Interest rates and inflation have no doubt been the hottest topic on the street for the past two years. Interest rates and inflation have a significant effect on currency, and as such the matter of foreign exchange and currency exposure has also been front of mind for investors.

An increasingly popular line of questions has been whether one should start looking at currency hedging, especially in the context of what appears to be diverging interest rate paths between the US Federal Reserve and the Reserve Bank of Australia. In this article, we seek to answer important questions about currency hedging, especially in the context of ETFs.

Key Questions Answered

Why should you hedge your investments?
When is it a good time to currency hedge your investment?
How does currency hedging work for ETFs?

Why Hedge?

When investing internationally, investors are naturally exposed to the additional risk of currency fluctuations. Oversimplified, international investors contend with both movements in the price of their investment and the foreign exchange rate, making investment returns doubly difficult to forecast.

Consider, for example, an Australian investor who purchases a US stock which proceeds to double in value. In the case that the Australian dollar (AUD) also appreciates 100%, the investor may find that his investment outcome in AUD terms nets out to zero, making what appeared to be a successful trade, a meaningless endeavour.

Of course, the opposite could occur where the US dollar (USD) doubles instead, giving our very happy investor an AUD return of quadruple the initial investment.

Graph: Investment Value: Currency Fluctuations

These examples are extreme, and such volatility is rarely observed in foreign exchange (outside of emerging markets), but they demonstrate the unpredictability of unhedged international exposures and its potential to either boost or, more dangerously, negate the value of your investment. A risk conscious investor can seek to remove this unpredictability by currency hedging their investments. Speculative investors can also use currency hedging to counter the expected appreciation/devaluation of their domestic currency/international currency exposure.

When Should You Currency Hedge Your Investment?

Investors may want to consider tactical currency hedging when they expect significant fluctuations in exchange rates that could impact their returns. For example, if interest rates are rising in their home country but decreasing or unchanged in the country where they hold investments. In this scenario, the home currency may appreciate, reducing the value of their foreign investments. Similarly, differences in inflation rates can also affect currency values; if inflation is higher in the country of the foreign investment, the local currency might weaken, diminishing returns.

For long-term allocations, the concept of “hard” and “soft” currency comes into play. Hard currencies are defined as being able to hold and appreciate in value relative to their currency pairs, while the vice versa is true for soft currencies. Each currency’s status as hard or soft is not a static label. Depending on macroeconomic conditions, particularly interest rates, inflation, or economic demand, dynamics can switch – however such inversions are rare and tend to return to the status quo in the long term. As an international investor, it is generally favourable to have consistent exposure to hard currencies, and less exposure to soft currencies.

Currency Hedging to the Australian Dollar

In the context of the Australian and US dollar, USD has historically demonstrated the properties of a hard currency. As displayed in the chart below, the AUD has consistently depreciated in relation to the USD since 1971 (the furthest Bloomberg data goes back). But there have been pockets on the timeline where AUD was the stronger of the pair.

Graph: AUD Has Historically Depreciated Against the USD

During these stretches of AUD dominance, currency hedging would have been invaluable in defending investment value. That being said, we generally consider AUD currency hedged (equity) ETFs as tools for short-term, tactical asset allocation rather than long-term buy and hold.

How do Currency-Hedged ETFs Work?

Currency hedged ETFs use foreign exchange (FX) forward contracts to limit the effect of currency fluctuations on the end investor’s home currency return. FX forward contracts are agreements between two parties to exchange currencies at a predetermined rate and a future point in time, regardless of the spot exchange rate at the time of exchange. This means, regardless of which direction the exchange rate moves, it will have no effect on your investment return as the exchange rate is locked in.

Mechanics of Implementation

For passive index-tracking ETFs, FX hedging generally occurs once a month on a pre-determined currency rebalancing day. For many funds, this is the last business day of the month. On this currency rebalancing date, an FX forward contract is overlaid on the full value of the fund, ensuring all currency fluctuations in the underlying are accounted for. If any currency fluctuations occurred in the prior month, gains and losses are offset by the portfolio management team to ensure local investors’ returns are representative of a hedged exposure.

To break down each step, let’s take our newly launched Global X FANG+ (Currency Hedged) ETF (ASX: FHNG), which seeks to hedge the Global X FANG+ ETF (ASX: FANG), as an example. On the last day of the ongoing month, the fund enters a “Sell USD, Buy AUD” FX forward contract that will expire at the end of the following month. This FX forward contract covers the entire value of the fund’s FANG exposure at the date of contract writing. In other words, FHNG’s FX hedge ratio (the value of the hedge compared to the underlying investment) is 100% at this moment in time.

Graph: Hypothetical Currency Rebalancing: AUD Depreciates

Over the next month as both the fund underlying and exchange rate changes, the fund’s FX hedge ratio will fluctuate and FHNG’s performance will be split into two elements. A hedged portion covered by the forward contract, and an unhedged portion which represents the performance of the underlying investment. At the end of the month (the new currency rebalancing date), the initial FX forward contract is closed out, and any profits or losses from the contract will be crystallised and reinvested or divested from the fund. If there was a gain from the forward contract (the AUD appreciates or USD depreciates), the crystallised profit will be used to buy more FANG to increase exposure and remove the negative currency effect. Conversely, if a loss is crystallised (the AUD depreciates or USD appreciates), the fund would sell FANG to counter the positive currency effect. Once these trades are actioned, the fund will enter a new FX forward contract to hedge the new value of the underlying.

Graph: Hypothetical Currency Rebalancing: AUD Appreciates

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