If you live outside of the USA, the world’s largest financial market, investing in a globally diversified portfolio means you are getting significant exposure to foreign currency, typically USD. This means that changes in exchange rates between currencies will affect your returns.
Should you expose yourself to these risks? Should you buy ETFs hedged to your currency to offset these risks? Or should you only invest domestic assets?
The purpose of fixed income (e.g. bonds) in a portfolio is to stabilize equity’s risk by reducing volatility. Fixed income sources typically have low volatility and low returns. Research (1) shows that currency accounts for two-thirds of international fixed income volatility. Therefore, you should hedge international fixed income to your local currency in order to reduce volatility and preserve the profile of fixed income within a portfolio.
Currency is a minor driver for volatility in the international equities side. The asset class is intrinsically very volatile and hedging it to local currency does not have a significant impact in reducing volatility. In fact, in some cases it even increases volatility depending on the relationships between the local currency and equities. Additionally, this relationship varies over time (2) so hedging may at times lead to higher volatility and in other times to lower volatility.
Moreover, the impact of foreign currency exposure on returns over the long term (e.g. 20 years) is minimal (3).
Therefore, I think the majority of investors should get unhedged versions of international equity index funds because hedging has a cost, its value is not significant and it varies over time and by geography.
The Vanguard Research paper that I based this article on goes into details of the nuances in which hedging international equities may be beneficial. I think it is worth taking a look if you are interested.
Fixed Income – hedge international assets to your local currency or get local currency assets
Equities – no need to hedge international assets.
(1) – Vanguard Research, “The portfolio currency-hedging decision, by objective and block by block”, Page 5, Figure 3
(2) – Vanguard Research, “The portfolio currency-hedging decision, by objective and block by block”, Page 6, Figure 3
(3) – Vanguard Research, “The portfolio currency-hedging decision, by objective and block by block”, Page 3, Figure 1