Investors can use currency-hedged ETFs to protect their investments from the risk of currency fluctuations. In this guide, moneyland.ch explains how currency hedging works, and whether it makes sense to use it.
Many ETFs are offered in two versions: the standard version without currency hedging, and a currency-hedged version. ETFs with currency hedging often contain the word “hedged” in their title. This guide looks at if and when using currency-hedged ETFs could make financial sense.
What is currency hedging?
Currency hedging is a financial practice that aims to insure an investment against a possible devaluation of the currency that the asset is denominated in. If you, as a Swiss investor, hold securities that are denominated in a foreign currency, a depreciation of that currency against the Swiss franc will negatively impact your investment returns in Swiss francs. ETFs with currency hedging have the goal of protecting investors from this risk.
Example of currency exchange rate risk
The easiest way to explain the impact of currency depreciation on an ETF investment is with an example:
Suppose you, as an investor in Switzerland, bought 1000 US dollars worth of shares in an ETF that replicates the US stock market, at an exchange rate of 0.85 francs per US dollar. The total cost of your investment would be 850 francs.
Within one year, the US dollar value of your ETF shares goes up by 10 percent, climbing to 1100 dollars. Within the same time period, the value of the US dollar against the Swiss franc declines to where a dollar is worth just 0.75 francs.
If you were to sell your shares, you would get just 825 francs. So although the value of the ETF gained 10 percent in US dollars, you as a Swiss investor would have made a loss on the investment in Swiss francs.
How does currency hedging work?
The service providers that manage currency-hedged investment funds – including ETFs – normally use recurring investments in currency futures to hedge against currency depreciation. In a currency futures contract, the two parties agree to exchange currencies at a specific exchange rate at a predetermined future date. So the ETF’s manager sells the ETF’s denominating currency and buys the hedged currency at regular intervals. This currency exchange is usually done on a monthly basis. Because the currency exchange rate is already agreed when the futures contract is created, any currency depreciation that happens during the contract term does not affect the value of the investment.
Currency-hedged ETFs normally replicate indexes that incorporate currency hedging. The S&P 500 (CHF Hedged) index – a subindex of the well-known US stock index S&P 500 – is one example of a stock index with Swiss franc currency hedging. The index’s performance is based on estimates, so the actual performance of ETFs that replicate the index may differ from that of the index itself.
What are the disadvantages of currency hedging?
The higher investment costs are the main disadvantage, because currency hedging is not free. The cost is passed on to you as the investor in the form of a higher total expense ratio (TER). Compared to unhedged ETFs that replicate the same index, the TERs of currency-hedged ETFs are often between 0.2 and 0.25 percent higher. You should also understand that the TER only accounts for the increased administrative cost of hedging. But there are additional, variable costs that may also apply:
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Whether you use hedged or unhedged ETFs, you should always pay attention to the fees charged by stockbrokers. High brokerage fees and custody fees detract from your investment returns. You can compare stockbrokers based on your specific needs using the interactive online trading comparison on moneyland.ch.
Tip: In addition to conventional banks and stockbrokers, you can also invest in securities using neobanks. These service providers typically have low fees, but only offer a limited selection of investments – which also applies to currency-hedged ETFs. The guide to investing with neobanks provides detailed information.
Does using currency-hedging bring higher returns?
There is no single answer. Whether or not currency hedging pays off largely depends on the specific ETF in question, how the ETF’s share price develops, and how the value of the ETF’s denominating currency develops in relation to the hedged currency. In very general terms: Currency hedging pays off if the depreciation of the foreign currency against the franc is greater than the total costs of hedging.
The graph below shows the performance of hedged and unhedged ETFs that track the same index across various periods of time. Whether the hedged or unhedged ETF delivered higher returns depends on the index and time period. The MSCI Japan index is particularly interesting: The very strong depreciation of the Japanese yen against the Swiss franc in the recent past resulted in exceptional performance for the hedged ETF.
The year 2024 is also interesting because, unlike many other years, the Swiss franc lost value in US dollars, British pounds, and euros. With the exception of MSCI Japan ETFs, the Swiss franc hedged versions of ETFs came in behind their unhedged counterparts in that year.
It is very important to keep in mind that it is impossible to accurately predict how the values of both assets and currencies will develop in the future. So there is no sure way to predict whether or not using currency hedging will result in higher returns over any period of time in the future.
Who could benefit from using currency-hedged ETFs?
ETFs with currency hedging are worth considering if you want to invest in foreign assets, but do not want to carry the currency exchange rate risk yourself. With very few exceptions, the Swiss franc has consistently gained value against foreign currencies in the past. This appreciation of the Swiss franc has negatively impacted Swiss franc returns from foreign investments. The more value the foreign currency loses against the Swiss franc, the greater the likelihood that the hedged version of an ETF will deliver a better return.
However, you should always be aware of the high costs of hedging, which often exceed the currency exchange rate loss.
Note: This article is provided for informational purposes only and should not be considered as investment advice. The publisher does not accept any liability in relation to this publication.
More on this topic:
Compare Swiss stockbrokers now
Forex: How to invest in fiat currencies
Checklist for choosing the right ETF
Common ETF investment mistakes to avoid
Using ETFs to invest: The pros and cons
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