Should you use currency hedging in your portfolio?

Currency Hedging

First, we start 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 differs from the currency you invest 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 it in USD. So, if the USD loses value against the Swiss franc, 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:

1. Forward contracts. These contracts will lock in the exchange rate for the future.
2. 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.

Currency-Hedged ETFs

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, negating 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.

We 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 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

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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-hedged 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 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 much about volatility. With a long-term horizon, investors focus more on average returns than volatility.

But if you need hedging to sleep at night, go for it! As said before, there is no evidence 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.

Half of your portfolio in currency-hedged ETFs will be more than enough to handle short-term currency volatility.

Conclusion

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 imperfect. 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, ensure 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 fine. Given 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.

If you want to learn more about portfolios, read how to design your own ETF portfolio.

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