Hedged vs. Unhedged ETFs
When investing internationally, currency fluctuations can significantly impact your returns. Understanding the difference between hedged and unhedged ETFs helps you make more informed decisions about how to protect and grow your wealth across various market environments.
From 30,000 feet, ETFs are simply funds that trade on an exchange. Investment companies can slice them and dice them any which way, providing a spectrum of products, ranging from low cost to high cost, active to passive, concentrated to diversified. It’s important to note Avenue will only use ETFs opportunistically on occasion if it makes sense within our investment mandates.
Benefits of ETFs
Before exploring the hedging decision, it’s worth understanding why Exchange-Traded Funds (ETFs) have become popular investment vehicles. ETFs can offer:
- Diversification across multiple securities
- Lower costs than many actively managed funds
- Trading flexibility throughout the day
- Tax efficiency compared to mutual funds
- Transparency of holdings
While these benefits have driven the growth of ETFs, they don’t address an important consideration for international investments: currency risk.
Hedged ETFs Explained
Currency Risk and Hedging
When you invest internationally, you’re actually making two investments – one in the foreign securities and another in the foreign currency. Currency fluctuations can either enhance or detract from your investment returns.
Hedged ETFs use financial instruments like futures contracts to minimize or eliminate the impact of currency movements on your returns. This approach focuses your investment outcome on the performance of the underlying securities rather than currency exchange rates.
Advantages of Hedged ETFs
Hedged ETFs offer several potential benefits for investors concerned about currency volatility:
- Pure Exposure to Foreign Markets: Hedging allows you to focus on the performance of foreign securities without the additional layer of currency risk. When you invest in a hedged ETF tracking Japanese stocks, for instance, your returns will more closely reflect the actual performance of those companies in their local market.
- Reduced Portfolio Volatility: Currency fluctuations can add significant volatility to international investments. By removing this variable, hedged ETFs may provide a smoother return profile, particularly during periods of currency market turbulence.
- Protection During Home Currency Strength: When the Canadian dollar strengthens against foreign currencies, unhedged international investments lose value in CAD terms. Hedged ETFs protect against this scenario, preserving returns during periods of domestic currency appreciation.
Potential Drawbacks of Hedged ETFs
Despite their advantages, hedged ETFs come with important considerations:
- Higher Expense Ratios: The cost of implementing and maintaining currency hedges typically increases the fund’s expense ratio. This ongoing cost can erode returns over time, particularly during periods when the hedge doesn’t provide meaningful benefits.
- Imperfect Hedging: Currency hedges aren’t always perfect, especially for ETFs covering emerging markets or less liquid currencies. This tracking error can result in performance that doesn’t precisely match the underlying market returns.
- Potential Opportunity Costs: By eliminating currency exposure, investors miss potential gains when the Canadian dollar weakens against foreign currencies. This opportunity cost can be significant during extended periods of CAD depreciation.
Unhedged ETFs Explained
Unhedged ETFs provide exposure to both the performance of foreign securities and currency movements, maintaining the dual nature of international investing.
Benefits of Unhedged ETFs
Unhedged ETFs can offer several distinct advantages:
- Lower Expense Ratios: Without the cost of implementing currency hedges, unhedged ETFs typically feature lower expense ratios. This cost advantage compounds over time, potentially leading to better long-term performance.
- Currency Diversification: Exposure to foreign currencies can provide valuable portfolio diversification, particularly for Canadian investors whose domestic economy and currency are significantly influenced by commodity prices and U.S. economic conditions.
- Potential Currency Gains: When the Canadian dollar weakens against foreign currencies, unhedged international investments benefit from currency translation gains. These gains can meaningfully enhance returns during periods of CAD depreciation.
Possible Disadvantages of Unhedged ETFs
Unhedged ETFs also present certain challenges:
- Increased Volatility: Currency fluctuations add another layer of variability to investment returns. This additional volatility may be uncomfortable for some investors, particularly during periods of significant currency market turbulence.
- Currency Risk During Home Currency Strength: When the Canadian dollar strengthens against foreign currencies, unhedged international investments lose value in CAD terms, even if the underlying securities perform well in their local markets.
