it depreciates.

Currency Impact on Investment Returns

1. Hedged ETF Returns
Currency Impact: Neutralized
Investment Strategy: Focuses solely on the performance of the underlying assets.
Risk: Less affected by currency fluctuations.
Example: A hedged ETF that tracks European stocks will show returns based on the performance of European equities alone, regardless of whether the euro strengthens or weakens against the dollar.

2. Unhedged ETF Returns
Currency Impact: Direct
Investment Strategy: Includes both the performance of the underlying assets and the impact of currency movements.
Risk: Can be significantly affected by currency fluctuations.
Example: An unhedged ETF tracking Japanese stocks will show returns based on both the performance of Japanese equities and the fluctuation of the yen against the dollar.

Key Considerations for Choosing Between Hedged and Unhedged ETFs

1. Investment Horizon
If you are investing with a long-term horizon, the effects of currency fluctuations may balance out over time, making an unhedged ETF a viable option. For short-term investments, however, currency movements can have a more pronounced impact, making a hedged ETF a more stable choice.

2. Currency Forecast
Your outlook on the future performance of foreign currencies should influence your decision. If you anticipate a strong appreciation of the foreign currency, an unhedged ETF might offer higher returns. Conversely, if you expect currency depreciation or volatility, a hedged ETF could offer more stability.

3. Costs
Hedged ETFs typically have higher expense ratios due to the costs associated with hedging strategies. Unhedged ETFs generally have lower expense ratios, but this comes with the trade-off of currency risk. It’s important to weigh these costs against the potential benefits of currency protection or exposure.

4. Diversification Goals
Consider how each type of ETF fits into your overall diversification strategy. Hedged ETFs can be useful for isolating the performance of international assets from currency risk, while unhedged ETFs might offer broader diversification benefits by incorporating currency movements into your investment strategy.

Practical Example: Comparing Hedged vs. Unhedged ETF Performance

Type of ETF	Example ETF	1-Year Return	Expense Ratio	Currency Impact
Hedged ETF	iShares Currency Hedged MSCI EAFE ETF	8%	0.35%	Minimal
Unhedged ETF	Vanguard FTSE Developed Markets ETF	12%	0.08%	Significant

In the table above, the hedged ETF has a return of 8% with a 0.35% expense ratio and minimal currency impact. The unhedged ETF has a return of 12% with a lower expense ratio of 0.08%, but the currency impact is significant.

Conclusion

Choosing between a hedged and an unhedged ETF depends on your investment goals, risk tolerance, and views on currency movements. Hedged ETFs offer stability by eliminating currency risk, while unhedged ETFs provide exposure to currency movements, potentially enhancing returns in favorable conditions. By carefully considering your investment strategy and the factors outlined above, you can make a well-informed decision that aligns with your financial objectives.