Investing in global mutual funds and ETFs offers diversification, but it also exposes you to fluctuations in currency exchange rates. Currency hedging is a strategy employed by some fund managers that may mitigate the impact of these fluctuations on your investment returns. Understanding how currency hedging works in funds, its benefits, and its drawbacks, will help you decide whether this investment tool is right for you.
What Is Currency Hedging?
Currency hedging involves reducing or eliminating the potential impact of foreign currency fluctuations on investments denominated in a different currency. When investing in a foreign market, currency hedging aims to protect the value of your investment against adverse movements in exchange rates.
Here is an example of the negative effect of currency fluctuations in Foreign Exchange (FX) between AUD and USD. In this example, AUD is the home currency and USD is the foreign currency.
Initial investment AU$ 100,000
FX day one 0.66
USD invested US$ 66,000
Profit 10% US$ 6,600
End USD value US$ 72,600
FX on sale (unhedged) 0.726 (AUD has strengthened 10%)
End value AU$ 100,000
FX on sale (hedged) 0.66 (FX negated by hedging)
End value AU$ 110,000
As you can see, the 10% return achieved within the fund was wiped out by the counterbalance of AUD strengthening by 10%. Had the FX been hedged, then this would have been avoided. (See the table below for further clarification.)
Benefits of Currency Hedging
- Reducing currency risk: By hedging foreign currency exposure, investors may be able to shield their investments from currency fluctuations that may erode returns. This is particularly important when investing in international markets where exchange rates can be volatile.
- By removing or reducing the currency component, investors’ returns will be more closely correlated to the underlying performance of the asset rather than being potentially skewed by currency market movements.
- Enhanced risk management: Currency hedging can be a useful risk management tool for investors with specific liability or cash flow requirements. It allows them to match the currency exposure of their investments with their future financial obligations.
Drawbacks of Currency Hedging
- Increased costs: Implementing currency hedging strategies incurs additional costs, such as transaction fees, hedging fees, and management expenses. These costs can impact the overall returns of the investment.
- Potential for reduced returns: While currency hedging can protect against the home currency strengthening, it may also limit potential gains if the investor's home currency weakens against the foreign currency. In such cases, the hedged returns may be lower than leaving the investment unhedged (see table).
- Complexity: Currency hedging involves sophisticated financial instruments and strategies that require expertise to execute effectively.
The Positive and Negative Effects of Currency Hedging
As illustrated in the table, it is more beneficial to use currency-hedged funds when the home currency is expected to strengthen.
Considerations for Investors
- Investment Horizon: The longer the investment horizon, the more significant the potential impact of currency fluctuations.
- Investment Objectives: Investors should consider their investment goals, risk tolerance, and the impact of currency movements on their portfolios.
- Fund Selection: If you are managing your own portfolio, consider whether the fund manager implements currency hedging strategies. Look for transparency in their approach and assess their track record in managing currency risk.
Currency hedging is a valuable risk management technique fund managers employ to protect investors from the uncertainties of foreign exchange markets. While it offers benefits such as reduced currency risk it also has drawbacks, including increased costs and potentially lower returns. Understanding the concept of currency hedging will empower you to make informed decisions and select investment options that align with your financial goals and risk tolerance.Should you have any questions, please contact a Wealth Planner at Avrio.
This material is intended for educational and informational purposes only. It is not intended to provide specific advice or recommendations for any individual. Additionally, you should consult with your Financial Advisor, Tax Advisor, or Attorney on your specific situation. The views expressed in the material are that of the author and do not necessarily reflect those of any market, regulatory body, State or Federal Agency, or Association. All efforts have been made to report or share true and accurate information. However, the information may become materially outdated or otherwise rendered incorrect due to subsequent new research or other changes, without notice. The author nor the firm are able to always verify the content from third-party sources. For additional information about the firm, please visit the MAS Website at https://www.mas.gov.sg/ and the SEC Website at www.adviserinfo.sec.gov. For a copy of the firm's ADV Part 2 Brochure, please contact us at firstname.lastname@example.org.