Hedged vs. Unhedged Investments: Which One Should You Choose?
23 Feb, 2025
⚠️ Warning: This blog will be boring, brief, but essential.
Question:
Ruth, could you help me understand how to choose hedged or unhedged when investing?
Sure, I’ll try, as this is one of the most frequently asked questions I receive.
Investing can be confusing. Not only do you have to consider fund provider, fund choice, and fees, but I often hear from people who come unstuck when they also have the option to choose between selecting “hedged” or “unhedged” for some investment types.
What is the difference between an investment that is hedged or unhedged?
It is all about attempting to manage the risk that comes from investing in assets priced in foreign currencies, such as the US dollar. It is an attempt to reduce the impact that the ups and downs of currency have on your New Zealand investments.
If you want to try to reduce your risk, you choose hedged. If you do not, you choose unhedged.
If you have taken an overseas holiday, you will know that what your NZD buys in your destination country currency varies hour by hour and day by day. It is the same when you are investing. Each time you invest, the exchange rate will be different. Whenever you look at your foreign investments in NZD, the exchange rate impacts what you see if you are an unhedged investor.
Hedged Investments
A hedged investment uses financial instruments to reduce the impact of exchange rate fluctuations. For example, if you invest in a US-based index or ETF fund that is NZD hedged, the fund manager takes steps to protect your returns from movements in the NZD/USD exchange rate. This approach attempts to reduce currency volatility and achieve more stable returns in New Zealand dollars. However, hedging can come with additional costs/fees that will reduce returns over time. Hedged investments suit those wanting stability and to focus on market performance rather than currency fluctuations.
Unhedged Investments
An unhedged investment leaves your returns exposed to exchange rate movements. If the NZD dollar weakens against the USD, your foreign investments increase in value when converted back to NZD, boosting your returns. Conversely, if the NZ dollar strengthens, your overseas investments lose value in local terms. Unhedged investments can provide diversification benefits, but they introduce additional volatility. Unhedged investments may benefit long-term investors willing to accept currency risk for potential gains.
** The investment you are buying goes up and down in value, depending on supply and demand, but then there is an additional impact, either working for or against you, when you take into account currency fluctuations **
Some investors “hedge” their investments to reduce/eliminate the impact of these foreign exchange rate fluctuations on their investments. So that all you see is the change in the underlying value of the fund itself.
If you have an unhedged investment:
If the exchange rate increases, the NZD gets stronger = The value of my investment drops
If the exchange rate lowers, the NZD gets weaker = The value of my investment rises
Exchange rates constantly move up and down, meaning the value of your investments also changes.
Reserve Bank of New Zealand: Exchange rates and Trade Weighted Index
But just wait a minute before you make your choice
At face value, it is ‘obvious’ to protect yourself from currency fluctuations by choosing a hedged investment. It sounds like a viable way to insure yourself against something we know will happen, i.e., currencies fluctuate.
Just wait a moment, though.
When you choose to hedge, a few humans are in the background making decisions about the future. Predicting the future is something we have yet to perfect.
A hedged investment provider uses financial instruments such as forward contracts and options to manage currency risk, and I’m not going to pretend for a moment that I understand all the ins and outs of this. But I do know that you will pay an additional fee to use a hedged fund as these very complex financial tools require the payment of fees or premiums. However, as with all things financial, paying more doesn’t necessarily mean better returns. You also need to be aware that each provider has their way of hedging.
A forward contract (a type of derivative) is an agreement to exchange one currency for another at a fixed rate on a future date. Investors or fund managers use these contracts to lock in an exchange rate, removing uncertainty about future currency movements. For example, a New Zealand investor buys a US stock fund and hedges their investment with a forward contract. If the NZD weakens against the USD, the forward contract offsets the potential loss, keeping returns stable.
A currency option gives the investor the right (but not the obligation) to exchange currency at a predetermined rate before or on a specific date. This strategy protects while allowing investors to benefit from favourable currency movements. For example, a Kiwi investor purchasing a USD-denominated fund could buy a currency option to protect against a strong NZD, ensuring the fund doesn’t lose value if the exchange rate shifts unfavourably.
Here is how I think about it.
Every single month for ten years, Jonny and I have invested a portion of our income into the share market. We have never, and will never, duck in and out of the share market. Instead, except for selling off a tiny 4% sliver each year, we buy and hold. These days, we invest in an unhedged KiwiSaver Fund and an unhedged Exchange Traded Fund.
NOTE: Consider it unhedged unless it says “hedged” on the label.
When I look at exchange rates over the decade, they look like a heart rate monitor image of a perfectly healthy human. There might be peaks and troughs, but they all average over time, and the heart keeps pumping.
We are 51 and 52 years old, and our investments still have another 50 years to run (I’m an optimist), meaning that we are L O N G term investors, meaning that the highs and lows of currency exchange rates should even out over time.
Just because fund managers have developed strategies to try to time the currency exchange market does not mean that they are successful over time. And as with most financial information, because the nature of providers is to chop and change their product offerings, deleting the ones that don’t sell/work, it is impossible to find clear historical information on whether someone who invests the way I do would end up better or worse off over time. If you find it, please tell me in the comments below.
If I were to try to hedge my investments, I would have to hit the currency exchange sweet spot twice: once when I buy and again when I sell. We are all spectacularly bad at market timing over the long term. Therefore, it is not for me.
The most significant positive impact on our investments won’t come from taking a punt at future currency rates but from our steady monthly investment habit. Through economic and political good times and bad, we invest. I believe picking a low-fee, passive ETF or Index investment strategy and investing your money over time is the most significant predictor of long-term wealth.
Sharesight shows me that Units/shares/stocks bought for $5 in 2017 are now worth $19. Each paid a dividend that has been reinvested in our fund. I reduced my fees as best I could by choosing a low-fee provider and setting my tax rates appropriately.
Other than that, I leave it be. On the first of every new month, I note our investments' current value (in NZD) when I update our net worth, and the value rises year after year.
Sub-optimal beats perfect!
In our daily lives, we are financially sub-optimal in many ways, yet we try to optimise every dollar when it comes to investing. For example, I’ve spent many hours writing this blog post for no financial gain while sitting in a $970,000 house that only costs me money. I’ve just bottled ‘free’ fruit from my apple tree into new jars that cost me $2.50 each. I could be working a PAYE job, renting a room in my house out and buying a can of puree apple for cheaper than I can produce.
But I’m happy with my financially sub-optimal decisions. Very happy indeed.
When you compare providers and products, it's like comparing rats with mice. Kinda the same, but each has its idiosyncrasies. But, put in a little mahi and go to your provider and find a fund, for example, a US 500 ETF or Index fund and compare their two options and historical returns of hedged vs unhedged. You might assume that ‘hedged’ will come out in front. But think again; my research has shown that to be incorrect.
That is why I don’t want you to angst about whether to hedge or unhedge your investments in an attempt to be the ‘perfectly optimised’ investor. There is no such thing. Instead, read more about it in the links I share below, look at past fund performance to get the lay of the land, decide, and then get on with it. Then, reassess a year from now.
Additional articles to help you with your education:
MoneyKingNZ: Hedged vs Unhedged funds: What is better?
InvestNow: The InvestNow Guide To Currency Hedging: The Impact of Foreign Currency on Investments
Canstar: Hedged vs. Unhedged ETFs: Which Is Better?
Kernel: Hedging: What is it, and how does it work?
Investopedia: Hedge definition and how it works in investing.
I hope this answers your question and gives you additional knowledge for your investment journey.
