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How hedging your shares against currency risk can boost returns

I wrote in January 2017 about using currency-hedged ETFs [1] 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 [2] turbo-charged our portfolios.

But currencies are fickle. After such a steep and politics-related [3] 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 [4]:

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 hedged US ETF (green) easily bested the non-hedged ETF (blue).

Source: JustETF [5]

According to Morningstar:

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 [1] 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 [8] – 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 [1] 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 [9].

Also look out for my follow-up post. This will explain why the case for currency hedging is different with bonds compared to shares.

  1. See Benchmark returns on THIS iShares page [ [12]]