I wrote in January 2017 about using currency-hedged ETFs to reduce currency risk in your portfolio.
Back then the UK pound had fallen sharply against other global currencies in just a few short months.
This depreciation had sent the value of overseas funds and shares soaring for UK investors – because overseas holdings denominated in dollars, euros, or yen were now worth much more in sterling terms.
Everyone likes volatility when it sends things up. 2016 was a banner year for globally diversified UK investors. Currency risk turbo-charged our portfolios.
But currencies are fickle. After such a steep and politics-related move, I felt the risk of the pound reversing represented a vulnerability to my net worth. So I chose to reduce currency risk in my overseas equity exposure by switching some of my money into hedged ETFs.
Now, the standard advice for long-term investors is to hedge bonds but not equities.
But to paraphrase myself:
Imagine you’re a 65-year old UK retired investor, the long-term is 50 years (which you haven’t got) and the boost to our portfolios from the weak pound we’ve seen over the past 12 months turns to work against you over the next 5-10 years.
Imagine a pound rally cuts your net worth and income by say 20%, at a time when you’re reliant on that portfolio for your living and you have no new savings – perhaps for years to come.
After a 20% fall in your income, you might be less inclined to care what worked in the long run for the most people around the world.
You might rather wish you’d protected what you had over a shorter time frame.
Academics can dine out on long-term results in their research papers. But in the real world we need to eat our portfolios some day.
A tale of two trackers
As it happens, we haven’t had to wait a decade to see what happens when the pound starts to climb out of its hole.
Sterling rose against the dollar in 2017. This rise reversed some of the windfall gains that UK investors in US assets enjoyed the previous year – but the very strong US stock market returns of 2017 easily papered over these currency losses.
Take a look at the total return of two ETFs tracking the US market in 2017:
- The iShares Core S&P 500 ETF (Ticker: CSP1)
- The iShares S&P 500 GBP Hedged ETF (Ticker: IGUS)
According to Morningstar:
- The hedged ETF returned 19.8%
- The unhedged ETF delivered 10.8%
Choosing the hedged ETF enabled you to enjoy most of the gains of the US market last year. With the standard ETF, you lost some gains due to the stronger pound.
What a drag!
We can see that currency hedged ETFs enable you to take currency risk out of your portfolio. Over some periods, like last year, they also boost your returns.
Of course, there are drawbacks.
Most obviously – swings and roundabouts!
In 2016 currency risk increased your returns when the pound fell. In 2017 it was a headwind that it paid to hedge against. What goes around comes around. You might have a simpler life just letting currencies do their thing and not trying to be too clever.
But there are more concrete concerns.
The hedged iShares S&P 500 ETF is more expensive. It has an ongoing charge of 0.20% compared to 0.07% for the vanilla version.
Even worse, as I wrote last time this figure may not represent the true cost of hedging.
Such ‘hidden costs’ are likely to show up in tracking error, which is the difference between the fund return and the return of the index it follows.
The S&P 500 returned more than 21% in 2017 with dividends reinvested1 – much more than the hedged S&P 500 ETF. So it does seem like the hedged ETF leaked a chunk of returns. This could be due to the cost and/or the implementation of hedging.
Of course you wouldn’t have complained last year, because by opting for the hedged ETF you still enjoyed much higher returns anyway.
But if you held the hedged ETF for many years, the impact of such a drag would add up.
Hedging your bets
This tracking error arguably underlines how hedging currency risk with equities is only something to do over the short to medium-term, if you want to maximize your long-term returns.
Remember – even small differences will compound into big differences over time.
But not all investors want or need to maximise their returns.
As you get older, you should typically take less risk because you have fewer years to make up for mishaps. In retirement you might well consider lower returns to be a price worth paying for greater stability and less risk to your spending money.
Or you might still be young, but just want to sleep better at night!
So as always, there’s going to be some personal decisions involved.
Please see my previous article on currency hedged ETFs for more on their pros and cons. I also discussed other ways to reduce currency risk, such as deliberately owning more UK shares than the 7% weighting in a typical world tracker fund.
Also look out for my follow-up post. This will explain why the case for currency hedging is different with bonds compared to shares.
- See Benchmark returns on THIS iShares page [↩]
I am the target market and I did get a slug of IGWD which is a hedged sort of VWRL which I have a lot of, because of, well, Lars. And it has done what you indicated it might to, in the unexpected (by me) relative rise in the pound. I am chuffed.
Didn’t realise there was a long term issue in holding things like that, I guess I need to divest into VWRL over the next few years, hopefully once Brexit settles down and hopefully we have gotten enough of the self-harm out of the national character.
