The main difference between a hedged and unhedged ETF is that a hedged ETF looks to mitigate for foreign exchange risk, while an unhedged ETF leaves investors exposed to currency fluctuations and risk.
Investors often choose different asset classes, investment time horizons and markets.
With the proliferation of exchange-traded products in recent times, individuals can express most views on global economies poised to rise.
Say, for example that with rising inflation, you see commodities coming back in favour, implying equity indices linked to commodity-rich nations to fare better.
Therefore, you invest in Russia given the abundant oil, natural gas and coal resources.
The ERUS ETF from iShares would let you express that view relatively easily.
However, you would quickly notice that while investing in an ETF that invests in foreign assets, those ETFs have a pronounced currency exposure risk.
Any appreciation or depreciation in that foreign currency will amplify or impede the return profile of such foreign assets.
Many Canadians are investing south of the border, and US Dollar exposure is the primary currency risk they face.
As a result, asset managers have launched several funds that allow investors to participate in the growth of these markets without speculating on currency markets and focusing on investing for the long term.
An ETF that exposes investors to currency risk would be called an unhedged ETF, and those that can use structures to mitigate foreign exchange volatility are referred to as hedged ETFs.
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What is a Hedged ETF?
An exchange-traded product investing in markets without taking on any currency risk would be defined as a hedged ETF.
Blackrock’s iShares Core S&P 500 Index ETF ($XSP) is an excellent example of a hedged ETF.
This product allows Canadians to invest in large-cap US stocks while minimizing any US dollar exposure.
Considerations When Purchasing a Hedged ETF
Any investing product that limits potential downside can be attractive, but there is no free hedge in financial markets.
These are the specific considerations to keep in mind while choosing to invest in hedged exchange products.
1. Costs
Index ETFs have gained widespread adoption amongst the retail investing universe.
These funds have been very successful in replicating market returns with minimal fees.
Most asset managers provide a suite of investment products available in both hedged and unhedged flavours.
For example, Vanguard’s unhedged funds that invest in large-cap US stocks have a similar cost structure to hedged products (VFV: Vanguard S&P 500 Index ETF vs VSP: Vanguard S&P 500 Index ETF – CAD Hedged).
However, for active mutual funds, this differential in management fees can be significant and eat into returns over the long term for investors.
2. Portfolio Construction
Investing strategies that focus on the long term should be geared towards the breadth of markets and diversify their foreign exchange exposure as currency price movements tend to be more pronounced in the short term.
A basket of funds exposed to different currencies should minimize the short-term noise of price changes and provide relatively hedged exposure on an unhedged basis.
However, an investor likely runs a highly concentrated portfolio and manages it actively in the short term.
It makes good sense to avoid undertaking any additional currency risk and invest in hedged ETFs.
3. Liquidity
Investors with long-term horizons usually pick funds that reflect those timelines.
Such views are often expressed by buying a basket of index ETFs to get diversified exposure to the economic growth story of a particular region/market.
With the greater financialization of the world, retail investors have opportunities to invest globally from the comfort of their own homes.
Investing in these frontier markets without taking on any currency risk can seem extremely attractive as these geographies have strong growth in economic productivity, supportive demographics and other macro catalysts.
However, this optimism should be tempered with caution as liquidity can be potentially thin in these markets.
The liquidity underlying these hedged ETFs should be another factor to be analyzed before investing in hedged exchange-traded products.
4. Safety
Under specific market regimes, a nimble investor can limit potential downside by investing in hedged products.
The Covid crisis of March 2020 is an excellent example of turbulence and heightened volatility where investors consider a flight to quality and de-risk their portfolios.
A hedged portfolio can tug on the currency exposure lever and ensure that they are not taking unintentional directional views on foreign exchange, especially those pertaining to emerging market economies, as they can be in freefall in a risk-off market environment.
Did You Know?
Most asset managers offer index ETFs that are completely hedged at very low extra fees. Blackrock’s iShares Core S&P 500 Index ETF ($XSP) charges less than ten basis points in fees for a completely hedged product offering.
What is an Unhedged ETF?
An Unhedged ETF seeks to invest in foreign assets without removing currency exchange risk.
As a result, such products ideally should have lower management fees than the hedged version of the same fund.
Most funds have both variants in their tool house, and investors can choose what they intend to invest in based on their investment thesis and research.
Blackrock’s iShares Core S&P 500 Index is an excellent example of an ETF that tracks the return of the S&P 500 index on an unhedged basis.
Considerations When Purchasing an Unhedged ETF
Like owning a hedged ETF, investors must have a framework in place while investing in unhedged products.
Here are some of the most critical considerations while picking unhedged exchange funds.
1. Potential Returns
When an investor has a firm conviction regarding currency price movements and is willing to take on marginal foreign exchange risk to augment the return profile of their investments, the investor should be highly strategic in choosing an unhedged ETF to capture favourable price movements.
2. Cost Benefits
As highlighted above, asset allocators running a highly diversified portfolio with a long-term investment horizon can gain incremental cost savings by investing in unhedged ETFs.
Currency fluctuations tend to even out in the long run, and picking a broad range of markets will dampen drag from foreign exchange price volatility.
3. Short-term Risks
The pandemic is an excellent example of a black swan event that caused significant market disruption and unprecedented levels of uncertainty.
On such occasions, investors that don’t want to have unintended exposure to currency price movements can buy peace of mind by paying a little bit in added fees without losing any exposure to the underlying long-term growth.
These are instances when an unhedged product can be unfavourable and work against the investor.
Frequently Asked Questions
- What is the Canadian equivalent of VTI?
- What is better a hedged or unhedged ETF?
