KEY POINTS:
- Hedging protects returns on overseas ETFs from losses due to fluctuations in the value of the NZ dollar
- While hedging can help prevent losses, it can also curtail any possible profits due to changes in the exchange rate
- Hedged ETFs come with slightly higher fees than similar unhedged funds
Investing in exchange traded funds (ETFs) can be an effective way to spread risk and gain exposure to overseas markets, without some of the hassles associated with international investing.
However, currency fluctuations can negatively affect returns from investing overseas. A rise or fall in the value of the NZ dollar can impact your profits when you convert your overseas investments back into NZ dollars.
One way to minimise losses due to currency fluctuations is to invest in hedged ETFs.
What is the difference between hedged and unhedged ETFs?
The main difference between a hedged and an unhedged ETF is that the fund manager of the hedged ETF will lock in an exchange rate for the currency or currencies used in the trade.
While this reduces the effect of exchange rate fluctuations on international investments, it does come with its own risks. For while hedging does mitigate losses associated with changes in currency, it also prevents any possible gains.
Hedged investments – what are they and who are they good for?
A hedged investment has a fund manager who uses strategies that, in theory, should offset impacts caused by currency fluctuations. However, the downside is that the fund can’t benefit from any positive changes in currency values.
For example, if you were invested in US assets via your ETF and the NZ dollar went up (appreciated) against the US dollar, your investment would ostensibly be worth less, because you would receive less in NZ dollars if you were to sell.
In periods when the NZ dollar is appreciating in value against foreign currencies, such as the US dollar, a hedged ETF will tend to outperform unhedged funds.
By contrast, however, if the NZ dollar depreciates against the US dollar, your investment will be worth more, because you’ll receive more NZ dollars upon selling. But because your investment is hedged, you won’t gain any benefit from the currency price change.
Investing in hedged ETFs is often about perceived risk. If an investor thinks that a currency is abnormally high or low, a hedged investment can provide a level of protection against losses caused by currency fluctuations.
However, it’s worth keeping in mind that hedged funds usually incur higher fees, due to the extra costs associated with the hedging process.
Unhedged investments – what are they and who are they good for?
An unhedged investment is one that is fully exposed to the risk of currency fluctuations. The fund manager does not generally actively try to offset any dips or rises in the value of your investment caused by changes to currency values.
This, of course, has its pros and cons. You run the risk of your investment decreasing in value, but it can also increase in value, depending on which way currency markets move.
Should I buy hedged or unhedged ETFs?
Whether to hedge or not is a personal decision that should be based on your investment goals, personal circumstances and appetite for risk.
If you favour stable returns, then you might decide that the extra costs associated with a hedged fund are worth it.
Whereas, if the NZ dollar is unusually strong against the greenback, and you foresee it dropping in the near future, you might want to take a gamble on extra returns by investing in an unhedged fund.
Hedged ETF pros
- Fluctuations in the value of the NZ dollar will not have a substantial effect on your investment returns
Hedged ETF cons
- You lose any profits possible by changes in the exchange rate
- A hedged fund involves additional costs
KiwiSaver: investing in all Kiwis
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About the author of this page
Bruce Pitchers is Canstar NZ’s Content Manager. An experienced finance reporter, he has three decades’ experience as a journalist and has worked for major media companies in Australia, the UK and NZ, including ACP, Are Media, Bauer Media Group, Fairfax, Pacific Magazines, News Corp and TVNZ. As a freelancer, he has worked for The Australian Financial Review, the NZ Financial Markets Authority and major banks and investment companies on both sides of the Tasman.
In his role at Canstar, he has been a regular commentator in the NZ media, including on the Driven, Stuff and One Roof websites, the NZ Herald, Radio NZ, and Newstalk ZB.
Away from Canstar, Bruce creates puzzles for magazines and newspapers, including Woman’s Day and New Idea. He is also the co-author of the murder-mystery book 5 Minute Murder.
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