Understanding currency risk

Currency-hedged ETFs are designed to protect investors from the potential negative impact of currency movements on their international investments. For example, currency risk can negatively affect investors when their home currency strengthens against a foreign currency, which in turn, reduces the value of assets held in that foreign currency. For instance, a European investor who buys shares in a US-based company might see those shares increase in value, but if the euro strengthens against the US dollar, the value of those returns could be reduced when converted back into euros.

Mitigating currency risk

To address this issue, currency-hedged ETFs offset the risk of currency fluctuations. They essentially make the ETF immune to the effects of currency movements so that overseas investment does not gain when the investor's home currency falls or lose when the home currency rises. Several factors influence a currency's value including economic performance, government debt, trade balances and commodity prices like oil and gold. For instance, a declining GDP, increasing national debt, and substantial trade deficits can weaken a currency. Conversely, countries that export oil or with large reserves may see their currency strengthen with rising oil prices. Currency hedging is made possible through using financial derivatives such as futures contracts, which are agreements to buy or sell a currency at a future date at a predetermined rate.

Types of currency-hedged ETFs

Broadly speaking, currency-hedged ETFs come in two main types. These are single-currency and multiple-currency, with single-currency-hedged ETFs being the more common of the two. Single-currency-hedged ETFs look to hedge against currency volatility in a single foreign currency. Multi-currency-hedged ETFs offer broader coverage, focusing on specific regions or company sizes, and can safeguard portfolios against significant currency depreciation, sometimes outperforming more traditionally composed non-hedged funds. Potential downsides of currency-hedged ETFs include missing out on potential gains from favourable shifts in your chosen currency's value.

Potential drawbacks

Another point to consider is, historically, the advantage or disadvantage of currency hedging has moved in cycles, making it difficult to forecast the long-term impact. So far, hedging over the long run has appeared to have less of an effect on the total return of foreign stocks than hedging over the short term, where it can lead to more pronounced fluctuations in returns, whether positive or negative. Overall, European investors face currency risk as an inherent part of international diversification, and hedging exchange risk is a strategy that should be considered during periods of unusual currency volatility.