Hedged vs. Unhedged ETFs : Which Is Better?

Author: James Hurwood
If you want to invest in ETFs you might not know whether to use a hedged or unhedged fund. Here’s our guide to the pros and cons of each approach.

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 ETFs?

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 with a fund manager who uses strategies that (in theory) offset impacts caused by currency fluctuations.

Hedged investments can be a good option for those looking to generate smaller but steady returns, without exposure to additional risks 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 NZD 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 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’d 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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About the reviewer of this page

Bruce Pitchers

This report was reviewed by Canstar’s Editor, Bruce Pitchers. Bruce has three decades’ experience as a journalist and has worked for major media companies in the UK and Australasia, including ACP, Bauer Media Group, Fairfax, Pacific Magazines, News Corp and TVNZ. Prior to Canstar, he worked as a freelancer, including for The Australian Financial Review, the NZ Financial Markets Authority, and for real estate companies on both sides of the Tasman.

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