- Less Predictable Return Patterns: The dual influences of security performance and currency movements make returns from unhedged ETFs more difficult to predict. This complexity can complicate portfolio planning and performance evaluation.
Hedged ETFs vs. Unhedged ETFs
Understanding the key differences helps identify which approach may better suit your investment goals and risk tolerance.
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Should Canadians Buy Hedged or Unhedged ETFs?
The choice between hedged and unhedged ETFs depends on several factors specific to your investment goals and personal circumstances. See Time Horizon Considerations, Goals, Risk and Portfolio information below.
Time Horizon Considerations
For long-term investors, currency movements tend to balance out over time. Our strategy recognizes that while currencies fluctuate in the short term, they generally revert to fair value based on purchasing power parity over extended periods.
Investors with shorter time horizons may be more concerned about interim currency volatility and might prefer hedged options to reduce this uncertainty.
Investment Goals and Risk Tolerance
Your investment objectives and comfort with volatility should influence your hedging decision:
Capital Preservation Focus: Investors primarily concerned with preserving capital and minimizing volatility might prefer currency-hedged ETFs, particularly for core portfolio holdings.
Growth Focus: Investors seeking maximum long-term growth potential might accept the additional volatility of unhedged ETFs, particularly given their lower expense ratios and potential for currency diversification benefits.
Portfolio Context
The decision should also consider your overall portfolio composition:
Canadian-Heavy Portfolios: Investors with significant domestic exposure may benefit from the diversification that unhedged international ETFs provide, including currency diversification away from the resource-dependent Canadian dollar.
Already Diversified Portfolios: Investors with substantial international holdings might prefer to limit additional currency risk through hedged ETFs, especially in regions with historically volatile currencies.
Frequently Asked Questions
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Do hedged ETFs outperform unhedged ETFs?
Performance comparison depends entirely on currency movements during the period examined. When the Canadian dollar strengthens against foreign currencies, hedged ETFs typically outperform their unhedged counterparts. Conversely, when the Canadian dollar weakens, unhedged ETFs generally deliver superior returns.
Over very long periods, the performance difference may be minimal as currency fluctuations tend to balance out. However, the higher expense ratios of hedged ETFs can create a persistent drag on returns that compounds over time.
Are hedged ETFs worth the extra cost?
The value proposition depends on your investment goals and risk tolerance. The additional cost (typically 0.10% to 0.50% annually) is worth considering for investors who:
- Have a shorter investment horizon
- Are particularly sensitive to volatility
- Have strong convictions about Canadian dollar strength
- Seek pure exposure to foreign markets without currency complications
For long-term investors focused on maximizing growth potential, the lower costs of unhedged ETFs may provide better results over extended periods.
Can I use both hedged and unhedged ETFs in my portfolio?
Yes, many sophisticated investors incorporate both approaches for different purposes within their portfolios. Some potential strategies include:
- Using hedged ETFs for core international holdings and unhedged for satellite positions
- Implementing hedged options for more volatile currency regions and unhedged for more stable ones
- Adjusting the hedged/unhedged balance based on macroeconomic outlooks and currency valuations
At Avenue, our portfolio approach focuses on owning quality investments that can compound wealth over time. We consider currency exposures within the broader context of portfolio construction, risk management, and long-term financial stability.
Have More Questions?
Making the Right Choice for Your Investments
The hedged versus unhedged decision reflects the broader principles of wealth management: achieving desirable long-term results with as little risk as possible, while always doing what’s best for your specific situation.
For Canadian investors building international exposure, consider these key factors:
- Investment Horizon: Longer time horizons generally reduce the importance of interim currency fluctuations, potentially favoring the lower costs of unhedged ETFs.
- Diversification Needs: Consider your existing currency exposures and whether additional foreign currency exposure would improve or imbalance your portfolio diversification.
- Cost Sensitivity: Higher expense ratios of hedged ETFs compound over time, potentially offsetting their volatility-reduction benefits for long-term investors.
- Market Timing Concerns: Attempting to switch between hedged and unhedged options based on currency forecasts introduces market timing risk that can undermine long-term performance.
The most successful approach often involves making a thoughtful initial decision based on your financial circumstances and risk tolerance, then maintaining discipline through market cycles rather than reacting to short-term currency movements.