How Does a Hedged ETF Work?

Imagine this: you invest in a foreign stock market because it's booming, but suddenly, due to currency fluctuations, your returns dwindle. That’s where a hedged ETF steps in to save your portfolio. Hedged ETFs aim to minimize the impact of currency fluctuations on investments, especially when you’re exposed to international markets.

The Foundation of Hedged ETFs

At their core, hedged ETFs invest in international assets, but unlike unhedged funds, they use financial instruments like forward contracts, options, or futures to mitigate currency risks. For instance, if a U.S. investor buys stocks in Europe via an ETF, a hedged version of that ETF would use these instruments to neutralize any potential loss caused by a weakening euro.

Here's an example: You buy a European stock ETF that gives you exposure to companies like Volkswagen, Siemens, or L’Oreal. Normally, if the euro drops relative to the U.S. dollar, even if these companies perform well, your gains might get wiped out by currency losses. A hedged ETF prevents that. The currency risk is "hedged," or protected, so your returns reflect the actual performance of those companies without worrying about foreign exchange rates.

Why Are Hedged ETFs Popular?

Hedged ETFs are designed for investors who want the benefits of international exposure without the rollercoaster ride of currency volatility. They are especially appealing during periods when currency markets are volatile. For example, in times of geopolitical instability or divergent monetary policies, the value of currencies can fluctuate drastically, affecting your returns even if the underlying assets perform well.

Let’s dig into a scenario: Consider two investors—one buys an unhedged European ETF, and the other buys a hedged one. Both hold their positions for a year. During this time, the euro depreciates by 10% against the dollar. While both ETFs might have the same stock gains, the unhedged investor's returns would be eroded by 10% due to currency devaluation. The hedged ETF holder, on the other hand, wouldn't experience this loss.

Types of Hedging Instruments Used

Hedged ETFs use several tools to mitigate currency risk. These include:

• Forward Contracts: These are agreements to exchange currencies at a future date at a predetermined rate. If the foreign currency weakens, the forward contract compensates for the loss.
• Futures Contracts: Similar to forwards but traded on exchanges, these allow the fund to lock in exchange rates ahead of time.
• Currency Options: These give the fund the right, but not the obligation, to exchange currency at a set rate, offering more flexibility.

A Balancing Act: The Costs of Hedging

Now, you might be thinking, "If hedging is so great, why wouldn’t everyone use it?" Good question. The truth is, hedging isn’t free. There are costs associated with using these financial instruments, which can eat into your returns. These costs vary depending on market conditions, and sometimes, the cost of hedging can outweigh the potential currency loss.

For example, during periods of low volatility, hedging might be relatively cheap, but in times of currency turbulence, the cost to maintain these hedges can rise. Fund managers need to make judgment calls: when does it make sense to hedge? What’s the tipping point where hedging becomes too expensive?

When Should You Consider a Hedged ETF?

Hedged ETFs might make sense if:

• You want international exposure but are concerned about currency fluctuations.
• You’re investing in countries where the currency has been highly volatile or is expected to be in the near future.
• You prefer stable, predictable returns from your international investments, rather than having to track both stock market performance and currency movements.

However, if you’re bullish on a foreign currency, meaning you think it will strengthen against your home currency, an unhedged ETF might be more appropriate. The currency appreciation could actually boost your returns.

A Real-World Example: Comparing Hedged and Unhedged ETFs

Let’s say an investor is looking at two ETFs that track the same index of Japanese stocks—one is hedged (ETF A), and the other is unhedged (ETF B). Over the course of the year, the Japanese yen weakens by 5% relative to the U.S. dollar.

• ETF A (Hedged): Returns 10% (stocks in Japan performed well, and the hedge neutralized the currency loss).
• ETF B (Unhedged): Returns 5% (the 10% stock gain was offset by a 5% currency depreciation).

In this case, the hedged ETF allowed the investor to capture the full benefit of the Japanese stock market performance, without worrying about the yen’s decline. On the other hand, the unhedged investor saw lower returns because of the currency factor.

The Risk of Over-Hedging

While hedged ETFs offer protection, there’s always a risk of over-hedging. For instance, if the foreign currency appreciates, an investor in a hedged ETF won’t benefit from that. In this scenario, the hedged investor might miss out on additional gains.

This brings us to a key point: hedged ETFs are most beneficial in environments where the currency is expected to weaken. If the opposite happens, you might feel like you paid for insurance you didn’t need.

Conclusion: To Hedge or Not to Hedge?

Whether to choose a hedged ETF comes down to your investment goals and market outlook. If you’re more focused on stock performance and don’t want to worry about currency movements, a hedged ETF might be a good fit. On the other hand, if you believe the currency might move in your favor, going unhedged could lead to better returns.

Remember, there’s no one-size-fits-all answer. Each approach has its pros and cons, and the decision ultimately depends on factors like market conditions, currency expectations, and your individual risk tolerance.

Key Takeaway: Hedged ETFs are powerful tools for minimizing currency risk, but they come with costs. Be mindful of when and how to use them, and always weigh the benefits of protection against the costs of implementation.