Currency-Hedged vs Unhedged International Investments: Making the Right Choice

Currency decisions are among the most consequential — and most frequently overlooked — choices facing internationally mobile investors. Every cross-border investment involves currency risk: a UK investor holding US equities is not just exposed to American company performance, but also to the sterling/dollar exchange rate. A eurozone investor holding Japanese bonds faces yen/euro exposure. For investors living, earning and spending across multiple countries, the layering of currency exposures can create portfolio risks that are as significant as the underlying asset-class risks.

This guide provides a practical framework for deciding when currency hedging adds value, when it detracts, and how to implement it cost-effectively in a diversified international portfolio.

Why Currency Matters: The Mechanics

When an investor based in the UK buys shares in a US company, two returns are generated over the holding period:

1. The local return of the investment (the dollar-denominated gain or loss on the US shares)
2. The currency return (the gain or loss on sterling/dollar exchange rate over the same period)

If sterling strengthens against the dollar while the investment is held, the dollar-denominated return is worth less in sterling terms when converted back. If sterling weakens, the USD return is amplified when converted to sterling.

For a single investment, currency movements are unpredictable and can cut either way. But for a portfolio of international investments, the cumulative impact of currency exposure — or the cost of removing it through hedging — is a real economic decision that deserves deliberate analysis rather than default acceptance.

What Currency Hedging Does

A currency hedge uses a forward foreign exchange contract (or FX swap) to lock in today's exchange rate for a future conversion, effectively neutralising the currency exposure of the investment. A hedged version of a fund or investment:

• Pays or receives the interest rate differential between the two currencies as the "hedging cost" (or benefit)
• Delivers returns determined almost entirely by the local asset-class return, stripped of exchange rate movements
• Removes the additional volatility that currency fluctuations add to the investment

An unhedged investment:

• Delivers returns that combine local asset-class performance and exchange rate movements
• Introduces additional volatility from the currency component
• Benefits if the investment currency strengthens against the investor's home currency; loses if it weakens

The Hedging Cost: Interest Rate Differentials

The cost of hedging is determined by the interest rate differential between the two currencies — specifically, the difference between their short-term interest rates. This is known as the "covered interest rate parity" relationship.

When you hedge USD exposure back to GBP, you:

• Lend USD at the USD short-term rate (by selling the USD forward)
• Borrow GBP at the GBP short-term rate

If US interest rates are higher than UK rates, hedging USD back to GBP costs money — you earn less than the USD rate while paying the GBP rate. This cost can be significant when interest rate differentials are large.

Example (illustrative figures only — not current rates): if US short-term rates were around 0.75% higher than UK short-term rates, the cost of hedging a USD investment back to GBP would be approximately 0.75% per annum. For a bond investment yielding 5% in USD, the hedged yield would be approximately 4.25% — still a positive return, but less than the unhedged USD yield. Interest rate differentials change continually; check current rates before applying this to a real decision.

Conversely, when the investor's home currency has higher interest rates than the investment currency (common for investors in emerging markets holding developed market investments), hedging generates a positive return — but this requires careful interpretation, as it simply reflects the interest rate advantage of the home currency, not excess investment return.

When to Hedge: Asset Class Matters

The hedging decision is not one-size-fits-all. Evidence and logic suggest different approaches for different asset classes:

Fixed Income: Hedge

For bonds and other fixed-income investments, currency hedging is almost always appropriate. The reasons are:

• Currency volatility swamps bond returns: a ten-year government bond in a major market might yield 4–5% annually. A currency move of 10–15% (quite normal for major currency pairs over a year) would completely dominate this return, turning the investment from predictable income into a speculative FX bet.
• The "safe haven" role of bonds is undermined: bonds held for their defensive, portfolio-stabilising properties do not serve that function if their returns are dominated by volatile currency moves.
• Hedging costs are typically modest relative to bond spreads: the yield earned on an investment-grade bond typically exceeds the hedging cost, leaving positive net yield after hedging.

For short-duration bonds (maturities under two years), hedged and unhedged returns converge quickly because the principal is returned in cash in the short term. For long-duration bonds, currency hedging is strongly advisable.

