Currency Hedged ETFs: You Already Made the Bet

The moment you bought an international equity fund, you took a position on the dollar. Nobody presented it as a choice and it does not appear anywhere on the fact sheet, but it is sitting in your portfolio and it has been driving a meaningful share of your returns.

Dan Petersen of New York Life Investments, who manages a partially hedged international equity ETF, laid out the mechanic on Behind the Ticker in the simplest available terms: "If I take my money and I put it into a Japanese equity, I have to convert my U.S. dollars that I’m investing in into yen."

Once that conversion happens, two things determine what you earn. What the Japanese stock did, and what the yen did against the dollar. You wanted the first one. You received both.

The question a currency hedged fund asks is whether you want to keep the second.

Why it went unexamined for so long

For most of the history of international investing, this was simply not treated as a decision. Petersen: "If you were to go back 20 years or so, you pretty much just accepted currency risk for what it was."

That inertia persists in the data. Looking at the foreign large blend category, Petersen noted that "99% of assets are in unhedged products, especially if you’re looking at market cap weighting."

Ninety nine percent is not what it looks like when investors weigh a trade-off and independently land in the same place, it is what a default looks like when nobody revisits it.

How the hedge is built

The mechanism is unglamorous, which is a point in its favour.

Petersen: "The short answer is going to be forward contracts, which is kind of the industry standard." Specifically, "it’s an agreement where whatever the currency move is over the next 30 days, it’s implemented at the beginning of each month with 30-day forward contracts."

So at the start of each month the fund enters forward contracts to sell the foreign currencies it is exposed to, in an amount matching its holdings, for delivery in thirty days. If the currency falls against the dollar, the forward gains roughly what the holdings lost in translation. If the currency rises, the forward loses roughly what the holdings gained.

Two consequences follow from that being a monthly rolling hedge rather than a continuous one. The hedge is sized to the portfolio’s value at the start of the month, so if markets move a lot the hedge drifts slightly out of proportion until the next roll. And the hedge is imperfect by construction, which is normal and small, not a defect.

What it costs, and it may not be a cost

This is the part most explanations get wrong by assuming a hedge must be expensive.

The pricing of a currency forward is set by the interest rate differential between the two currencies. For a dollar investor hedging a currency whose home interest rate is lower than the dollar’s, the forward prices in that gap, and the hedge earns rather than costs. Hedge a currency with a higher home rate and the reverse applies.

That differential moves with central bank policy, so the economics of hedging the same currency can flip over a cycle without anything about the fund changing. Any statement that hedging costs a fixed amount per year is describing one moment rather than a rule.

There is also the ordinary expense ratio difference. A hedged fund does more work and generally charges a little more for it.

The case for hedging

It removes a risk you are not compensated for. Over long periods, currency movements between developed markets tend toward a wash. You are carrying volatility without a reliable expected return attached, which is close to the definition of an uncompensated risk.

Petersen’s observation from running the strategy is direct: "by and large, when I reduce currency exposure in the portfolio, it takes away volatility."

The two risks stack in the wrong direction. This is the strongest argument and it is not obvious. Petersen: "if you have both equity and foreign currency exposure, you’re kind of getting double the downside."

The reason is a pattern in how the dollar behaves under stress. "There’s a flight to quality trade that happens where everybody starts to go into the dollar for stability if we’re in a market downturn or any type of recession." When global markets fall, capital moves into dollars, the dollar rises, and foreign currencies fall against it. So the unhedged US investor takes the equity loss and a translation loss in the same month.

The currency exposure you are carrying is therefore not neutral. It has a mild tendency to hurt precisely when everything else is hurting.

The dollar smile. Petersen described the framework: "there’s these two ends of the spectrum where the dollar strengthens and then there’s that middle ground, which actually should happen more commonly where you have expected inflation and stable growth where foreign currencies can benefit."

The dollar tends to strengthen at both extremes, when the US economy is outperforming and when the world is frightened, and to weaken in the ordinary middle where global growth is steady. Unhedged international exposure pays off in that middle and hurts at both ends.

The case against

Currency exposure is diversification. Holding assets in several currencies is a hedge against dollar-specific problems. A US investor with all dollar assets is concentrated in one currency and usually does not think of it that way.

Hedging can remove a tailwind. In a sustained dollar decline, unhedged international beats hedged, sometimes by a lot. Hedging is symmetric, so giving up the unhelpful half means giving up the helpful half with it.

It adds a moving part. Forward contracts, counterparties, a monthly roll, and tracking that is close but not exact. More machinery is more to go wrong and more to explain to a client.

Timing it is a bet in itself. Switching to a hedged fund because you expect dollar strength is a currency forecast. If you would not put on a currency trade directly, be honest that this is one.

What practitioners actually do

The most common answer in practice is not either.

John Davi of Astoria described the decision his firm reached: they "made a decision years ago to kind of split our currency risk, like half currency hedge, half unhedged." Worth disclosing: Petersen, quoted throughout this piece, manages a fund built on the same fifty percent approach, so he is not a neutral party on this particular conclusion.

Half and half has an underrated property. It guarantees you will never be maximally wrong, and it removes the temptation to time it, which is where most of the damage in this decision gets done. It also halves the volatility contribution of the currency without eliminating the diversification entirely.

The short version

Buying international equity unhedged is a decision, even when nobody framed it as one. It adds volatility, it has a mild tendency to hurt in the same months your equities do, and over long horizons developed-market currency moves tend to wash out.

Whether to hedge is a portfolio question rather than a forecast. If the currency line item is large enough to change how a client behaves in a difficult quarter, that is the argument for reducing it, and it is a better argument than any view about where the dollar goes next.

This is educational content and not investment advice. It is not a recommendation regarding any security. Investing involves risk, including possible loss of principal. Past performance does not guarantee future results.