Should you hedge the currency? What hedging actually does (and does not)

You buy an MSCI World ETF priced in dollars and wonder whether that means you are taking currency risk. The short answer is no, and understanding why is what makes the hedge-or-not decision straightforward.

The most repeated mistake: trading currency

The currency an ETF is priced in does not determine your currency exposure. It is just the unit the price is expressed in, like measuring a distance in miles or kilometres: the journey does not change.

What determines your exposure is which currencies the underlying assets are in. An MSCI World is ~70% US companies, so you have ~70% dollar exposure — whether you buy the dollar, euro or Swiss franc line. They are the exact same portfolio.

Put another way: buying the euro line of an unhedged fund protects you from nothing. If that is what you were after, you need a hedged share class, which is a different product.

What a hedged class does

A EUR Hedged class uses derivatives (usually one-month forwards, rolled monthly) to neutralise the move between the asset currencies and the euro. If the dollar falls 5% against the euro, the hedge roughly offsets that loss.

"Roughly" is the key word: the hedge is sized on the fund's value at the start of the period, and that value moves during the month. The imprecision is called hedging error, and it is never zero.

What it costs

Two costs, and the second one surprises people:

• The higher TER. In this catalog, the iShares Core MSCI World charges 0.20% and its EUR Hedged version 0.30%. Ten basis points of explicit difference.
• The interest-rate differential. This is the big one and it appears nowhere in the TER. Hedging dollars into euros costs, roughly, the gap between short-term US and eurozone rates. When US rates sit 2 points above European ones, hedging costs you on the order of 2 points a year, not 0.10.

That cost is not a fee: it is the market price of the hedge, and it moves with monetary policy. It can even turn negative (i.e. pay you) if rates invert.

In equities: usually not

Three reasons, and the third is the one that counts:

• Currency adds no expected return over the long run. But it does not subtract either: over long horizons it tends to be noise around zero, not a steady drain.
• Hedging costs for certain, while the benefit is uncertain. You are paying a known cost to remove an uncertainty that tends to wash out over 20 years.
• Currency usually cushions drawdowns. When equities crash, the dollar tends to strengthen (flight to quality). For a euro-based investor that softens the fall. Hedging removes that cushion exactly when you need it most.

In bonds: almost always yes

Here the reasoning flips, and it matters. A global bond fund yields 3-4% with volatility of 4-6%. The euro-dollar exchange rate moves 8-10% a year.

In other words: currency would be the main driver of your bond allocation, and fixed income is there precisely to provide stability. Unhedged, it does not do its job. That is why nearly every global bond fund aimed at European investors comes in a EUR-Hedged version — you will find several in the fixed income catalog.

Deciding it in two questions

1. What is this asset in my portfolio for? If it is to grow long term (equities), currency is tolerable noise. If it is to stabilise (bonds), currency breaks that job and is worth hedging.
2. When will I spend this money? If it is in 25 years, the noise washes out. If it is in 3 and you spend in euros, a dollar fall at the wrong moment genuinely changes your outcome.

In short

• Trading currency does not matter: what counts is the currency of the underlying assets.
• Hedging costs the extra TER (~0.10 points) plus the rate differential, which can be several points and appears on no factsheet.
• In long-term equities it usually does not pay off, and you lose the drawdown cushion.
• In bonds, almost always yes: unhedged, currency cancels the stability you were buying.

Educational content, not investment advice. The cost of hedging moves with interest rates and is not a fixed figure.