Or Brexit is a stonking success and the pound inherits the erstwhile Deutschemark’s reputation for fiscal probity and strength as we take over the mantle of exporting to the world with our newfound freedom. In which case IGWD will win the race and I will kick myself for not getting more.
It does help one sleep at night. Thank you for introducing me to this opportunity!
@ermine — Glad the heads-up was useful. 🙂 I’m not entirely sure how big any persistent drag from hedging will be with respect to tracking error (as opposed to the higher ongoing charge figure, which I think many people would swallow to be rid of currency risk). There may be other issues at work; even unhedged ETFs do diverge more than they should from the index they track from time to time. Haven’t come across much comment on this to-date. More digging required!
Interesting analysis as always. The biggest risk to our currency isn’t really Brexit in my book but a Corbyn Government. You don’t have to take my word on that as we know they have been planning for a post election run on the pound. It’s one of the main reasons I don’t hedge foreign equities.
PS Can I take your decision to hedge as tacit confirmation that Brexit is likely to be a success and the pound will strengthen as currency markets acknowledged that they have mispriced the economic damage of an exit under WTF tariffs 😉
@Passive Investor — No. As I have said countless times any sort of no deal Brexit will be painful but is unlikely to be a complete and permanent *catastrophe*, economically speaking. However I do believe anything but full on membership of Customs Union and Single Market *will* have a real negative impact on GDP growth for years to come. Long shot we “go Singapore” and this eventually does lift GDP to where it might have been if we hadn’t Brexit-ed, but obviously won’t help would-be shipbuilders on the dole in Newcastle who voted Brexit etc. (I agree there’s no scenario where a Corbyn government combined with hard Brexit seems good for Britain economically-speaking, as a whole, except perhaps as a short, sharp shock that forces the center to tackle things like housing access issues for the young).
In light of all that, as I said in the original article my decision to hedge was about reducing risk and volatility, not trying to get extra returns, although clearly it’s all related. I felt the pound’s fall had probably overdone it, likely because some institutional money felt it could have an easier life by leaving Britain alone until the dust settled.
i.e. I judged there was probably excessive fear in the price.
For what it’s worth, in my opinion it’s pretty clear the pound has rallied because the prospects of a no-deal hard Brexit have greatly receded. (I have a half written blog from July 2017 about this that I decided I couldn’t be bothered to argue about again. 🙂 )
Now we’ve both represented each side I think ideally further comments would focus on hedging and ETFs, rather than the *merits* of Brexit, although I can see that might be difficult.
(Sorry for any sense of humour failure here. It is the weariness of facing years of having my nuanced position — that Brexit is bad politically and economically and also counterproductive, but there exists an outcome that isn’t “off a cliff” — misquoted back at me in the future.)
@PI > of an exit under WTF tariffs
A Freudian slip for what was presumably WTO tariffs 😉
Impressive stuff TI – a good call, and kudos to ermine for actioning it.
I thought it looked attractive based only on mean reversion, no macro-political reasoning required. But I didn’t do anything so that doesn’t count for much.
My approach to the mini-pound rally was simpler, just flip to measuring net-worth in dollars rather than pounds. Yay, the numbers have gone up again, its miraculous!
Surely the retiree worried about currency risk by exposure to equities having a serious impact on net worth should reduce their exposure to equities and seek shelter in domestic fixed income? Specifically gilts and inflation index-linked gilts, with shorter durations in the current low interest rate environment (is this timing the bond market, or risk management?).
Even the UK domestic biased passive equity investor can’t protect them self from currency risk due to the FTSE’s exposure to multinational listings. I wonder if there is a market for a “domestic” FTSE All Share tracker with multinationals excluded depending on the percentage of revenue derived ex-Stirling.
Interesting reading nevertheless. Thanks TI!
No, I understand your position and my comment was meant in the spirit of teasing jest not to cause upset. I shan’t rehearse the arguments again.
An additional reason I don’t hedge is I have insight into the fact that my psychological response to a loss would be much more if I hedged and lost the bet than if I don’t hedge and lose. As my portfolio is trundling along nicely (along with everyone else’s) I hadn’t even noticed that the pound’s appreciation had wiped out so much of the S & P 500 gain. I don’t calculate my investment return I just think about how much risk I want to take on in terms of bond:equity ratio, how much emerging market exposure I want and how much home bias I have. Just one way of swinging a cat I guess
I have also tried to control expectations by valuing and measuring performance in USD, EUR, AUD and the IMF’s Special Drawings Rights basket. SDR gives me a much more sobering 6.8% annualized return for the last 2.5 years, compared to 14.2% in GBP ,7.3% in USD, 5.0% (!) AUD and 3.6% (!!!) EUR for a low key Tim Hale inspired 80/20 global portfolio.
