Should a UK Investor Consider a Currency-Hedged ETF?

The decision to buy a currency-hedged ETF (Exchange-Traded Fund) as a UK investor is often clouded by uncertainty. While currency hedging offers protection against adverse movements in foreign exchange rates, it also comes with its own set of trade-offs. In this article, we will explore the pros and cons of currency-hedged ETFs for UK investors, helping you make an informed decision.

Understanding Currency Hedging

Currency hedging is a financial strategy designed to reduce or eliminate the risk of adverse currency fluctuations on a portfolio or investment. This can be particularly valuable for investors who are exposed to foreign markets but are also subject to currency volatility. However, it is important to weigh the benefits against the potential drawbacks.

The Cost of Currency Hedging

One of the primary downsides of currency-hedged ETFs is the increased expense ratio. Currency hedging adds an extra layer of financial complexity, which is reflected in the higher fees the investor pays. According to market experts, this added cost can significantly eat into your returns over time. For instance, a non-hedged ETF might have an expense ratio of 0.15%, whereas a currency-hedged ETF might have an expense ratio as high as 0.50%.

Volatility in the Face of Currency Risk

While it is true that currency fluctuations can create volatility, the reality is that asset prices themselves are subject to volatility as well. Currency hedging does not eliminate this inherent market risk. UK investors who invest in foreign assets must be prepared to weather both currency and market ups and downs.

For instance, if you are invested in a US-based ETF, you will still experience volatility based on factors such as company performance, economic conditions, and global market trends. Therefore, hedging against currency risk alone may not provide the complete protection you desire.

The Long-Term Perspective and Compounding Returns

Over a long period of time, the impact of currency movements becomes less significant compared to the compounding power of returns generated by the underlying assets. By not hedging, you potentially save on fees, and your non-hedged investments can benefit from the overall market growth and performance.

Consider the following: if you invest ￡10,000 in a non-hedged ETF that generates a long-term average annual return of 5%, it would grow to approximately ￡38,115 after 20 years, assuming an expense ratio of 0.15%. In contrast, a currency-hedged ETF with an expense ratio of 0.50% might cost more but still offer similar long-term returns. However, the difference in fees can be substantial, potentially amounting to thousands of pounds over a period of two decades.

Is Currency Hedging Necessary for a UK Investor?

While diversification is a fundamental principle of investing, it is important to consider whether currency hedging is truly necessary. The main goal of diversifying into foreign assets is to reduce dependency on the domestic economy. A UK investor’s livelihood, home value, pension, and cost of living are already closely tied to domestic factors. Therefore, the argument for diversifying into foreign assets is primarily based on exposure to a wider range of economies and markets.

Currency fluctuations, while important, are just one aspect of investing in foreign assets. As you noted, the US Dollar has been strengthening for four years, but this trend is not likely to last indefinitely. A strong dollar can hurt foreign companies that export goods globally, such as Apple, Johnson Johnson, and Boeing. These companies still operate in a diverse global marketplace, and their performance is influenced by many factors beyond just their home currency.

Investors should consider that currency risks and rewards are inherently linked. A strengthening dollar can create challenges for foreign companies, but it can also present opportunities for investors. By not hedging, you have the potential to benefit from favorable currency movements that could enhance your overall returns.

Conclusion

While currency-hedged ETFs offer protection against foreign exchange risk, the added expense ratio and ongoing volatility make them a less advisable choice for many UK investors. Instead, consider focusing on non-hedged ETFs that allow you to benefit from the full range of market opportunities. Over the long term, the compounding returns on non-hedged investments can be more substantial, ultimately leading to greater wealth accumulation.