In the past year, we have seen the euro strengthen against the dollar for the first time in a long time. This means that you can buy more dollars for one euro today than you could a year ago. The reverse is also true: if you have a certain amount of dollars, they will be exchanged for fewer euros in the bank today than they were last February.

Finax holds a number of dollar-denominated equity positions (since, for example, shares in US companies are mainly available in this currency). However, our investors are understandably interested in the appreciation they have achieved in euros.

As the dollar has weakened during 2023, Intelligent Investing has seen its profits cut somewhat by the exchange rate. The 100/0 portfolio, for example, achieved a slightly lower return than some of the US indices you may have heard about in the media (although it was still a nice 14.6% after fees). You can check the 2023 performance of the Finax portfolios in this article.

So naturally, many people wondered whether it was possible to protect the investment against exchange rate fluctuations. The answer is yes: dollar positions can be currency hedged, which is what some of our competitors are doing. However, since we've been teaching investors for years that they should consider longer-term data instead of looking at a single year when evaluating an investment setup, we decided to examine such numbers.

After all, currency hedging isn't free, you have to pay some extra costs for it. Will you get a higher expected return for that price? And how much does currency hedging actually cost today? These will be the main questions of today's post.

How Does Currency Risk Work?

Imagine you have 1,000 euros that you want to invest in the US stock market. However, the American companies issue shares in their home currency: the US dollar. If you want to buy them on the stock market, you must first convert your euros into dollars and then use the dollars to buy shares.

If the exchange rate at the start of your investment is 1.05 dollars to 1 euro, you get $1,050 for your 1,000 euros. You will use these dollars to buy ETFs replicating US stock indices. To your delight, a strong year comes and your ETFs rise by 20%. You have thus appreciated the original $1,050 to $1,260.

But that's not the end of the story. You live in Europe and the vast majority of your expenses is in euros. Hence, you're mostly concerned about the amount of euros you'll carry away after exiting your investment. This is where the exchange rate level after one year becomes relevant.

Imagine that after one year, you can exchange 1.10 dollars for 1 euro. The euro has, therefore, strengthened and the dollar has weakened during the year. You can convert your $1,260 into roughly 1,145 euros.

What is the final return on such an investment? You turned the original €1,000 from the first paragraph into €1,145, earning a return of 14.5%. Because of the depreciation of the dollar, you did not earn the full 20%; the exchange rate development took a cut of its own.

Don't worry if you don't understand all the numerical calculations in detail. The important thing is whether you understand the story behind them. Here's the intuition: if you hold the dollar and the dollar weakens, your investment will weaken along with it. It's a simple logic.

But now comes the important flip side of the coin: it also works the other way around. A strengthening dollar will boost your investment's return.

Let's go back to the example above, in which you had earned $1,260 after a year of investing. This time, however, imagine that the bank offers you an exchange rate of exactly 1 dollar to 1 euro after exiting your investment. Thus, the euro has depreciated over the life of the investment. One euro now buys fewer dollars compared to the past (when you got $1.05 for 1 euro).

With this exchange rate, you can turn your $1,260 into €1,260. You have, therefore, earned a 26% return on your original deposit of €1,000! Thanks to the exchange rate movement, you have achieved an even higher return than the underlying indices (which have risen by 20%).

This is one of the most important points of today's post. Currency risk doesn't necessarily mean you will earn less. Exchange rate movements will help you in some years and reduce your returns in others.

Currency risk just creates another element of uncertainty about the final return, being capable of moving it both up and down. Remember this conclusion, as we will come back to it when we ask whether currency hedging improves your expected return.

Shield Against Currency Risk

Because investors do not like uncertainty, financial markets have developed tools to remove currency risk. This is usually done using so-called financial derivatives, such as currency swaps or forwards.

We will not go into the details of how they work, as it is unnecessarily technical and complicated. You just need to know that they can be used to "lock in" the exchange rate in advance at a future date when you would like to exit your investment.

This allows you to determine the rate at which you will exchange your future investment proceeds already today, removing the uncertainty around unexpected exchange rate swings.

