Almost every mutual fund and ETF has some degree of currency risk, as the companies in these portfolios may have operations in many countries. These businesses generate profits based on a foreign currency, which exposes the investor to currency risk. Consider these reasons why currency hedging is an important tool to reduce risk.
Assume, for example, that Acme Company is based in the United States and has retail stores in the United Kingdom. Acme provides capital to its U.K. stores, which requires the firm to convert U.S. dollars into pounds. Also assume that $1 is converted into £2.
Acme reports its year-end financial results in U.S. dollars. The profit generated by U.K. stores must be converted from pounds into dollars. Assume that the exchange rate is now $1 dollar to £4. It now takes twice as many pounds to convert into a single U.S. dollar, which makes the British pound sterling, or GBP, far less valuable.
This risk is also applicable to mutual funds and ETFs. If you own a portfolio of stocks based in the United Kingdom, you’re exposed to currency risk. The value of your fund can decline due to changes in the exchange rate between the United Kingdom and the United States, which is one of several reasons why currency hedging is important.
1. Eliminate Risk Over the Long Term
Suppose you own a U.K.-denominated fund. Your investment objective is to own companies based in that country that perform well. The exchange rate between the dollar and the pound will change over time, based on economic and political factors. For this reason, you need to hedge your currency risk to benefit from owning your fund over the long term.
2. Foreign Stocks Add Portfolio Diversity
You want to own companies in the United States and in foreign countries to properly diversify your portfolio. For example, frontier and emerging markets are attractive to investors who want to take more risk and achieve higher returns. Since most investors use foreign-based investments, they can reduce their risk exposure using currency-hedged ETFs and mutual funds.
3. Forward Contracts
Many funds and ETFs hedge currency risk using forward contracts, and these contracts can be purchased for every major currency. A forward contract, or currency forward, allows the purchaser to lock in the price they pay for a currency. In other words, the exchange rate is locked in place for a specific period of time.
However, there is a cost to buy forward contracts. The contract protects the value of the portfolio if exchange rates make the currency less valuable. Using the U.K. example, a forward contract protects an investor when the value of the pound declines relative to the dollar. On the other hand, if the pound becomes more valuable, the forward contract isn’t needed.
Funds that use currency hedging believe that the cost of hedging will pay off over time. The fund's objective is to reduce currency risk and accept the additional cost of buying a forward contract.
4. Hedging Large Currency Declines
A currency hedging strategy can protect the investor if the value of a currency falls sharply. Consider two mutual funds that are made up entirely of Brazilian-based companies. One fund does not hedge currency risk. The other fund contains the exact same portfolio of stocks, but purchases forward contracts on the Brazilian currency, the real.
If the value of the real stays the same or increases compared to the dollar, the portfolio that is not hedged will outperform, since that portfolio is not paying for the forward contracts. However, when the Brazilian currency declines in value, the hedged portfolio performs better, since that fund has hedged against currency risk.
Political and economic factors can cause large fluctuations in exchange rates. In some cases, currency rates can be very volatile. A hedged portfolio incurs more costs, but can protect your investment in the event of a sharp decline in a currency’s value.
