Hedged vs. Unhedged ETFs: What’s the Difference?

ETF providers address currency risk with two main product types: hedged and unhedged ETFs.

Hedged ETFs. By using financial contracts or derivatives, these ETFs aim to offset any gains or losses from currency fluctuations. Their objective is to enable Canadian investors to benefit solely from the performance of the underlying assets, without worrying about changing exchange rates.
Unhedged ETFs. These funds carry full currency exposure. If the underlying investments are in U.S. dollars and the loonie weakens, your returns are amplified; if the loonie strengthens, your returns are diminished even if the underlying asset value rises.

For example, imagine two versions of a U.S. equity ETF: a hedged version aims to neutralize exchange-rate movements, focusing solely on stock gains or losses. In contrast, an unhedged version lets your total return reflect both the performance of U.S. stocks and the movement of the USD/CAD exchange rate.

Cost Considerations of Currency Hedging

Choosing a hedged ETF comes with potential trade-offs. Implementing hedging strategies can incur additional costs, as financial contracts used to offset currency risk require greater management and resources. Over time, these costs can erode overall returns. At times, currency hedging itself may underperform in periods of sharp currency movements or extreme volatility.

Accordingly, Canadian investors should carefully consider whether the goal of reduced volatility justifies these extra expenses. While hedging can be an effective way to reduce short-term currency-induced market swings, the drag on returns might not be worth it for every investment case.

When Should You Consider Hedged ETFs?

Hedged ETFs may make sense for specific use cases:

Short-term investments. If you plan to hold an ETF for less than a year or are particularly sensitive to short-term fluctuations, currency hedging can help reduce the risk of sudden swings that could impact your returns.
Fixed income investments. Currency movements can significantly alter the performance of foreign bond ETFs. Hedging can help preserve the stability and predictability of fixed income returns, especially since bonds typically offer lower returns than stocks.

On the other hand, if you are investing in international equities for the long haul, currency movements often “even out” over time, and the additional cost of hedging may not be justified. Many experienced investors opt for unhedged ETFs when holding positions for several years or more.

Assessing Your Personal Risk Tolerance

Determining whether to use hedged or unhedged ETFs comes down to your risk tolerance, investment time frame, and portfolio objectives. If you are comfortable with occasional currency-driven fluctuations and have a longer time horizon, unhedged options may suit your goals. However, if you value stability and prefer to avoid additional volatility, particularly when investing for specific short-term objectives, hedged ETFs can offer an extra layer of certainty.

Canadian ETF Investors: Practical Scenarios

As a practical example, consider these two investors:

Investor A selects an unhedged U.S. equity ETF. If the U.S. dollar rises compared to the Canadian dollar, Investor A benefits from both rising U.S. stocks and a favorable currency swing. If the U.S. dollar falls relative to the loonie, any positive stock performance may be offset by adverse currency movement.
Investor B chooses a hedged U.S. equity ETF. Their returns closely mirror the U.S. stock market’s underlying performance, as the ETF’s hedging mechanism aims to remove the impact of exchange rate fluctuations.

Making an informed decision between hedged and unhedged versions allows investors to align their approach with personal goals, timelines, and comfort with global risk factors.

Conclusion

Currency risk is a key consideration when investing in ETFs that hold international assets. Canadian investors should understand how currency movements can impact returns and make clear-eyed decisions about whether to hedge that risk based on their goals and risk tolerance. Balancing hedging costs and volatility reduction can help ensure your investment choices remain closely aligned with your broader portfolio strategy and financial objectives.