It is important to note that a currency hedge locks the future exchange rate at a certain level. Hence, it removes both favorable and unfavorable exchange rate movements. Your final return can turn out both higher and lower compared to investing without a currency hedge.

Should the foreign currency weaken, the currency hedge will counter this weakening and increase your performance. However, if it strengthens against the euro, the currency hedge will remove this favorable movement and reduce your performance.

Therefore, to determine the effect of currency hedging on your expected performance, you need to look at the typical behavior of the exchange rate. If the dollar tends to weaken against the euro over the long term, currency hedging would increase the expected performance.

If it tends to strengthen against the euro, a currency hedge is more likely to be detrimental. If depreciation and appreciation are about equally likely, it essentially doesn't matter and the currency hedge won't change your expected performance much.

Does Currency Hedging Improve Expected Returns?

Since Finax's inception, we have been collecting long-term data on the exchange rate between the euro and the dollar. In the chart below, you will find the one-year change in this rate for each year from 1988 to 2023 (returns prior to the official launch of the euro are modeled by Bloomberg).

If this change is positive (the bar in the chart points upwards from zero), the dollar has strengthened in that year, enhancing the investment's euro return. In such years, currency hedging would reduce your performance.

If the return is negative (the bar in the graph points downwards from zero), the dollar has weakened in that year. A currency hedge would increase your performance in these cases.

Source: Bloomberg

The dollar has strengthened in 20 of the 36 years in the period under review. Conversely, it has weakened in the remaining 16 of the 36 years. Thus, between 1988 and 2023, locking the exchange rate would have an overall negative effect on the final return. We cannot infer that currency hedging increases expected performance; this dataset suggests quite the opposite.

Of course, the past exchange rate evolution is no guarantee that it will evolve in a similar way in the future. If you were to sample other horizons, you would observe a 50/50 ratio of positive to negative years in some of them, and maybe a slight prevalence of negative years in others.

However, when we examined a number of analyses of the historical evolution of exchange rates, we saw most of them conclude that exchange rates don't tend to evolve in one direction over long periods of time. In the long run, the changes tend to balance each other out. If a currency appreciates over a period, it tends to weaken in subsequent years. This conclusion can be found, for example, in this study from AQR or this text from Morningstar.

This suggests that exchange rate movements don't matter much for long-term returns. A currency hedge will boost your performance in about half the years, and weaken it in the remaining half. Over long horizons, a currency hedged and unhedged investment would perform about the same. You can see it in this chart, which compares the development of a currency-hedged and an unhedged version of a global bond index for a euro-based investor.

Source: Bloomberg Barclays and PineBridge Investments as of 31.8.2019

Currency Hedging and Investment Risk

The expected return, however, is not the only thing we tend to look at when setting up an investment. The volatility of an investment, i.e. how sharply its value fluctuates up and down, is also important. Higher volatility means higher downside risk, which is why investors usually try to limit it.

You will probably notice on the chart that the currency-hedged line has a more stable trend. Its volatility is, therefore, lower. This fact has also been recognized by the analyses mentioned above: although a currency hedge does not increase the expected return, it can reduce the investment's volatility. However, other studies have pointed out that this effect is more likely to be true when investing in less-volatile bonds than in equity portfolios (this conclusion can be found, for example, in this study by Dimensional or in this analysis by AES).

A number of people use this fact as an argument in support of currency hedging. You'll get a similar expected return, but with less risk. That's why some people refer to it as a "free lunch".

This statement would be accurate if currency hedging came at no cost. However, this is not true. Locking in exchange rates using financial derivatives involves several types of costs that eat into investors' returns. Let's go through them one by one.

Don't Look for a Free Lunch: the Cost of Currency Hedging

The first cost of currency hedging is the most explicit: it is the transaction and other fees associated with trading financial derivatives. To cover them, currency-hedged ETFs charge a slightly higher fee than unhedged versions. This fee, in turn, reduces the ETF's performance.

However, this cost in itself is not that significant. For example, when we considered including short-term U.S. government bonds in the new composition of our Intelligent Wallet, the currency-unhedged version had an internal fee of 0.07% per year and the currency-hedged version had a fee of 0.10%.