Equities: Generally Do Not Hedge (for Long-Term Investors)

For long-term equity investors, currency hedging is generally less beneficial and often counterproductive:

• Currency moves are smaller than equity moves over long horizons: over five to ten years, the underlying equity return typically vastly exceeds currency fluctuations, rendering the hedging decision relatively minor.
• Hedging costs accumulate: paying 0.5–1.0% per annum in hedging costs over a ten-year equity holding materially reduces compounded returns.
• Currency diversification has genuine value: for an investor with a single spending currency, holding equity assets denominated in multiple currencies provides natural currency diversification. The US dollar, euro, yen and Swiss franc all have different cycle patterns; holding a mix reduces concentration in a single currency regime.
• "Real" exchange rates tend to mean-revert: currencies that deviate significantly from purchasing power parity tend to revert over time, reducing the long-run impact of short-term currency moves.

There are exceptions: if an investor is highly concentrated in a single foreign currency equity market and has a shorter-than-typical horizon, hedging part of the exposure may be justified.

Real Assets: Mixed

• Gold: typically held unhedged, as gold functions itself as a currency-like store of value and currency diversifier.
• Infrastructure with USD revenue, held by a EUR investor: may benefit from partial hedging, particularly where cash flows are contractually defined.
• Property: typically held unhedged, as the investor ultimately owns physical assets in a specific currency.

Alternatives: Case by Case

Hedge funds, private equity and similar alternatives are typically held unhedged at the fund level (in the fund's base currency); the investor can hedge currency at the portfolio level if needed.

The Internationally Mobile Investor: A Different Calculation

Standard hedging frameworks assume a single home currency. For internationally mobile investors — those who earn in multiple currencies, spend in multiple countries, and may not know definitively where they will retire — the calculation is more nuanced:

What is your "spending currency"? An investor who spends 50% of their budget in GBP and 50% in EUR has a blended benchmark currency, not a single one. Over-hedging to a single currency imposes an artificial constraint.

Multi-currency reserves as a hedge: maintaining significant cash and liquid investment reserves in multiple currencies (USD, EUR, GBP, CHF, SGD) provides natural currency diversification without the ongoing cost of forward hedging.

The dynamic nature of currency exposure: an investor who moves from the UAE (spending in AED/USD) to Spain (spending in EUR) needs to rethink their currency hedging strategy on relocation. Currency hedging decisions should be reviewed whenever the investor's country of residence or spending patterns change significantly.

Carry and currency selection: rather than passively hedging or leaving currency open, sophisticated international investors sometimes take deliberate currency positions as part of their overall strategy — overweighting currencies with high carry (interest rate advantage) or underweighting currencies expected to depreciate. This is an active strategy and carries its own risks.

Implementation: Hedged vs Unhedged Share Classes

For investors holding ETFs or UCITS funds, the simplest implementation of a hedging decision is through share class selection:

• Unhedged share class (e.g., iShares MSCI World ETF in USD): delivers returns in the fund's base currency; UK investors holding this fund in a GBP account experience USD/GBP currency moves
• Currency-hedged share class (e.g., iShares MSCI World ETF GBP Hedged): the fund manager implements rolling FX forwards to neutralise the currency exposure; the investor receives returns approximately equal to the USD return minus hedging cost

For bond ETFs and fixed-income funds, GBP-hedged share classes (or EUR-hedged) are generally preferable for investors whose spending currency matches the hedge.

How Global Investments Can Help

Global Investments works with internationally mobile clients to design currency strategies integrated with their overall portfolio. Our advisers assess each client's spending currency situation, evaluate the hedging cost/benefit trade-off across asset classes, and implement appropriate strategies through hedged share classes, forward contracts, or multi-currency structures.

We bring a specific expertise in cross-border currency planning that is often absent from advisers focused on domestic markets — helping clients avoid both over-hedging (incurring unnecessary costs) and under-hedging (accumulating unintended currency concentration). Contact us for an initial consultation.

Capital is at risk. The value of investments and any income from them can fall as well as rise, and you may receive back less than you invest. Currency hedging involves costs and does not guarantee against currency losses. Past performance is not a guide to future results. This guide is for information only and does not constitute regulated financial advice. Tax treatment depends on individual circumstances and may change. Seek independent regulated financial advice before making investment decisions.