Should you use currency hedging in your portfolio?| Updated: |
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Currency Hedging is a technique that tries to reduce currency risk when investing in foreign equities. In practice, it sounds great, but it has several disadvantages that many people do not know about.
So, should investors use currency-hedged ETFs? Or should they stick to the standard non-hedged ETFs?
First, let’s start at the beginning with what currency hedging is. You will sometimes find it called Foreign Exchange Hedging or Forex Hedging. These three terms are the same thing.
When your base currency is different from the currency you are investing in, you take on an additional currency risk. For instance, a Swiss investor has its money in CHF but will likely invest a significant portion of its money in USD. So, if the USD loses value against the Swiss francs, the portfolio will also lose value. Of course, it is also possible for the USD to gain value, in which case the portfolio also increases in value.
For example, you are investing in the S&P 500 index in USD, and your base currency is CHF. If the index gains 10%, but the USD loses 10% of its value against CHF, you will be left with no returns. On the other hand, if the USD gains 10% over CHF during the same period, you will have 21% returns! So, with currency risk, you could get positive returns or negative returns.
Some people do not want to take that extra risk. To avoid currency risk, investors can use currency hedging. The idea is to guarantee that fluctuations in exchange rates will not negatively impact an investment’s performance.
There are two main ways to perform currency hedging:
- Forward contracts. These contracts will lock in the exchange rate for the future.
- Options. These options set the exchange rates at which an exchange of currencies can be done in the future. The option does not have to be exercised.
There are other ways, but forward contracts and options are the main ways asset managers use for currency hedging.
In this article, I will focus on hedging in a portfolio. This form of hedging is called long-term hedging.
Some people use hedging to bet against currencies. But this is an active management strategy, and I do not want to delve into that. I talk about passive investors using index ETFs (or mutual funds) in their portfolios and whether investors should use currency-hedging or not.
In practice, you do not want to hedge currency yourself! Hedging with contracts or options (or other techniques) is too advanced and is not something you want to do yourself. Instead, you could use currency-hedged Exchange Traded Funds (ETFs).
Many of the ETFs are also available as Currency-Hedged ETFs. For instance, you could get an ETF of the U.S. stock market, hedged in Swiss Franc.
Currency-Hedged ETFs generally use forward contracts to eliminate currency risks. The asset manager will take a forward contract for the value of the assets of the ETF.
With these contracts, if the hedged currency gains value, the forward contracts will gain value. This gain will negate the lost value in the investments themselves. On the contrary, if your currency loses value, the forward contracts will also lose value, which will negate the increase in the value of the investments.
So, in both cases, currency fluctuations get canceled by the forward contracts.
In practice, this sounds perfect. But there are many points that people ignore and that we need to consider.
Currency-Hedging is not perfect
On paper, a currency-hedged ETF should always negate currency fluctuations. But this is not entirely true in practice. Nobody can perfectly hedge currency risk.
Let’s start with the first problem. When the forward contract starts, it covers the current value of the fund. For instance, if the assets are worth 1 billion dollars, the forward contract will be made for 1 billion dollars. But when the contract expires, the assets could be worth 1.1 billion dollars. In this case, the forward contract would not cover the entire assets of the fund. Therefore, it would not negate the entire impact of currency fluctuations.
The second problem is a matter of timing. A forward contract has a duration. If a currency-hedged ETF takes monthly contracts, it will be less accurate than if they took daily contracts. However, daily contracts would be more expensive.
In practice, this can make a significant difference. Over a year, several cases have been observed where a fund’s performance was more than 1% different from the index it followed because of the inaccuracy of monthly contracts.
For fund managers, the forward contracts’ frequency will be chosen based on a balance between accuracy and costs.
Currency-Hedging is not free
A currency hedge is a form of insurance against currency risk. And no insurance is free. Currency hedging is no exception. There are costs to currency hedging.
The first cost is the spread of the currency pair. When you convert currency, you pay a different price when you sell and buy. The difference between these two prices is the spread.
Because of this spread, currency-hedged ETFs are only available for major currencies. In practice, the spread of exotic currencies would be too high for hedging.
The second cost is simply the cost of the transactions. You need to pay to enter into forwarding contracts.
The final cost is the short-term rate differential. It is the difference between the short-term interest rates between the hedged currency and the non-hedge currency. When you hedge foreign currency, you will pay the foreign interest rate, and you will receive the domestic interest rate. So, the difference between these two rates will incur a cost. But this cost can sometimes be negative, so this could be a return for you.
