What Is a Hedged ETF and How Does It Work?

Exchange-Traded Funds (ETFs) are popular investment vehicles that track an index, a commodity, a bond, or a diversified basket of assets. These funds offer investors exposure to various markets, often with lower costs and greater flexibility compared to traditional mutual funds. This article explores hedged ETFs, detailing their function and characteristics.

Defining a Hedged ETF

A standard international ETF invests in foreign countries, exposing investors to fluctuations between their home currency, such as the U.S. dollar, and the foreign currency where assets are denominated. For instance, an ETF holding European stocks is influenced by both stock performance and the euro-to-dollar exchange rate. A strengthening U.S. dollar can diminish foreign investment returns when converted back, even if underlying assets perform well locally.

A hedged ETF aims to neutralize or mitigate the impact of these currency movements. The fund incorporates strategies to reduce the effect of foreign exchange rate changes on returns. This allows investors to focus primarily on the performance of the underlying foreign assets, such as foreign stocks or bonds, without significant interference from currency volatility. The primary goal of a hedged ETF is to separate the asset’s performance from currency fluctuations.

How Currency Hedging Operates

Hedged ETFs achieve currency protection through financial instruments like forward contracts or currency futures. These are agreements to exchange one currency for another at a predetermined rate on a future date. The ETF manager enters into these contracts to lock in an exchange rate for future currency conversions, offsetting potential gains or losses from currency swings.

For example, a U.S.-dollar-denominated hedged ETF investing in Japanese equities will have its manager enter forward contracts to sell Yen and buy U.S. dollars. If the Yen weakens against the U.S. dollar, the loss on the Yen value of the underlying assets is offset by a gain on the forward contract. Conversely, if the Yen strengthens, the hedging contract incurs a loss, offsetting the currency gain. These hedging activities typically occur within the ETF’s portfolio, often on a monthly rebalancing schedule, and are managed by the fund to maintain the desired currency exposure.

Important Features of Hedged ETFs

Hedged ETFs possess several characteristics that distinguish them from their unhedged counterparts. Their expense ratios are typically higher, covering the costs of managing and maintaining hedging contracts, such as transaction costs and interest rate differentials. This additional cost can range from approximately 0.03% to 0.13% annually.

Hedged ETFs also have the potential for increased tracking error. Tracking error measures how closely an ETF’s performance mirrors its underlying index. While hedged ETFs aim to replicate their benchmark closely, the costs and complexities of currency hedging, including managing multiple contracts and rebalancing, can introduce slight deviations from the index’s performance. For example, a monthly hedging strategy might lead to some unhedged exposure between rebalancing dates if the underlying asset value or currency exchange rates shift significantly.

The performance of a hedged ETF will differ from an unhedged ETF depending on the currency environment. When the investor’s home currency, such as the U.S. dollar, strengthens against the foreign currency, a hedged ETF mitigates the negative impact on returns. Conversely, if the foreign currency strengthens, an unhedged ETF would benefit from that appreciation, while a hedged ETF would limit such gains. This mechanism effectively isolates the asset’s performance from currency volatility, allowing investors to gain exposure to foreign markets without taking a view on currency movements.

Tax considerations for hedged ETFs can be complex. The tax treatment of gains or losses generated by the hedging instruments within the ETF may differ from the taxation of the underlying assets. For instance, currency ETFs that utilize futures contracts for hedging may be treated as limited partnerships for tax purposes, subjecting gains and losses to a “mark-to-market” rule. This rule means that gains and losses are recognized annually, regardless of whether the investor has sold their shares, and are often treated as 60% long-term and 40% short-term capital gains or losses. Investors should consider consulting with a tax professional to understand the specific tax implications of their hedged ETF investments.