Sofia buys an S&P 500 ETF. The ETF invests in US companies priced in USD. Her wealth is measured in EUR. If the EUR strengthens against the USD, her Italian-euros value falls even if the US stocks didn’t move. Conversely if EUR weakens.
This is currency risk. Today’s lesson is what it actually means in practice, the hedging options available, and — for most retail investors — why not hedging is often the right call.
The basics
Any investment in a foreign-currency asset has two sources of return:
- Asset return (what the stock/bond did in its own currency).
- Currency return (what your home currency did vs the foreign one).
Total return to an EUR investor = Asset return (USD) + EUR/USD change.
Example: S&P 500 returns +10% in USD over a year. EUR/USD goes from 1.10 to 1.05 (EUR weakened 4.5%). For the Italian investor, total return = +10% + 4.5% = +14.5% in EUR.
Reverse: if EUR strengthens to 1.15 (+4.5% vs USD), total return = +10% − 4.5% = +5.5% in EUR.
What drives EUR/USD long-term
Theoretically, currencies move based on:
- Purchasing Power Parity (PPP): long-term, currencies should equalize purchasing power. Inflation differentials matter.
- Interest rate differentials: higher rates attract capital.
- Trade balances: exporting countries’ currencies strengthen.
- Fiscal and monetary policy.
In practice: EUR/USD fluctuates in a broad range (roughly 0.80 to 1.60 over past 25 years) driven by these factors plus market sentiment.
Long-term: PPP and productivity trends dominate. Short-term: noise.
How much does currency move your portfolio?
For a global equity ETF with ~63% US weight, USD exposure is significant.
Historical annualized USD/EUR volatility: about 10%.
A typical year’s EUR-value return on a global equity ETF moves roughly:
- Asset return: -20% to +30% (high volatility).
- Currency return: -10% to +10%.
Asset volatility dominates currency volatility, usually. But currency can meaningfully amplify or dampen.
Hedging: what it is
Currency hedging uses financial instruments (forwards, swaps) to eliminate currency exposure while preserving asset exposure.
How it works for ETFs: the fund manager enters into a currency forward contract offsetting the expected FX exposure. The fund pays a small annual cost (cost of forward) and in exchange, the investor gets only the asset return, not the currency return.
Example: EUR-hedged MSCI World ETF. You get the MSCI World asset return in EUR terms, without USD/EUR fluctuation effects.
The cost of hedging
Hedging isn’t free. Costs:
- Interest rate differential. Roughly equal to (USD short-term rate) − (EUR short-term rate). In 2024 with Fed rates ~5% and ECB ~3.5%, hedging USD exposure cost ~1.5% per year.
- Rolling costs. Forward contracts roll periodically; costs accumulate.
- Higher TER. Hedged ETF variants typically charge 0.1-0.2% more than unhedged.
Total drag: roughly 1-2% per year for USD hedging from an EUR base. That’s material — and it’s certain, not conditional.
The argument for hedging
Reduces volatility
Currency moves add to equity volatility. Hedging removes that component. An EUR-hedged MSCI World ETF has lower σ (volatility) than unhedged — maybe 13% vs 15%.
Useful for investors with short horizons or high sensitivity to annual swings.
Eliminates one source of uncertainty
If you know you’ll spend in EUR forever, matching EUR exposure reduces one unknown. Your wealth grows or declines based only on stock picking, not currency.
Particular benefit during EUR strength
When EUR strengthens persistently (like 2002-2008), unhedged foreign-currency investments lose relative value. Hedged portfolios were happy during this period.
The argument against hedging (the usual better choice for equity)
Long-term currency is close to a wash
Over 20-30 year horizons, major currency movements partly cancel out. PPP forces roughly equalize.
Global companies have international revenue exposure
Apple is listed in USD but earns worldwide. Its fundamental currency exposure is already diversified. “USD-denominated” stocks aren’t pure USD plays.
Hedging costs certain
The 1-2% annual drag is certain. The benefit (reduced volatility) is uncertain and possibly negligible over long horizons.