Generally, currency-hedged ETFs will add these costs to their Total Expense Ratio (TER). So, currency-hedged ETFs are generally more expensive than their non-hedged counterparts. Generally, they include the spread and the transaction costs in the TER. But the interest rate differential is typically not included.
The full costs of currency hedging can vary a lot. For EUR and USD hedging, the costs ranged between -3% and +2% in the last 20 years. So, they are not negligible.
Investing fees are significant in the long term. It is fundamental to reduce your investing fees.
Currency Hedging reduces your diversification
Diversification is a great thing! Diversification will reduce the volatility of your portfolio and increase your average returns. Diversification is the only free lunch in investing.
Global diversification is the best form of diversification. But currency diversification is also a good form of diversification. So, when you are using currency-hedged ETFs, you reduce the benefits of diversification.
No evidence for or against hedging
When I have to choose between two things, I like to look at the research regarding this choice.
For currency hedging, there has been a lot of research done to evaluate whether it is beneficial to hedge or not. But, overall, this research is not conclusive.
There is no substantial evidence that currency hedging will increase your returns. But there is no evidence in the other direction as well. So, we cannot say that currency-hedged ETFs will produce worse results than non-hedged ETFs.
Currency Hedging will protect your local buying power
If you know where you will spend your invested money, it may make sense to hedge your assets.
If you are a Swiss investor, you will likely spend CHF. So, if the CHF gets too strong against other currencies, your foreign investments (in USD, for instance) may lose their value in CHF. In that case, to reduce your investments’ volatility, you could hedge some portion of your portfolio to reduce that risk.
As seen in the previous section, there is no evidence that you will improve your returns over the long term. But you will protect yourself against variations. Keep in mind that currency hedging not being perfect. It will not entirely protect you.
But, in the long-term, you do not care that much about volatility. With a long-term horizon, investors focus more on average returns than on volatility.
But if you need hedging to sleep at night, go for it! As said before, there is no evidence saying that it is worse in returns than non-hedged.
Do not hedge too much
If you decide to go for hedging, you should not hedge your entire portfolio.
Professional investors generally agree that investors should not hedge more than half of their portfolios. If you hedge too much, you will lose the benefits of currency diversification.
Having half of your portfolio in currency-hedged ETFs will be more than enough to handle short-term currency volatility.
As you can see, currency hedging is not an easy concept. Its goal is very clear: eliminate currency risks.
In practice, currency hedging will not eliminate currency risks since it is not perfect. But it will reduce them. And it incurs costs. But the most important thing about hedging is that there is no conclusive research that shows that it will increase returns over the long term. But there is no definitive research in the opposite direction either. However, hedging will reduce your diversification in global currencies.
So, if you decide to use currency-hedged ETFs in your portfolio, make sure you do not hedge your entire portfolio. Investors should probably not hedge more than 50% of their portfolio as a rule of thumb. And keep in mind that currency-hedged ETFs are generally more expensive.
But, if you do not want to hedge, this is perfectly fine. Given there is no evidence for hedging, I do not recommend investors to hedge. For me, in the long-term, it does not make sense to hedge for currency risk. My portfolio is currently not hedged, and I do not plan to hedge in the future.
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21 thoughts on “Should you use currency hedging in your portfolio?”
These days (Apr 2023) the USD devaluation compared to CHF has accelerated and may not slow down due to a high inflation rate in the US (and many other factors). In some articles, you wrote that it is good to keep ~20% of your portfolio in CHF in order to naturally hedge against the FOREX risk. However, I believe you wrote these lines when USD what more or less stable. Does the recent fall makes you review your portfolio balance or even consider another strategy?
As today, USD is down 11% over 5y compared to CHF which is hurting the investments..
Thanks for your time and the effort you put in the blog!
If you look at the last 10 years, the rate is more or less stable, so I am not very worried. Also, since I am still investing, this is currently not too bad since what I put inside is also cheaper than before.
If you are worried, you have a few options:
* Increase your home bias
* Use currency hedging
* Invest in your second pillar which should be mostly in CHF
* Keep cash
Thank you for the resources. Just a hint on currency hedging: interest rates differential (between borrowing and lending now and in the future) are not separate costs but are part of the price for the derivative contracts: When pricing forward exchange rates, investment banks / providers of derivatives use the difference between the two interest rates.
