Currency hedging, in the context of bond funds, is the decision by a portfolio manager to reduce or eliminate a bond fund’s exposure to the movement of foreign currencies. This risk reduction is typically achieved by buying futures contracts or options that will move in the opposite direction of the currencies held inside of the fund.
Currency Hedging Explained
The best way to understand currency hedging is to look at an example. Say a fund manager wants to invest $1 million in U.S. dollars to buy bonds issued by the Canadian government, but she has a negative outlook on the Canadian dollar. The portfolio manager can buy the bonds and protect against losses by placing a “hedge” against the Canadian currency by buying an investment that moves in the opposite direction of the Canadian dollar.
If she sets up her hedge properly, and if the Canadian currency falls 5%, the hedge gains 5%, and the net effect is zero. On the flip side, if the currency gains 5%, the value of the hedge will fall by 5%. Either way, the impact of the currency's fluctuations is neutralized.
This strategy is important to control currency fluctuations and ensure that, even a year later, the Canadian government bonds are unchanged in price, meaning no gain or loss in the value of the position.
If the value of the Canadian dollar falls by 5%, however, the portfolio manager will see the value of the $1 million U.S. dollar position fall to $950,000 even though the value of the bonds themselves is unchanged.
The reason for this is that the manager must exchange U.S. dollars into Canadian dollars to make the purchase. By hedging, the manager removes the risk of being hurt by unfavorable currency movements.
Currency Hedging at Work
Hedging is typically employed in two ways. First, a manager can hedge “opportunistically.” This type of hedge means that the manager will own foreign bonds in her portfolio, but only hedge the position when the outlook for certain currencies is unfavorable. In a simple example, say the portfolio manager has invested 20% of her portfolio in five countries: Germany, the United Kingdom, Canada, Japan, and Australia.
The manager has no opinion on the majority of the underlying currencies, but she has an extremely negative view of the Japanese yen. The manager can opt to hedge only the position in Japan and maintain the hedge until she takes a more favorable view on the yen. You will often see this referred to in fund literature as “tactical” currency hedging.
The second way to use hedging is in funds that are hedged as part of their mandate. Typically, the term “hedged” will even be used in the name of the fund. In these cases, every position is hedged, so the fund has no foreign currency exposure whatsoever.
How Hedging Affects Fund Returns
The difference can actually be substantial in the short term. Currencies can make large moves in relatively short periods, so there can be substantial gaps between the performance of hedged and non-hedged portfolios in any given calendar quarter or year.
On a longer-term basis, however, the difference may not add up to much since developed-market currencies aren’t the type of asset that provides long-term appreciation.
Hedged vs. Unhedged Foreign Bond Funds
One good way to acquire a position in foreign bonds is to buy one or more mutual funds or ETFs specializing in the foreign bonds of one or more countries. This method allows you to diversify your bond holdings with a small investment.
Look for funds or ETFs with low management fees—several independent studies of funds and fees have determined there is an inverse relation between fund fees and performance—the higher management fees, the worse the performance.
Theoretically, an investor can choose a hedged or unhedged fund based on recent currency movements. For example, if the dollar had been performing particularly poorly in the previous year (meaning that it would be more likely to recover in the year ahead, equating to a loss in value of foreign currencies), an investor may see better performance from a hedged portfolio.
In practice, however, predicting currency movements is next to impossible. Instead, consider your risk tolerance. Unhedged portfolios typically experience higher volatility, while hedged portfolios provide smoother results. For funds that hedge “opportunistically” or “tactically,” look at their track record. If the fund has demonstrated consistent underperformance, clearly, their approach isn’t working.