Currency Hedged vs Unhedged ETFs: Should You Hedge Your International Investments?

The Currency Dimension in International Investing

When you invest in assets denominated in a foreign currency, you take on two separate sources of return and risk: the performance of the underlying assets, and the movement of the exchange rate between your functional currency and the currency in which the assets are denominated.

These two sources of return are entirely independent. The S&P 500 could rise 15% in dollar terms while the dollar weakens 15% against sterling — a UK investor's return in sterling terms would be approximately zero. Alternatively, if the dollar strengthens 15%, the UK investor's return in sterling terms would be approximately 30% even though the US market only rose 15%.

Currency movements are large, unpredictable over the short term, and have a material impact on investment returns. The GBP/USD exchange rate moved from approximately 1.40 in early 2021 to 1.07 in September 2022 — a 24% appreciation of the dollar against sterling. A UK investor in unhedged US equities collected a 24% currency tailwind over this period, in addition to whatever the market itself did.

The question of whether to hedge this currency risk — and how — is one of the most debated in international portfolio management.

How Currency-Hedged ETFs Work

A currency-hedged ETF uses foreign exchange forward contracts to neutralise the currency effect on your return. In practice:

1. The ETF buys the underlying foreign securities (say, US equities denominated in USD)
2. Simultaneously, the ETF enters into forward contracts to sell USD and buy GBP at a predetermined rate
3. These forwards are rolled forward regularly (typically monthly)
4. The result is that the ETF's GBP return reflects the local market performance (in USD) rather than the combined effect of market performance plus currency movement

Hedged ETFs are typically labelled with "(GBP Hedged)" or a similar notation in the share class description. Most major ETF providers (iShares, Vanguard, Xtrackers) offer hedged and unhedged share classes for their largest products.

The Cost of Hedging: Forward Points and Interest Rate Differentials

The cost (or income) from hedging is determined by the interest rate differential between the two currencies — a relationship known as covered interest rate parity.

If US interest rates are 5% and UK interest rates are 4%, a UK investor hedging USD exposure will pay approximately 1% per year in net hedging cost. Hedging means selling USD forward and buying GBP, so the investor effectively gives up the higher US rate and earns the lower UK rate — the difference is a cost. The forward market prices in this differential.

Conversely, if UK rates were 5% and US rates were 4%, a UK investor hedging USD would receive approximately 1% per year in net hedging income (a positive carry).

This has important practical implications:

• 2015–2021 (US rates low, UK rates low): Hedging cost was minimal — interest rate differentials were small
• 2022–2024 (US rates rose faster than UK): The interest rate differential created a negative carry for UK investors hedging USD — with US rates above UK rates, they paid to hedge
• As rate cycles evolve: The cost/income from hedging changes continuously

Many investors assume hedging always costs money. This is incorrect. The hedging cost reflects the interest rate environment, not a fee charged by the ETF provider.

When Hedging Makes Sense: The Case for Fixed Income

The consensus among institutional investors and academics is clearest for bonds: hedge currency risk on international fixed-income holdings.

The reason is straightforward. Suppose you invest in a portfolio of US government bonds yielding 4.5% per annum. If the dollar depreciates 10% against sterling over the year, your sterling return is approximately -5.5%. Currency risk has completely overwhelmed — and reversed — the bond yield you were being paid.

For a bond investor, the primary objective is collecting reliable income and preserving capital in local currency terms. A 10% currency swing — which is entirely plausible in a single year — is enormous relative to the 3–5% yields available in most developed market bond markets. Currency risk fundamentally changes the risk profile of an otherwise conservative asset class.

For this reason, most institutional investors hedge currency risk on developed market bond portfolios. The hedged yield (after accounting for the cost or income of hedging via forward contracts) gives you the actual return you will receive in your functional currency. This is the economically meaningful number for a sterling-based investor.

When Hedging Is Less Important: The Case for Long-Term Equity Investing

For long-term equity investors, the case for hedging is much weaker. The academic and practitioner consensus is broadly: leave global equity portfolios unhedged.

The reasoning:

Currency risk averages out over long periods. Over a 10–20 year investment horizon, the evidence suggests that currency fluctuations largely cancel out. Major currencies tend to mean-revert towards purchasing power parity over long periods — a currency that weakens significantly tends to eventually recover. Investors who hold through full currency cycles are not systematically harmed by currency exposure.