@Fremantle – well its a funny old game looking at all the different currency returns. Makes you realise how mad exchange rates are.
If I assume your a UKer, then really what you need to do is look at real GBP return, i.e. inflation adjusted and thats the relevant no., its your current spending power.
You should prob try and use your own inflation figure rather than RPI/CPI but I’m not sure its possible to calculate in any sensible way?
On the subject, I managed to change 50 raisins for 1,000,000 sultanas at the travel agents the other day… I couldn’t believe how good the currant exchange rate was.
You got lucky, I tried the same, but they offered me peanuts.
Does anyone have any opinion on which of IGWD (OCF = 0.55%) and IWDG (OCF = 0.30%) would be best as a World Hedged ETF? My instincts suggest IWDG due to its lower OCF but many previous posters refer to IGWD, so I assume that I am missing something.
In my mind, investing in hedged ETFs is like active investing in currencies. You invest in hedged ETFs if you think your home currency will weaken, but how can you know it’s really going to? It might strengthen as well. It’s like timing the market.
Ironically, as I’ve always hedged equities, my main currency risk is the FTSE100 due to it’s unhedged foreign revenue exposure.
I’ve never understood the “hedge your bonds not equities” ethos. Either way you end up with the same USDGBP forwards. I guess people just like the look of the low vol fixed income charts.
Btw, telling people to watch out for tracking error can be misleading since the stated numbers on factsheets are the standard deviation about the benchmark, which could be zero even if they’re spending a fortune on hedges. People never use the expression “tracking difference” but it would lead to less misunderstanding if they did.
@Kamil — I take your point, and in my first article (linked to above) I stressed passive investors could feel fully entitled to take the attitude that the market knows best. (I am not a passive investor, but think most should be.)
However, when you write…
…with respect I think you’re slightly missing the nuance of what I’m saying (or disagreeing — fair enough) which is that you could use hedged ETFs to the extent you think your home currency *might* weaken (or strengthen).
This might seem a pedantic point, but it’s crucial to why I felt there was a case for all investors to *consider* hedging early last year. These were unusual times, with to me an unusually large chance of currency moves negatively hitting your wealth. You didn’t have to think the pound *would* recover, you just had to think there was a higher than usual chance that it would, for hedging some portion of your overseas exposure to arguably make sense.
But as I say, fully agree there’s a strong case for pure passive investors to ignore the whole thing, especially give the cost consequences.
@John — Yes, meant to say tracking difference. Slightly off my beat with funds, where’s @TA when you need him! 😉 (Writing as ever the Monevator book, that’s where…)
@Freemantle — Yep, shifting to domestic bonds is an acceptable response in so far as it goes. In theory though, especially over the short run, hedged overseas equities have a very different return profile to bonds. Using hedged ETFs you can get the equity premium without the unwanted currency risk, all things equal. (They are probably not, due to costs, tracking difference drag, natural hedging etc. 🙂 )
@PI — Cheers for the clarification.
@Kamil > investing in hedged ETFs is like active investing in currencies
Yes and no 😉 The attraction of IGWD for me was that is was the same basic underlying asset as VWRL – world equities according to the MSCI World index according to Lars. As I understood Monevator’s original post, I want to regularly invest in that asset, but due to a rush of blood to the head there was a peculiar hit on the GBP. Possibly overdone at the time.
I still want to buy that asset regularly, but hedge it. My target is roughly a half split VWRL/IGWD. Same underlying asset, reduce currency exposure by half. Unlike many on here I don’t have decades of contribution ahead, in that case I can understand the don’t hedge angle. But I was Monevator’s use case – someone who was sitting on a big nominal bump up on existing holdings due to Brexit and at the end of my working life. I am fortunate in that I am using this ISA to defend my long term, not calling on it for several years.
There’s some market timing in hedging just after Brexit, in that I was feeling particularly pauperised by the unilateral decision of slightly over half of my countrymen to destroy roughly 20% of the value of any future income I might get, but I was sitting on a nominal lift of that much in my portfolio. Buying IGWD (while keeping the original slug of VWRL) was to insure myself a bit against the bump of that 20% on the portfolio coming down, if the pied pipers of Brexit were right and the Pound stepped into the boots of the Deutschemark and appreciated back up to where it was in the 1960s and you got 11DM to your pounds which is where we should be before we were ground into the dust when Britannia surrendered in 1973 to the rule of the EEC/EU according to some.
