The diversification benefits of investing internationally are clear: exposure to global sectors and companies under-represented in Australia, opportunities to temper domestic market swings, and a way to mitigate behavioural biases that lead many to over-invest in securities familiar to them. 

But just as when you travel overseas and the amount of local currency you can buy with your Australian dollars is determined by foreign exchange rates, international investment returns can be similarly influenced. This is why individual and institutional investors employ currency hedging as a form of insurance. 

By hedging investments, investors are effectively locking in a fixed exchange rate so the impact of future currency fluctuations on the value of international assets is reduced. 

The purpose of currency hedging is not necessarily to improve returns but to lessen its variability. Foreign exchange market movements are notoriously difficult to predict - rates are driven by a variety of economic and political factors, so hedging provides a way for investors to manage currency risks. 

[Editor’s note: To learn more about the features, benefits and risks of Exchange Traded Funds, take the free ASX online ETF course.]
 

Two sides to every hedge 

Hedged ETFs, such Vanguard’s MSCI Index International Shares (Hedged) ETF (ASX: VGAD) can often provide the same market exposure as an unhedged ETF like Vanguard’s MSCI Index International Shares ETF (ASX: VGS).

The difference is that some hedged ETFs are hedged to Australian dollars, so the return - the income and capital appreciation – of the ETF is relatively unaffected by currency fluctuations. 

So, if that’s the case, why don’t all investors who hold global securities tie their investments to their local currency?  

While hedged investors benefit should the Australian dollar rise against other currencies, unhedged investors actually benefit when the dollar falls. [Editor’s note: this does not account for price movements in an ETF’s underlying exposure in shares or other securities]. 

This is because when the dollar depreciates, returns from unhedged investments are given a boost because earnings from overseas are “worth more” in Australian dollars once converted back from the foreign currency. The opposite happens when the dollar appreciates. 
 

What to consider when hedging

To hedge or not to hedge ultimately comes down to personal preferences and how much risk each investor is willing to tolerate for the investment time frame they have. 

Investors who have a shorter time frame (say, nearing retirement or close to achieving a savings goal) are likely to have less tolerance for large deviations in their investment returns than someone with a longer horizon (say, younger investors). 

If the thought of prolonged periods of unfavourable currency movements is unnerving, then hedging could be a possible strategy to consider implementing.

Regardless of your situation, when looking at an international investment it is a good discipline to consciously decide about whether to hedge or not.

The decision to hedge also requires a whole-of-portfolio perspective and should be made in conjunction with other asset-allocation choices. 

Investing internationally, both in equities and bonds, naturally reduces home bias but hedging should be applied differently to each. Aside from that, there’s also the consideration that foreign currency exposure can itself be a source of diversification. 
 

Which assets to hedge?

Vanguard research has found that, because currency movements are typically more volatile than fixed income assets, investors should consider whether it is appropriate to hedge their fixed income exposure. 

Equities, however, is where the rubber hits the road, and whether to hedge depends on the relative volatility of the underlying asset and the correlation (relationship) between it and the foreign currency. The higher the correlation, the higher the volatility. 

That being said, these correlations vary over time, making it difficult to predict currency moves in the future. A potential solution to this is to consider partially hedging a portfolio – investors can therefore aim to reduce their currency risks but at the same time, minimise forecasting errors. 

In Vanguard’s experience, some financial advisers recommend taking a “no-regrets” approach and hedge 50% of the portfolio. 
 

How much for that hedge?

As with every investment, costs are a key consideration. 

Hedged investments are likely to entail higher fees than an unhedged investment as there’s an additional cost involved in implementing a hedging strategy. 

Over time, Vanguard research anticipates long-term returns on hedged equities to be potentially lower than unhedged equities due to these additional costs, which suggests hedging may either be an effective short-term strategy or better partially applied to a portfolio. 

All these considerations may seem daunting, but investors would do well to understand that hedging is simply a personal preference and ultimately, a decision to be made only once a strategic asset allocation and investment time frame has been determined.