Exchange-traded funds (ETFs) have revolutionized the way investors access international markets. They provide a convenient way to gain exposure to a wide range of assets, from stocks and bonds to commodities and currencies. When investing in ETFs, one important decision investors face is whether to choose currency-hedged or unhedged ETFs. In this blog post, we’ll delve into the key differences between these two approaches and analyze their respective results to help you make an informed investment decision.
Understanding Currency Risk
Before we dive into the analysis, let’s first understand what currency risk is and why it matters to investors.
Currency risk, also known as exchange rate risk, arises when you invest in assets denominated in a foreign currency. Changes in exchange rates can significantly impact the returns on your investments. If your domestic currency strengthens against the foreign currency in which your investments are denominated, you may experience currency-related losses. Conversely, if your domestic currency weakens, you may gain from the exchange rate movement. Currency-hedged and unhedged ETFs provide different approaches to managing this currency risk.
Currency-Hedged ETFs
Currency-hedged ETFs are designed to mitigate the impact of currency fluctuations on your investment returns. These funds use financial instruments, such as forward contracts, to offset the currency exposure. As a result, when you invest in a currency-hedged ETF, you’re essentially isolating the performance of the underlying assets from currency movements.
Pros of Currency-Hedged ETFs:
Reduced Currency Risk: Currency-hedged ETFs can provide a more stable return profile by eliminating the impact of currency fluctuations.
Cons of Currency-Hedged ETFs:
Higher Costs: Currency hedging comes with additional costs, which can result in slightly higher expense ratios compared to unhedged counterparts.
Unhedged ETFs
Unhedged ETFs, on the other hand, do not attempt to mitigate currency risk. When you invest in these funds, your returns will reflect both the performance of the underlying assets and the changes in exchange rates.
Pros of Unhedged ETFs:
Lower Costs: Unhedged ETFs typically have lower expense ratios since they don’t incur the expenses associated with currency hedging.
Currency Upside: In a scenario where your domestic currency weakens against the foreign currency, you could benefit from currency appreciation.
Cons of Unhedged ETFs:
Currency Volatility: Your returns can be highly volatile due to currency fluctuations, potentially leading to unexpected losses.
In an effort to provide an illustrative example, I wanted to discuss domestic listings of U.S. S&P 500 and Nasdaq 100 ETFs. However, the competition among institutions in this space is intense, resulting in minimal differences in the fees for hedged and unhedged options. Whether you choose a hedged or unhedged index fund, the annual expense ratio typically falls within the range of 0.05% to 0.3%. Even to secure the top spot, the fees for the same product offered by the second to fifth-ranked institutions remain exceptionally low. As of the time of writing, the TIGER U.S. S&P 500 Futures(H) ETF, which is hedged to the S&P 500 ETF, boasts the largest market capitalization among such products at KRW 278.6 billion, with an annual expense ratio of 0.3%. In contrast, the KODEX U.S. S&P 500 Futures(H) ETF, the second-largest in market capitalization at KRW 141.6 billion, charges an annual expense ratio of only 0.05%. While this is a favorable situation for consumers, it remains uncertain whether this will persist over time.
As such, I’ve taken the liberty of examining ETFs listed in the U.S., focusing on those that target relatively stable currencies like the USD and GBP. For comparison, I’ve selected the iShares MSCI United Kingdom ETF (Ticker: EWU) and the iShares Currency Hedged MSCI United Kingdom ETF (Ticker: HEWU), both of which are listed in the U.S. Comparing their fees reveals the following:
In this case as well, it appears that there is competition in the market, with some providers waiving related costs through promotions until 2025, aligning the fees with those of unhedged products. Upon inspecting the composition of HEWU, we find that it includes GBP/USD forward contracts in its holdings. This suggests that additional expenses are incurred for currency hedging operations and personnel costs, contributing to the slightly higher fees.
Analyzing the Results
To determine whether currency-hedged or unhedged ETFs are more suitable for your investment goals, it’s crucial to analyze historical data, your risk tolerance, and your investment horizon.
Short-Term vs. Long-Term: For short-term investors or those with low risk tolerance, currency-hedged ETFs may be a better choice, as they offer stability. However, long-term investors with a higher risk appetite might opt for unhedged ETFs to potentially capitalize on currency fluctuations.
Historical Performance: Review the historical performance of both currency-hedged and unhedged ETFs in the regions or countries you’re interested in. This will give you insights into how each strategy has fared in different market conditions.
Diversification: Consider how currency exposure fits into your overall portfolio. Diversifying across currency-hedged and unhedged ETFs can be a balanced approach.
Costs: Don’t forget to compare the expense ratios of the ETFs you’re considering. Lower costs can have a substantial impact on your long-term returns.
Conclusion
The choice between currency-hedged and unhedged ETFs depends on your investment objectives, risk tolerance, and time horizon. There is no one-size-fits-all answer. By understanding the pros and cons of each approach and analyzing historical performance, you can make an informed decision that aligns with your financial goals. Whether you prioritize stability or are willing to embrace currency fluctuations for potential gains, ETFs offer flexible options for international investing.
-> Personally, I invest in unhedged products as I have a long-term investment horizon, and these products offer exposure to both the U.S. dollar and the target asset. When approaching the market from the perspective that downturns may occur in the U.S. financial market, leading to a significant drop in index values, the USD/KRW exchange rate could see a sharp increase. This could partially offset the losses. Looking at historical events like the dot-com bubble and the 2008 financial crisis, we observed that exchange rates surged. However, if a Black Swan event or similar occurrence were to take place at the time of retirement and withdrawal, it could pose a challenge. By investing in unhedged products, I anticipate that a significant portion of currency risk can be mitigated. Conversely, what if the Korean economy is performing exceptionally well, and the U.S. dollar is flowing abundantly, causing the exchange rate to continuously decline? In that case, wouldn’t it be beneficial to hold some premium Korean stocks? 🙂
-> Some may argue that strategies can be employed, such as investing in hedged products when exchange rates are high and switching to unhedged products when they are low. While this may seem like an ideal approach, predicting factors like interest rates, exchange rates, and stock pricing is, in my opinion, nonsensical. As Peter Lynch once said, “If you predict the interest rate 3 times, you could be a billionaire. Even the chairman of FED can’t predict the rate, how can the average person predict them?” However, what we do know is the historical returns of the U.S. market, the upward trend of indices, and the consolidation of exchange rates. Therefore, for long-term investments, I believe that unhedged products are the better choice.