What are hedged and unhedged ETFs and which is better for you?
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If you want to invest in global ETFs you will need to decide whether you want to take a hedged or unhedged approach.
While investing means you will have to take on some risk, some prefer a hedged approach, taking out currency movements, while others prefer not to hedge.
This guide will help you learn about what the difference between a hedged and unhedged ETF is, how it will impact returns and what might be right in your personal situation.
What does hedged and unhedged mean?
When it comes to buying international ETFs you will have the option of choosing between a hedged and unhedged option.
Hedging is effectively taking out insurance. Currency hedged ETFs are designed to hedge against the risks associated with currencies.
Say, for example, you are looking to buy an ETF that gives you exposure to the S&P500, such as IVV. In this situation, you would be exposed to both the fluctuation in the 500 businesses listed as well as currency fluctuations between the Australian and US dollars.
If you owned US$100 in this ETF and the Australian dollar went from 70 to 80 cents, at the same time that you wanted to sell, your returns would be diminished due to the rising Australian dollar.
On the flip side, you can buy an unhedged ETF. In this instance, you are not purchasing any of the foreign exchange contracts.
While you will face a currency risk, it can be beneficial should currencies move in the right direction. Say you are buying a US ETF and the exchange rate is 80 cents to the dollar. If the Australian dollar falls to 70 cents US, you will effectively pocket the difference, adding to your overall returns.
How do the funds hedge?
To protect the underlying ETF against currency movements a hedged ETF will usually enter what is known as forward contracts in the currency markets.
A currency forward is a binding contract in the foreign exchange market that will see the ETF provider lock in the value of an exchange rate on a future date.
Through these contracts the ETF is protected against loss in value attributed to currency movements but it also will prevent gains should the currency movements go in the right direction.
Why you should consider a hedged ETF
With a hedged investment, the fund manager has theoretically taken into account the impacts caused by currency fluctuations and has tried to mitigate against these.
So with this in mind, hedged investments usually favour those who are looking for a more secure, stable investment over the longer term. If you would prefer to have one less risk factor then a hedged investment could be for you.
Another reason to take out a hedged option is if you have a shorter time horizon or you need the money on a specific date. For example, if you are looking to buy a house in the next 3 years and are investing your deposit. In situations such as these it might be better to mitigate against currency risks.
Finally, a hedged option could be for those that either have an incredibly strong conviction in which one currency is moving or for those that have absolutely no idea as to which way the Australian dollar will go. If you believe the Australian dollar is going a certain way, then hedging against it could help. At the same time if you have no strong views on currency movements, again, this could be a reason to consider a hedged option.
Pros and cons of hedged ETFs
- Protects your portfolio against unforeseen events.
- You get a truer representation of what you own and what it is worth.
- Removes a key risk when investing in foreign markets.
- Makes investment decisions clearer and easier to understand.
- Bigger dividends if the currency swings in the right direction.
- Costs money to hedge.
- Doesn't always go in your favour. You could lose money by hedging instead of taking an unhedged approach.
- Lacks long-term benefits.
Why you should consider an unhedged ETF
Remember an unhedged investment has a full exposure to currency fluctuations, with the ETF provider not trying to protect the underlying assets against currency movements.
Choosing not to hedge your investment may be beneficial if you haven't got a specified selling date in mind or if you plan on holding the investment long-term.
It varies depending on which study you follow, but some research shows that if you wait long enough currency fluctuations will balance out because at some points the Aussie dollar is high, while at others it is lower.
This means, paying less and choosing an unhedged option could be more beneficial for some of the longer term investors.
At the same time, choosing an unhedged ETF could be beneficial if you do not need to cash in on your investment at a certain date or if you do not need steady returns. After all, if you hold an unhedged fund, you can simply wait until the currency situation is in your favour to sell. While it runs the risk of the share price fluctuations, you can theoretically find a time when the currency and share price are aligned.
Pros and cons of unhedged
- You will pay less as you are not setting up a hedge.
- Higher gains without hedging.
- Forces you to think longer term.
- You could benefit from currency swings in the right direction for your investment.
- Currency fluctuations in the wrong direction will hurt your returns.
- Disfavours investors with a set selling date/shorter-term investors.
- Taking on risk that you otherwise could avoid.
How have each performed over time?
Given that financial returns is one of the key considerations when deciding on which strategy to go with, we have compared the pair.
Blackrock run both a hedged (IHVV) and an unhedged (IVV) S&P 500 ETF. The returns are as follows:
|IHVV||1 Year||3 Year||5 Year|
|IVV||1 Year||3 Year||5 Year|
As you can see in the case of Blackrock's S&P500 ETF an unhedged portfolio outperforms over a the longer term.
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