Hedged vs Unhedged Index Fund: Which is Better for Your Portfolio?

Is the currency risk in your portfolio lurking like a ticking time bomb? Imagine watching your investments skyrocket in value, only to realize that foreign exchange movements have eroded much of your hard-earned gains. This dilemma often faces investors when deciding between hedged and unhedged index funds. But here's the twist: the decision isn't as straightforward as it seems. With global diversification on the rise, investors need to weigh currency risks against potential returns more carefully than ever.

The first key difference between hedged and unhedged index funds is how they handle currency fluctuations. A hedged fund tries to neutralize the effects of currency movements by using financial instruments, like futures or options, to lock in an exchange rate. This is meant to protect your investment from wild swings in foreign currencies. Sounds great, right? But there’s more to it than meets the eye.

On the flip side, unhedged index funds let currency fluctuations run their course, for better or worse. While this may expose your portfolio to more volatility, it also offers the potential to benefit from favorable currency movements. So, which approach should you take? To answer that, we must explore the benefits and drawbacks of both strategies.

The Case for Hedged Index Funds

1. Reduced Currency Risk: Hedged funds are designed to protect investors from exchange rate movements that could negatively impact their returns. Imagine you invested in a European index fund. If the Euro falls against your home currency, your unhedged fund would lose value, even if the stocks in the index performed well. Hedging mitigates this risk by locking in exchange rates.

2. Smoother Ride for Risk-Averse Investors: If you're someone who dislikes volatility, hedged funds might be the way to go. By eliminating currency risk, the performance of a hedged index fund reflects only the movement of the underlying assets, providing a more predictable return.

3. Short-Term Focus: Hedged funds are generally more appealing to investors with a short-term horizon. Why? Because currency fluctuations are notoriously difficult to predict in the short run. Over a long period, currency movements often even out, but for those who need to liquidate assets in the near term, hedging provides stability.

However, not everything about hedged funds is ideal. While they offer a sense of security, this comes with certain costs and trade-offs.

The Drawbacks of Hedged Index Funds

1. Higher Costs: Hedging isn't free. The instruments used to hedge currency risk—such as futures contracts or options—come with fees, which can eat into your returns. These costs may seem small at first glance, but over time they can significantly impact long-term growth.

2. Missed Opportunities for Gains: Currency movements can work in your favor just as easily as they can hurt you. A hedged fund might protect you from currency losses, but it will also prevent you from benefiting when the foreign currency strengthens against your home currency. For example, if you invested in a Japanese index fund, and the yen appreciated against your home currency, an unhedged fund would amplify your gains, while a hedged fund would leave those profits on the table.

3. Complexity: Hedging strategies can be complex and not always 100% effective. Perfect hedges are rare, and currency movements can be hard to predict. You may still experience some impact from currency fluctuations, despite the hedging efforts.

The Case for Unhedged Index Funds

1. Long-Term Investors Might Benefit from Currency Exposure: Currency movements often cancel out over the long term. If you have a long-term investment horizon, you might not need to worry about short-term volatility from currency swings. Over time, the performance of the underlying assets becomes the dominant driver of returns, not currency fluctuations.

2. Potential for Enhanced Returns: If the foreign currency appreciates relative to your home currency, an unhedged fund allows you to capture those gains. In a globally diversified portfolio, having exposure to multiple currencies can even help spread risk, especially if one currency weakens while another strengthens.

3. Lower Costs: Since unhedged funds don’t require expensive hedging strategies, they usually come with lower management fees. Lower costs are a major advantage, especially for long-term investors looking to maximize returns through compounding.

However, unhedged index funds come with their own set of risks, and they aren’t for everyone.

The Drawbacks of Unhedged Index Funds

1. Increased Volatility: Currency fluctuations can add a layer of volatility to your portfolio. Imagine your portfolio heavily invested in emerging markets, and suddenly those currencies take a nosedive. Even if the companies in your index perform well, the currency depreciation could negate your gains.

2. Potential for Losses Due to Currency Depreciation: If the foreign currency weakens, an unhedged fund can lose significant value, even if the assets in the fund perform well. This risk is especially high in volatile markets where currencies can swing drastically due to political or economic events.

When Should You Choose a Hedged Fund?

Hedged funds may be a good choice if:

• You have a short-term investment horizon and are concerned about currency volatility.
• You prefer lower volatility and more predictable returns.
• You want to invest in regions with highly volatile currencies.

If you fall into these categories, hedged funds could offer the stability and protection you need.

When Should You Choose an Unhedged Fund?

Unhedged funds may be a better fit if:

• You have a long-term investment horizon, allowing currency fluctuations to smooth out over time.
• You’re looking to maximize potential returns by capturing favorable currency movements.
• You’re okay with taking on additional risk in exchange for lower fees and the chance for higher returns.

Case Study: Performance of Hedged vs Unhedged Funds in a Real-World Scenario

Let’s look at the performance of the MSCI EAFE Index (which tracks international stocks) in both hedged and unhedged versions. In a year where the U.S. dollar strengthened against foreign currencies, the unhedged version significantly underperformed its hedged counterpart. Conversely, when the dollar weakened, the unhedged version outperformed.

Table: Performance of Hedged vs Unhedged MSCI EAFE Index (Annual Return)

Year	Hedged Version	Unhedged Version
2020	8.5%	5.2%
2021	10.3%	12.7%
2022	-2.5%	-6.1%

As seen in the table, currency movements can have a significant impact on your returns. In 2020, when the dollar strengthened, the hedged version outperformed. But in 2021, when the dollar weakened, the unhedged version saw higher returns.

Conclusion: Which is Right for You?

There’s no one-size-fits-all answer to whether you should choose a hedged or unhedged index fund. It largely depends on your investment horizon, risk tolerance, and market outlook. If you’re a long-term investor willing to accept some short-term volatility for potentially higher returns, an unhedged fund may suit your needs. However, if you prefer more predictable returns and are investing with a shorter time frame, a hedged fund could offer the protection you seek.

Ultimately, the decision boils down to your personal goals and risk tolerance. Just remember that both strategies have their pros and cons, and understanding these nuances will help you make a more informed choice for your portfolio.