Many people will look at this difference and conclude it's not a big price to pay for removing currency risk. However, this overlooks two much more important costs associated with currency hedging. It is easy to overlook them, as they are not charged explicitly in the form of higher fees. They are implicit and related to the level at which you can "lock-in" the future exchange rate.

This is because derivatives will not allow you to lock in an exchange rate identical to the one at which you convert your invested money today. It will usually be set at a slightly higher or lower level. Whether the exchange rate is set to strengthen or weaken over the investment period depends on two factors.

The first is the difference in short-term interest rates. If domestic interest rates are lower than the interest rates in the foreign country in whose currency we are investing, the investor has to pay a cost equal to the difference in these rates when hedging the currency. The second cost is the so-called currency swap basis, which deprives investors of performance if it has a negative value.

Unfortunately, over the last decade, both of these factors have played out against euro-based investors. Let's start with the interest rate differential. For most of the last few years, interest rates in the US have been higher than those in the euro area. 

This chart shows the total monetary hedging cost of dollar investments. The blue area indicates the impact of the interest rate differential. You can see that this has been the most significant cost recently, often exceeding 2% per year.

Source: Bloomberg and Pictet Asset Management, data covers the period from 31.12.1999 to 30.9.2022

The second type of cost is the so-called cross-currency swap basis. This is the deviation of the price of the derivative used in hedging (the swap) from the theoretical textbook price. The theoretical price would be achieved in an environment where banks can execute arbitrage trades quickly and efficiently.

Do not be daunted by the complexity of these terms. Again, there is no need to understand them in detail. The more important fact is that the textbook theory used to apply quite accurately until the 2008 financial crisis. The cross-currency swap basis had a value of almost zero until then, not representing an extra cost for investors.

However, the financial crisis changed this. In the chart below, you will see that the cross-currency swap basis between the euro and the dollar moved away from zero after 2008. Unfortunately for euro investors, it has slipped into negative territory, eroding investors' performance by roughly 0.1% to 0.5% per year over the past decade.

Source: Bloomberg and ECB

Evidence from Actual ETF Development

When you add all three types of costs together, you come up with an unexpectedly high number. Currency hedging would have cut 2-3% of your total annual return in several years of the last decade. That's quite a difference, especially if it gets compounded over multiple years.

When changing the Intelligent Wallet's composition, we had the opportunity to confirm these conclusions by observing the performance of real ETFs. Let's go back to the aforementioned example of the ETF replicating the performance of short-term US Treasuries. This chart compares the performance of two versions of this ETF.

The blue line tracks the performance of the classic currency-unhedged version of this ETF expressed in US dollar terms (i.e., the "original" return achieved by American investors). As long as the currency hedge has no cost and merely removes the impact of exchange rate movements, a euro investor in the currency-hedged version of this ETF should achieve the same return as the dollar version.

Source: BlackRock. The performance was calculated based on the NAV rate values reported on the ETF issuer's website as of 30.01.2024. The chart covers the period from 27.01.2023 to 29.01.2024. Past performance is not a guarantee of future returns.

However, the orange line shows that this is not true. It shows the performance of the currency-hedged version of the ETF expressed in euros. You can see that the cost of the currency hedge has "eaten away" more than 2 percentage points of the underlying investment's dollar return. And that's just one year, imagine what that percentage would add up to over a decade.

Costs Saved Represent a Certain Return

Is this a price worth paying for currency risk elimination? It depends on the goal of the investment. If you're investing for the short term and need to minimize risk (volatility), you should probably avoid currency risk even if it means higher costs. That's why the bond components of Intelligent Investing portfolios contain currency hedged funds.

However, when investing for the long term, you should ignore short-term fluctuations over a horizon of several years. When investing for decades, currency is highly unlikely to generate a significant benefit or harm to your return. Therefore, we think currency risk is worth accepting in order to avoid the significant annual costs associated with currency hedging in the current environment.

If you agree with this view, open an account with Finax. We will reward you for transferring your investments in competing products to our portfolios. We'll manage half of the transferred amount for two years at no charge. A great way to save on two types of costs at once.