Hedging costs erode long-term returns. Even when hedging income/cost is theoretically neutral (per covered interest parity), real-world hedging has frictional costs: bid/ask spreads on forward contracts, the operational cost borne by the ETF, and basis risk (imperfect hedging). These costs compound over time.

Equity returns are typically larger than currency moves. Equities return 6–9% per annum over long periods. Annual currency moves of 5–10% are meaningful in context of a single year but represent a smaller proportion of total returns over a decade.

Real asset theory. Owning equities is equivalent to owning claims on real productive assets — companies that manufacture goods, provide services, and operate globally. These real assets have some natural currency protection: a multinational company's revenues and profits tend to adjust over time as currencies move, reducing (though not eliminating) pure currency risk.

Interest Rate Parity and Its Imperfections

In theory, the forward exchange rate exactly compensates for the interest rate differential — this is covered interest rate parity (CIP). If CIP holds perfectly, hedging is neutral in expected value terms: the currency movement you lock in via the forward exactly equals what the interest rate differential predicted.

In practice, CIP does not hold perfectly. There are persistent deviations — known as the "CIP basis" — particularly in stressed market conditions. The basis means that the expected gain or loss from hedging can differ from the interest rate differential.

More importantly for investors: currencies do not follow interest rate parity predictions in the short run. The dollar strengthened enormously in 2022 despite other currencies having higher real interest rates; sterling collapsed after the September 2022 "mini-budget" regardless of what interest rate parity theory predicted. Over short periods, technical factors, risk appetite, and political events drive exchange rates. Over longer periods, purchasing power parity and interest differentials are better guides.

Practical Guidance by Scenario

Long-term (10+ year) global equity investor, stable residency: Leave the portfolio unhedged. The currency risk is acceptable over a long horizon, hedging costs erode returns, and the complexity is not justified.

Medium-term (3–7 year) investor approaching a large spending need: Consider hedging a portion of the international allocation for the years immediately preceding the spending requirement. Currency certainty becomes more valuable as the time horizon shortens.

Fixed income investor: Hedge. Currency risk is too large relative to bond yields.

Investor with unknown future residency (internationally mobile): Currency hedging to a specific functional currency may itself introduce risk if you move countries. A globally mobile investor may be better served by a portfolio of assets in multiple currencies that naturally diversifies across their likely future spending currencies, rather than hedging everything to a single currency they may not spend in indefinitely.

Investor in an emerging market currency: Hedging EM currency risk is expensive — the interest rate differentials are large — and the forward market is less liquid. EM-focused investors typically accept currency risk as part of the emerging market premium, or choose USD-denominated emerging market investments (hard currency bonds) which eliminate local EM currency risk.

A Note for Internationally Mobile Investors

For investors who do not have a single stable functional currency — because they live in one country, earn in another, and may retire in a third — the hedging question is more complex than it appears for a settled UK investor comparing GBP returns.

An investor earning in USD who is currently resident in the UAE (pegged to USD) but plans eventually to retire in Europe may have a EUR functional currency objective in the long run, making EUR-hedged products relevant — even though today they are spending in AED.

The appropriate framework is to identify your long-run consumption currency (where you will ultimately spend your wealth) and consider that when making hedging decisions. For investors genuinely uncertain about future residency, maintaining a portfolio of assets spread across major currencies may be a more practical approach than complex hedging strategies.

Risks and Considerations

Currency hedging does not eliminate all risk. Basis risk (imperfect hedging), counterparty risk on forward contracts, and roll risk (the cost of rolling forward contracts at unfavourable rates) all exist within hedged ETFs. The ETF manager bears these risks operationally, but they ultimately affect the fund's tracking error and return.

For unhedged investors: currency movements can be large and unfavourable over meaningful time periods. Investing internationally always involves accepting that some years the currency will work against you. This is a real risk, not a theoretical one.

Capital invested in all forms of investment can fall as well as rise. Exchange rate movements are unpredictable. Rules on currency hedging products and their tax treatment may change. Seek professional financial advice before making investment decisions.

How Global Investments Can Help

Our advisers work specifically with internationally mobile clients who have complex currency situations — earning in one currency, spending in another, planning for retirement across borders. We can help you assess your genuine functional currency exposure, determine the appropriate hedging strategy for your specific portfolio and life situation, and select the right currency share class for each ETF in your portfolio. Contact us to discuss your currency and investment strategy.