For some investors, ETFs can be an effective way to diversify their investments and gain exposure to overseas markets without some of the hassle that can be associated with international investing. That being said, one (relatively unavoidable) risk which can come with international investing is currency fluctuations – a rise or fall in the value of the NZ dollar can impact on the value of your investments and returns.
What is the difference between hedged and unhedged funds?
Currency hedging can help reduce the effect of exchange rate fluctuations on international investments. If you invest in international ETFs, choosing a fund that uses hedging can help to protect you against the downside of currency fluctuations. But it also means you may not benefit from situations when a currency fluctuation could boost your investment.
Choosing an unhedged ETF can allow you to gain from beneficial currency changes, but you also carry the risk of the negative effects of currency price changes. So, which approach could be best? Here’s a guide to both types of funds.
Hedged investments – what are they and who are they good for?
A hedged investment is one when the fund manager uses strategies which will (in theory) offset the impact caused by currency fluctuations. The fund manager’s job in this situation is to try to make sure that the value of your investment is being affected solely by the changing value of the assets you’re invested in, and not changes to the value of currencies.
Hedged investments can be a good option for those looking to generate smaller but steady returns, without exposure to additional risk caused by currency fluctuations. However, the downside is that in a situation where a currency fluctuation may have increased the value of your investment, your investment may not reflect this because of the active currency management being undertaken by your fund manager.
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 NZD if you were to sell it. 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 decreased (depreciated) against the US dollar, your investment would usually be worth more because you’d receive more NZ dollars upon selling it. But because your investment is hedged, you receive no such benefit from the currency price change.
Investing in hedged ETFs can, for the canny investor, be a matter of timing, much like locking in a fixed rate on a home loan. Investing when a currency is at an abnormal high or low and then receiving a level of protection against any future fluctuations is something that has proved popular among ETF investors in the US. Hedging is also a popular strategy for some super funds, for whom risk management and long-term returns are key.
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. As mentioned previously, this has pros and cons. You run the risk of your investment decreasing in value, but you can also see your investment increase in value, depending on which way certain currencies move in value.
Choosing not to hedge your investments may be beneficial if you aren’t relying on them to generate a steady stream of income, and especially if you plan to hold your investment for the long-term. Some figures suggest that currency fluctuations generally balance out over the long run. So if you’re in it for the long haul, you may not feel any need to hedge your investments. But one more recent analysis in Australia suggests that hedged funds do outperform unhedged portfolios over time. This may be something to keep in mind if you’re eyeing long-term performance.
Should I buy hedged or unhedged ETFs?
At the end of the day, your decision to hedge or not to hedge should depend on your investment goals and personal circumstances, and if in doubt we recommend seeking professional advice before making your choice.
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