Currency risk is acceptable volatility
For equity investors already accepting 15-20% annual volatility, adding 10% currency volatility is marginal. Hedging to reduce it 2-3 percentage points isn’t worth the 1-2% return drag.
The rule for retail
Two distinct situations:
For equity investments, long-term, EUR investors
Don’t hedge. Just hold unhedged global equity ETFs. Over 20-30 year horizons, currency wash + cost avoidance > variance reduction.
This is the standard recommendation from Vanguard, Morningstar, and most financial academics for long-term investors.
For bond investments, EUR investors
Do hedge foreign-currency bonds to EUR. Reasons:
- Bonds are low-volatility assets. Currency volatility can dominate bond returns, making unhedged foreign bonds more volatile than unhedged foreign stocks relative to the base asset.
- You hold bonds for stability and income. Currency risk defeats that purpose.
- Hedging cost (1-2%) eats a bigger share of bond yields (2-4%) than equity returns (5-7%).
Use EUR-hedged bond ETFs for global bond exposure: e.g., Vanguard Global Aggregate Bond UCITS ETF EUR Hedged (IE00BG47KH54).
For short-horizon positions
If you need the money in 1-3 years, currency fluctuations matter. Hedge (or simply hold EUR-denominated assets).
Examples of hedged vs unhedged ETFs
Let’s look at common pairs:
MSCI World exposure
- Unhedged: iShares Core MSCI World UCITS ETF (IE00B4L5Y983). TER 0.20%. USD fund currency, EUR-tradable.
- EUR-hedged: Xtrackers MSCI World EUR Hedged UCITS ETF (IE00BM67HQ30). TER 0.35%.
Historical: EUR-hedged has roughly equivalent returns over the past decade, slightly lower volatility, 15 bps higher cost.
For long-term buy-and-hold: unhedged is almost always fine.
US Bond exposure
- Unhedged US Treasury ETF: volatile in EUR terms.
- EUR-hedged US Treasury ETF: much more stable, captures US rate yield in EUR terms.
For EUR investors considering US bonds at all: use hedged.
What about currency as a diversification tool?
Some argue: foreign currency adds diversification because its correlation with EUR assets is different from stock-bond correlation.
True, but:
- The diversification benefit is small (currencies are noisy).
- The cost in hedging is certain and meaningful.
- Equity already provides substantial diversification.
Niche topic. Not a major reason to tilt one way or another.
Emerging market currencies
Investing in EM equities exposes you to many small-country currencies (Brazil BRL, India INR, South Africa ZAR, etc.). These have much higher volatility than EUR/USD.
Options for EUR investor:
- EM equity ETF unhedged: significant currency volatility (usually not hedged because hedging many emerging currencies is costly).
- EM equity ETF EUR-hedged: exists but expensive (~0.50-0.80% TER vs 0.18% unhedged).
For long-term holders: unhedged EM is typical. Accept the currency exposure as part of the EM risk premium.
Currency in multi-currency life
If you genuinely split life between two currencies (Italian working 6 months in UK, paid partly in GBP), natural hedging happens — your income and some expenses are GBP.
For most Italians: entirely EUR-domiciled life. Currency in portfolio is incidental.
What to do with this lesson
Three things:
- For equity: default to unhedged. Lower cost, benefits over long horizons.
- For bonds: default to EUR-hedged when holding foreign-currency bonds. Or just hold EUR-denominated bonds (BTP, EU aggregate).
- Don’t obsess over currency if your horizon is 20+ years. Asset return dominates currency return over that timeframe.
Sources
- Vanguard Research — To hedge or not to hedge? Various papers on currency hedging.
https://www.vanguard.com/pdf/ISGIOCE.pdf. - Morningstar — Currency-hedged vs unhedged ETF performance. Multiple research pieces.
- Eun and Resnick — International Financial Management (academic textbook).
- Fidelity Research — Long-term FX behavior.
Next lesson: rebalancing — when, how, and the Italian tax wrinkle. Realizing gains = 26% tax. How to minimize the drag while keeping your target allocation.