Currency Risk and Hedged Share Classes

The three currencies, disentangled

The most common European confusion, dissolved:

• Trading currency. The same fund (one ISIN, Chapter 7) may list in EUR on Xetra and USD on the LSE. Buying the EUR line converts your euros at the point of trade instead of your broker doing it; it changes your FX transaction cost (Chapter 14), not your exposure. A "EUR" S&P 500 ETF gives you exactly as much dollar exposure as the USD line.
• Base currency. The unit the NAV is struck in. Accounting, not risk. A world fund reporting in USD held by a euro investor has the same underlying exposures as its EUR-reporting twin.
• Underlying currencies. The real thing. A world equity fund is roughly 60–65% USD-denominated assets, then JPY, GBP, EUR, CHF and others. Your return in euros = the assets' local returns + the currency moves against the euro.

What hedging is and what it costs

A hedged share class sells forward the foreign currencies your holdings are denominated in, rolling the contracts (typically monthly), so returns approximate the local-currency returns of the assets. It doesn't remove risk in general; it removes one risk and adds several mechanical features:

The cost is the interest-rate differential, not a fee line. Forward pricing embeds the difference between the two currencies' short rates. If your home rate is below the foreign rate, hedging costs roughly that gap annually (and pays it when the relationship inverts). In a period where, say, dollar short rates sit 2 points above euro rates, hedging US exposure back to euros costs a euro investor roughly 2% a year: an enormous, invisible drag that dwarfs every TER discussion in this book. When the differential reverses, hedging earns the carry. The published TER difference between hedged and unhedged classes (usually 0.03–0.10%) is trivia by comparison.

Second-order frictions. Hedges are struck on the portfolio's value at a point and rolled periodically, so market moves between rolls leave the hedge slightly over- or under-sized; and hedging a fund's stated currency exposure isn't the same as hedging its economic exposure (a European company earning in dollars carries dollar risk your euro-denominated holding doesn't show). Hedged classes also introduce a small tracking-difference wobble of their own.

The asset-class split, and why it's principled

Bonds: hedge. The point of a bond sleeve is stability (Chapter 19). Currency volatility runs roughly 8–10% annually; a global aggregate bond fund's own volatility is about 4–6%. Leaving foreign bonds unhedged means the currency noise exceeds the asset's, converting your stabilizer into a currency fund with a coupon. Every serious analysis reaches the same conclusion: hedge foreign-currency bonds back to your spending currency, and if hedging isn't available cheaply, hold home-currency bonds instead. This is one of the few near-consensus rules in portfolio construction, and this book adopts it without hedging its own language.

Equities: usually don't hedge. Three arguments, in descending strength:

1. The volatility contribution is modest. Equity volatility (~15%) and currency volatility (~8–10%) are imperfectly correlated, and currency exposure has historically added only a little to a diversified equity portfolio's total volatility: sometimes reducing it, because currencies like the dollar tend to strengthen in global risk-off episodes, cushioning equity falls for non-dollar investors.
2. The cost is real and unbounded in advance. You pay the rate differential every year, forever, for a risk that historically mean-reverts over long horizons.
3. Diversification across many currencies self-mitigates: a world fund's currency exposure is a basket, not a bet.

The honest counterargument, printed per house rules: over a decade-scale stretch, currency moves can be large and one-directional, and a retiree spending euros while holding a 65% dollar portfolio does carry genuine purchasing-power risk. The academic literature is genuinely split on the optimal equity hedge ratio, with respectable answers ranging from 0% to 50%.

Our view (labeled)

Consensus first: hedge bonds, and treat equity hedging as optional with a wide band of defensible answers.

Our position: for accumulation-phase investors with long horizons, hold equities unhedged: the cost is certain and the risk is not, and a global currency basket is already diversified. As the portfolio approaches its spending phase, the calculus shifts: money that will be spent in euros within a few years should not carry 65% dollar exposure. The practical implementation is not usually an equity hedge but the glidepath itself (Chapter 62): the near-term spending money moves into home-currency bonds and cash-like instruments (Chapters 43–44), which are hedged or home-denominated by construction. In other words: solve the currency problem for near-term money by changing the asset, not by hedging the equity.

Where an equity hedge is genuinely justified: single-country funds held tactically (an unhedged Japan fund is two bets, and you may want one), investors whose entire liability is in a currency that is not well represented in world indices, and institutional mandates with explicit currency budgets.

A worked example

Katrin, in Vienna, holds a world equity fund and is offered a EUR-hedged class of the same fund.

• The cost check: short-rate differential at the time is ~1.8% in the dollar's favor, so hedging the fund's dollar sleeve costs roughly that annualized on that portion: on a 65% dollar weight, roughly 1.2% a year of drag on the whole fund, against an equity risk premium she expects at 4–5%.
• The benefit check: her horizon is 25 years; her spending is in euros but not for decades; her fund's currency exposure spans a dozen currencies.
• Decision: unhedged. She writes one line in her policy: "Currency exposure is accepted and diversified; when spending approaches, near-term money moves to euro bonds and cash, not to hedged equity."
• Her father, 71, takes the opposite path correctly: his five years of spending sits in euro-denominated target-maturity bond funds and a €STR fund (Chapters 43–44), while his remaining long-horizon equity stays unhedged. Neither of them ever bought a hedged equity class, and both solved the currency problem.