Pure purchasing of currency is all very well, but it’s just holding cash, in a foreign currency. That’s not a productive asset. I was happy with buying productive assets of MSCI World equities, but wanted to hang on to some of my Brexit boost. Had the pound appreciated to 20% up on May 2016, while my portfolio would have taken a hit in a Brexit bust, I could look forward to buying more world equities with my strong pounds. Whereas sitting with a 20% hammered currency, it didn’t feel good to be buying world equities from that hole in the ground.
@Gizzard > IWDG v IGWD
Interesting that the OCF on the income version is a lot less than the acc version, as is the tracking error. Looks like I failed to research this fully, as the income version slightly fits my aims better and is cheaper – thanks for the heads-up.
One takeaway from all this is that investing gets harder as you get older – what a shame. Be better if it were the other way round.
The case for making active decisions based on macro events becomes much more compelling.
“..if we hadn’t Brexit-ed, but obviously won’t help would-be shipbuilders on the dole in Newcastle who voted Brexit”
Seems a bit harsh to pick our Geordie friends to highlight this point, after all they did vote remain.
But it’s true that it would be a very long shot to bet on the return of shipbuilding to the Tyne now. As far as I can tell from this remarkable website
only two ships were built in the Newcastle reaches of the Tyne in the 20th Century
Name Shipbuilder’s Name District Dates Ships
Anderson John Anderson Ouseburn 1902 – 1902 1
Purdie D Purdie, St Anthony’s St Anthony’s 1902 – 1902 1
(click shipbuilders on the home page, then click Newcastle on the map – isn’t that great 🙂 )
Currency hedging smacks to me of market timing. How are we supposed to know when it’s a good time to hedge or not? Surely a passive investor just puts his faith in the global market.
5 year annualised returns:
@ermine, excellent work glad it worked out for you and I understand the logic behind your 50/50 split to benefit from either etf. The pied piper will most likely be wrong, this brings to mind something I read “you will always loose money going long sterling”. Me personally I prefer unhedged global equities , a useful tool against UK inflation
I moved abroad but my investments are still in the UK. I always forget to assess my portfolio in new currency sometimes it looks like it’s gone down in sterling but overall up in local.
One of the problems with hedging is that while the original idea for options trading was to reduce risk, it has been used by some to take on risk, so hedge funds get the reputation for great rises, great falls. People need to be clear whether they are adopting these funds to smooth currency fluctuations, or try to take advantage of them.
Do you know how forward points are calculated?
Do you know the effect of low UK interest rates vs US?
Do you know what cross currency basis is?
Having a bit if not all your Europe ex UK and VWRL unhedged is the only sane way to buy exposure to forex, and surely being invested in dollars and euros as currencies, as well as in the underlying assets, broadens your diversification, and that’s a good thing?
I have a GBP hedged US TIPS ETF and High Yield Bond ETF, and they’ve been handy nullifying the pounds recent gains.
Another year and we could be back to an exchange rate of 1.50 if our European chums are not too horrible to us.
But interested in the real cost of hedging (over and above the published TER).
I bought my accumulating TIPS ETF in July and it is still 0.5% down (hardly any volatility though), which maybe a combo of dealing spread and TIPS not doing that great in total return terms. Plus US treasury yields climbing in general don’t help.
Maybe if it still shows no gains after a couple of years I will review, its a relatively new ETF from UBS so not a long history of performance.
The GBP/USD FX forward poinsts for 1 year out are around 207 pips i.e if spot GBP/USD is 1.385, GBP/USD 1-year forward is 1.4057 i.e your breakeven for GBP/USD spot in 1 years time is 1.4057. If it’s lower you would have been better buying the unhedged product, if it’s higher you’d be better off buying the hedged product. This 1.5% difference stems from the differential in 1-year implied yields (0.57% in UK, 2.05% in US). Of course most funds hedge monthly (1 month pips are 14.3) and this excludes bid/offer.
I’m not sure I understand why people think hedging currency risk is equivalent to market timing. My view would be the converse i.e having an open currency position is equivalent to market timing. With all my investments I prefer to consider each risk discretely i.e if I buy a normal S&P 500 tracker, I am taking two views a) the S&P500 will go up and b) that GBP/USD will go down. If I just think the S&P 500 goes up then I would overlay a GBP/USD forward against the position (or buy the hedged tracker). Perhaps it’s because my background is fixed income and we generally always think in FX hedged terms
Could we have a guest post from ZX please? I think it would be fascinating!
The point above about being natural to hold an overseas equity with currency hedging is interesting. I would find further discussion useful.
Many uk equities have significant overseas earning which seems to provide some perhaps unintended currency hedging.