Should you pick a currency-hedged ETF if you don't live in the USA?

Some ETFs are 'hedged'. This usually means they are currency-hedged.

Currency-hedged ETFs are designed to protect investors from currency risk. They are a simple, cheap and effective way for small investors to access currency management techniques that were once the preserve of major financial institutions.  

Currency risk affects you negatively when your home currency strengthens against a foreign currency – reducing the value of your assets held in that foreign currency. That means UK based investors are exposed to currency risk on all non-hedged ETFs that trade in overseas securities.  

Currency-hedged ETFs are useful because they remove the uncertainty of exchange rate fluctuations. They sterilise your portfolio against the effect of currency so that your overseas investment doesn’t gain when the pound falls or lose when the pound rises.  

Let us look at the US Dollar versus the GB Pound.

At the beginning of this year 1 USD = 0.824 GBP

Today (18/10/2024) we have 1 USD = 0.766 GBP

Let us convert this into real money. Suppose I had $1000 of US Equities in Jan 2024, it would be worth £824 but assuming the US equities did not change in price, those stocks would now be worth £766.

• Jan 2024 - $1000 = £824
• Oct 2024 - $1000 = £766 - £58 less in one year!

Over the last 10 years, the USD-GBP exchange rate has varied quite a bit from 0.6 to 0.9!

Since October 2022 the exchange rate has steadily declined by about 15%. But will it continue to decline?

NASDAQ Example

Comparing NASDAQ 100 we get for this last year assuming we bought £1000-worth of ETFs in January 2024:

EQQB (Acc) - £1280 - approx 28% gain  TER=0.07

EQGB Hedged (Acc) - 1370 - approx. 37% gain  TER=0.20

So the hedged ETF performed better as the dollar exchange rate went down even though the TER is almost x3 that of the unhedged ETF.

Buying hedged ETFs which contain a lot of $-based stocks now (with a weak £) might not be as good as buying the unhedged ETF however.

Note that buying the currency hedged ETF does not mean it is less volatile than the unhedged ETF, it's just that any Foreign Exchange (FX) change is also added onto the price.

If you think that the USD-GBP exchange rate will continue to fall, buy the hedged ETF. Note that if you bought the hedged NASDAQ ETF 3 or 5 years ago however, you would have not made as much as if you had bought the unhedged ETF (30% vs 40%, 147% vs 161%).

If you think you can predict the USD-GBP FX rate, you may decide to switch ETFs:

Think the rate will fall? - buy hedged ETF

Think the rate will rise? - buy unhedged ETF

S&P 500 Example

We see a similar story with the S&P 500. The hedged version has performed better over the last year, but worse over the last 3 and 5 years.

Conclusion

FX rates can affect the value of foreign stock gains by +/- 10%.

If you are about to make a significant purchase of an ETF that is comprised of mainly non-UK stocks (e.g. US companies), check the FX rate predictions to see if you think the rate will continue to drop for the next 1-3 years.

If you think the USD-GBP rate will continue to drop due to a weak UK economy or strong US economy, you may want to consider buying a hedged version of the ETF.

Since the rate is quite low at the moment (0.76 GBP per $), if you are buying mainly US-based stock inside an ETF, it may be best to just buy the unhedged ETF in the hope that the dollar rate will improve.

Finally, here is a 12+ year chart which includes a physical gold ETF SGLN in red.

You can see that, long-term, the unhedged S&P 500 has performed better.

Note: Although much more volatile (e.g. a 25% LOSS in 2022), the NASDAQ has shown better performance  in >5 years than the S&P500. Keeping a satellite NASDAQ ETF for the long term may be a good idea as long as you are not tempted to sell it if it drops 25% one year!

 However, the NASDAQ has broadly matched the performance of the S&P 500 over the last 1 and 3 years...