Thanks a lot for pointing that out! I did not know that! I will change that on my next update of this article!
thanks for the article. It seems to me that exposure to currency risk is particularly severe if you live and have most expenses in CHF. Historically the central bank has repeatedly dropped the cap they were trying hard to maintain (in 2011 and then 2015).
if you are buying to hold long term I think this must be considered as a likely scenario that justifies the extra costs of ETFs hedged to CHFs.
The Vanguard document talks about USD. Maybe it makes sense for USD, I don’t know, but I don’t see how it applies directly to CHF.
Often a big part of the expenses come from mortgages for the very expensive real estate market, and that fixes their expenses in a particular currency for (usually) a decade or more.
Please let me know if you see any mistake in this argument, I would happy to read any research about this
It’s true that the SNB actions can have a large effect on the exchange rate. However, you are talking about EUR and Swiss investors will mostly hold USD, not EUR. And it’s less hectic in the last 20 years. But it’s also been dropping significantly.
Actually, currency hedging is more helpful in the short-term than in the long-term, where it should average down.
I also do not understand your reference to mortgages?
A very good resource on the subject is this video: https://www.youtube.com/watch?v=K3flJjh00gA
Hi Mr Poor Swiss!
I read the article and still not sure what to do in my situation.
I live in Switzerland now and will live here for a couole of more years. After I’ll move back to my home country with € currency.
Now I plan to invest into US based Etf in USD.
But at the end of the day I’ll need € in 10 or 20 years.
Now I am in a dillema. The US based Etf are much cheaper and better. But at the end I would have then 2 currency exchanges. From USD to CHF, and from CHF to €.
Question1: I saw an option on IB to covert directly from USD to €. Do you think if I am a tax resident of Switzerland this is allowed at that time? And to later transfer the money to an account with €?
If you have some other ideas how to tackle this issue I am open for suggestions!
I believe this would be allowed. A Swiss resident is allowed to have EUR. It just needs to be declared to the tax authorities.
Since IB offers currency conversion at a very good price, I would simply do all the conversions there. You should be able to declare several withdrawal methods. And you will be able to keep your account when you move back to your country. There, you can sell the shares, convert to EUR and send to your new bank account.
That’s what I would personally do.
Thanks for the advice! :)
Thank you for this, I was often wondering how this hedging works. I do have a question though. Or call it a doubt. This is going to be a long one, here goes:
We are talking really long term here. 30-35 years. If you look back, the dollar was almost CHF 2.00 then. It is now CHF 0.88. EUR is a similar story, now somewhere around CHF 1.08, but much more expensive back then. You often mention on your blog that, on average, we can expect the stock market to grow, and I agree on this. But the same is not true for currencies. Currency is different. We can not expect the FX rates to change in our favour in the long term. Indeed, having a strong base currency like CHF, historical data shows that another currency might lose a lot of value in comparison. And this loss is not like some bad years of stock market crash which you can sit out. It is here to stay. Yes, it could also be the other way around in the future, nobody can know. My point is I’m not sure whether you can say “well in the long term it should not make a difference”. If we expect the stock market to grow because it always has, we could also expect the USD to loose more value, because it always has.
So I’m thinking that, if we invest in foreign currency, it is exactly the other way around than when investing in stocks: in the short term we are safe, there will only be a little fluctuation which will not matter (assuming we’re not billionaires investing huge amounts). But in the long term, there is a serious risk of sustainable value decay for a foreign currency. And it will never go back.
I like investing in USD, it is cheaper and there are some great products out there. But is it really a smart choice for the long term? Having some part of my portfolio in CHF will not protect me against against a value loss of the USD of 50%-75%. But I’m not sure if hedging would help here? Can it compensate such a long term value loss? And it will be expensive of course.
Also I’m wondering what the benefits of currency diversification are. If you are in Switzerland and plan to stay here, you will spend CHF. Why would you protect yourself against FX volatility if you just need CHF? If you want to buy something here you don’t really care if the CHF is 0.1 or 10 USD. Yes it might have some impact on local prices, but does that really justify having a lot of foreign currency?
The more I’m thinking about it, the less sure I am that I want to keep large amounts of USD (or any other foreign currency) in the long term. I think I’ll wait for some time now, and see if a normal US president has any impact on the USD. But if it continues to fall I might have to rethink my strategy.
Cheers, have a nice weekend.
That’s good thinking.
