Investing in global ETFs is a popular way for Australians to gain exposure to international markets — from the S&P 500 to Europe, Asia, and beyond. But when you invest globally, you’re not just buying foreign shares. You’re also taking on currency risk. And that’s where currency hedging comes into play.
This article unpacks what currency hedging means, how it works in the context of global ETFs, and what everyday investors might want to consider when weighing up hedged versus unhedged ETF options.
What is currency hedging?
Currency hedging is a strategy used to reduce the impact of exchange rate movements on an investment. When Australian investors buy global ETFs, the underlying assets are typically priced in foreign currencies — like USD, EUR, JPY, or GBP. But the returns are eventually converted back to Australian dollars (AUD), and that conversion can either work in your favour or against you.
Currency risk in global investing
Here’s a simple example: imagine you invest in a US ETF and over the next year, the ETF rises 10%. However, if the Australian dollar strengthens against the US dollar during that same period, some of those gains might be eroded when converted back to AUD. Conversely, if the AUD weakens, your returns might get a boost.
This variability in returns due to currency movements is known as currency risk .
Hedged vs unhedged ETFs
To manage this risk, ETF providers often offer two versions of the same fund:
- Unhedged : Leaves currency exposure intact. Your returns are affected by both asset performance and currency fluctuations.
- Hedged : Uses financial instruments to minimise the impact of exchange rate movements. Your returns more closely reflect the performance of the underlying assets alone.
How hedging works in global ETFs
ETF issuers use financial contracts — typically forward exchange contracts — to lock in currency exchange rates over a set period. These contracts aim to “neutralise” the effect of currency moves between the fund’s base currency and the investor’s currency (AUD, in this case).
An overlay, not an add-on
It’s worth clarifying that individual investors don’t personally hedge. Rather, they choose ETFs that already have the hedge built in. So when people talk about “overlaying” a currency hedge on global ETFs, it means opting for a hedged version of an ETF rather than modifying a fund themselves.
For example:
- Vanguard International Shares ETF ( VGS ) – unhedged
- Vanguard International Shares (Hedged) ETF ( VGAD ) – hedged
These ETFs track similar underlying indexes but handle currency exposure differently.
Examples of hedged vs unhedged ETFs
To make things more tangible, let’s look at a few real-world ETF pairs that offer both hedged and unhedged options:
|
ETF |
Type |
Region |
Hedging |
|---|---|---|---|
|
VGS |
Vanguard International Shares ETF |
Developed Markets (ex-AU) |
Unhedged |
|
VGAD |
Vanguard International Shares (Hedged) ETF |
Developed Markets (ex-AU) |
Hedged |
|
IVV |
iShares S&P 500 ETF |
US |
Unhedged |
|
IHVV |
iShares S&P 500 ETF (Hedged) |
US |
Hedged |
|
NDQ |
Betashares Nasdaq 100 ETF |
US (Tech-focused) |
Unhedged |
|
HNDQ |
Betashares Nasdaq 100 ETF (Hedged) |
US (Tech-focused) |
Hedged |
These pairs provide a way to directly compare how hedging affects returns over time.
Diverging performance
During periods where the AUD is volatile, returns between hedged and unhedged ETFs can differ significantly.
For instance, in 2020 when the AUD fell sharply against the USD during the initial COVID market panic, unhedged global ETFs saw a boost in AUD terms. Investors in unhedged funds benefited not only from the market recovery, but also from favourable currency movements.
However, during 2017–2018, when the AUD strengthened, hedged versions often outperformed because they weren’t dragged down by currency losses.
Pros and cons of currency hedging
Currency hedging is neither inherently good nor bad — it’s a trade-off. Let’s look at some of the key benefits and drawbacks:
Benefits of hedging
- Reduces currency volatility : Hedging limits the impact of exchange rate swings on investment returns.
- Aligns with local spending needs : If your future spending will be in AUD (for example, retirement in Australia), hedging can help match investment outcomes to future liabilities.
- Clearer exposure to underlying assets : Performance is more directly tied to the companies in the index, not currency movements.
Drawbacks of hedging
- Costs : Hedging involves costs that may slightly reduce long-term returns (though these are generally small for large, passive ETFs).
- Opportunity Loss : If the AUD weakens, unhedged ETFs may benefit — hedged ETFs won’t.
- Imperfect Hedging : In fast-moving markets, hedges aren’t always perfect. The fund might not eliminate 100% of currency effects.
How might investors think about hedging?
There’s no one-size-fits-all answer, and this article won’t try to provide one. But here are some neutral factors investors might consider when weighing their options:
Investment horizon
Long-term investors may be more comfortable with currency fluctuations evening out over time. Others might prefer short-term stability and reduced volatility, especially if they're nearing retirement or needing predictable returns.
Where will you spend?
If you plan to retire in Australia and spend in AUD, a hedged ETF might align more closely with your future financial needs. If you’re saving for overseas expenses — such as travel or relocating — an unhedged ETF could make sense.
Views on the AUD
If you believe the Australian dollar is likely to rise in value, hedged ETFs may help preserve returns. If you expect it to fall, unhedged ETFs could provide an uplift — though currency forecasting is notoriously difficult.
Portfolio diversification
Some investors hold a mix of hedged and unhedged ETFs to spread risk. For example, using hedged ETFs for core holdings and unhedged for satellite exposure.
A Quick comparison: VGS vs VGAD
Here’s a simplified illustration of how two similar ETFs can perform differently due to currency effects:
|
Year |
VGS (Unhedged) |
VGAD (Hedged) |
AUD/USD Change |
|---|---|---|---|
|
2020 |
+5.8% |
+1.4% |
AUD weakened |
|
2021 |
+25.2% |
+22.5% |
AUD strengthened |
|
2022 |
-12.4% |
-18.6% |
AUD volatile |
Note: Figures are illustrative and rounded. Actual ETF performance may vary.
This table shows that currency movements can amplify or reduce returns depending on market conditions.
Final thoughts
Currency hedging is an important — but often overlooked — dimension of global investing. Whether or not to hedge isn’t a matter of “right” or “wrong,” but of understanding what each approach entails.
As an investor exploring global ETFs, being aware of your exposure to foreign currencies, and how hedging affects performance, is a useful step toward making informed investment choices that align with your own goals.