Indeed, there have been huge variations of the dollar, and the EUR on a smaller scale, compared with the CHF. Now, the stock market has done much better than the difference in currency. Since 2003, the S&P 500 returned about 275% and the dollar lost 37% to the CHF. So, even in the long-term, it’s not catastrophic.
However, I agree that it’s a risk. But when you look at historical data, people with hedging have not done better than people without hedging (and vice-versa!). So, there is no evidence that hedging helps. For me, this is an important point.
Now, there is nothing fundamentally wrong with hedging. If you need hedging to sleep at night, then use hedging in your portfolio. There is nothing wrong with that.
Regarding currency diversification, it helps based on your local currency. If the CHF loses a lot of value to inflation, your purchasing power will go down only on the CHF part of your portfolio. So the USD part of your portfolio will not move relative to your purchasing power (it will give you more CHF for the USD).
But again, these are just my thoughts. I am far from being a professional investor :)
Thanks for stopping by!
Thanks for your reply.
I see, you want to protect agains CHF inflation with other currency, I guess that makes sense.. I only thought about the FX rate.
And yes, we have to hope that market gains will be higher than FX loss so we can still make some profit.
In the past year, the USD lost about 0.1 CHF in value, but the years before that it seemed to be quite stable. So I think I’ll give it another year and then reevaluate. Let’s hope for the best.
Yes, that’s it :)
Now, if you do not feel comfortable, you can increase the CHF part of your portfolio either with Swiss stocks or with hedging.
Hi, thanks for the article. I plan on buying some Swiss stocks to compensate my exposure in USD (my portfolio is mostly in USD and I am a little affraid dollar will lose a lot of value towards CHF, esp. with FED printing the money at astronomical rate now). I have different question then, maybe you or someone knows. So –
1/ when you use Interactive Brokers account, you can buy directly Swiss stocks from Swiss exchange, with CHF, no need to convert to USD, then buy the stock via American depositary receipt (ADR) from US stock market right?
2/ If the above is true (buying stocks right away in Swiss exchange and not via US exchange) – does it have any implications, negative or positive for dividend income from such stock? I kind of understand how it works for US stocks, where you declare it in tax declaration, how you declare Da-1 to get back paid US taxes etc. But do you know how it works for dividends paid on Swiss stocks? Sorry, a little bit irrelevant question, just not sure where to find the answer.
Thanks in advance.
1) I am not sure I understand the question. Do you want to buy ADRs of Swiss Stocks? If so, no need. For me, when I buy Swiss Stocks, I directly buy on the Swiss Exchange, in CHF, without currency conversion or anything complicated like an ADR.
2) Swiss Stocks dividends are withheld at 35% automatically. But you can declare it on your tax declaration as already paid taxes. It’s actually simpler than for U.S. because you do not have to deal with foreign dividends withholding, only domestic.
I hope this helps!
1/ yes, thats the question. I wonder if I should buy for example Roche or any local Swiss stock, I should do it directly from Swiss exchange or via US listed ADR-equivalent. I think the cost to buy in Swiss exchange will be higher (fees) but thats probably not significant.
2/ This I need to investigate, I have never had dividend yet, so I am a little affraid how to declare it, but I have read some about US dividends in USD. Not sure how you declare it for Swiss companies. I will figure that out, thanks :)
1) If you want to buy Roche, the best way is simply to buy Roche on SIX, the Swiss Stock Exchange.
2) It’s fairly easy to declare it. And it’s easier to reclaim for Swiss dividends than for U.S. one.
Thanks for stopping by!
great topic PoorSwiss, I have most of my portfolio in USD and had been thinking about whether I should hedge. After reading a Vanguard article on this I concluded that with a long term investing horizon, and being invested in equities only and no fixed income that hedging is expensive and offers little upside. I think that could change if I had more fixed income products and need to have less short term volatility.
thanks for a great article,
Yes, I have the same conclusion for my own investing. I am investing a lot in USD but I have no fixed income. So, for now, I am not hedging.
But it could still be something I would consider in the future.
Thanks for stopping by!
I’ve read an article referring to this research from Vanguard and the bottom line is that hedging (considering benefits vs costs) does not make much sense for stocks but they do help a lot when used for bonds.
See fig. 3 and 4.
This research is really good, these two figures show well that the impact of hedge on the volatility of bonds is much higher than on the volatility of stocks.
It makes sense since stocks are more volatile than currency while bonds are less volatile.
Thanks for sharing!