Hedged vs unhedged ETFs: Which is better?

It's no secret that there are compelling reasons to invest internationally.  It gives your portfolio extra diversification and access to companies, sectors, and markets that are barely represented here in Australia.

But just as holidaymakers need to plan for the impact of currency movements, so too do investors.  

One way to shield overseas investments from currency fluctuations is through 'hedging'. But, along with its benefits, hedging can also come with drawbacks.

Let's take a closer look at how hedging works and what to consider when deciding if a hedged or unhedged ETF is right for you.

Investing globally and currency risk  

While investing outside of Australia brings opportunities, it also introduces currency risk to your portfolio.

Currencies can (and do) move swiftly, depending on interest rates, inflation, economic growth, capital flows, and geopolitical tensions. Long-term trends also come into play.

As anyone planning an overseas trip in 2025 will know, the Australian dollar is particularly weak at present.

However, this wasn't always the case. Four years ago, in early 2021, the Aussie dollar was trading at almost 80 US cents. Fast forward to early 2025, and it's worth closer to 60 US cents.

This fall in the Aussie dollar can have major implications for investors.

How currency movements impact ETF investors 

Investing internationally can see your returns impacted by currency movements. That's because money invested overseas needs to be converted back into Aussie dollars at some stage.  

In simple terms, a fall in the Australian dollar magnifies gains when investments are converted back into Aussie dollars. 

Conversely, a rise in the Aussie dollar will erode any gains when overseas investments are converted back into our own currency.  

The good news is that currency risk can be managed through 'hedging'. 

What is a hedged ETF? 

Hedged ETFs offer Aussie investors a way to invest internationally without feeling the pinch of currency fluctuations. 

The process of hedging can sound complicated. As ETF giant Vanguard explains, it usually involves taking out a forward contract to lock in a set exchange rate.  

The bigger issue for investors is whether hedging works in their favour. .

Pros of hedged ETFs 

• If the Aussie dollar rises, the value of your investment - and investment returns - will not be affected.  

Cons of hedged ETFs 

• If the Aussie dollar falls in value, you won't gain the exchange rate benefit . 
• Hedging comes at additional cost. So, for a hedged ETF to be financially worthwhile, the benefits need to outweigh the costs. 

How do hedged and unhedged ETFs compare?

In theory, the long term net (after costs) returns on an unhedged portfolio should be higher than a hedged portfolio owing to the additional costs of hedging. 

Let's look at two near-identical international ETFs offered by Vanguard. The unhedged Vanguard MSCI Index International Shares ETF (ASX: VGS) has an annual management fee of 0.18%. 

Its stablemate, the Vanguard MSCI Index International Shares Hedged ETF (ASX: VGAD), which invests in virtually the same stocks (allowing an apples-for-apples comparison), comes with an annual management fee of 0.21%. 

In other words, hedging bumps up the annual fee by 0.03%. Yet, the two ETFs have delivered quite different results over time. 

If you had invested $10,000 in Vanguard's unhedged international share ETF in late 2019, your investment would have been worth around $19,425 by 31 December 2024. 

By contrast, if the same $10,000 had been invested in the hedged version of Vanguard's international ETF, it would have grown to $16,507 over that same five-year period. 

The $2,918 difference between the two funds isn't just a matter of the 0.03% higher fee - it's also driven by currency movements. 

For the record, in the five years since late 2019, the Australian dollar initially rose against the US greenback until about 2021, after which it has steadily declined in value.  

The bottom line is that when the Aussie dollar is on a downward trend, as it has been lately, investors can be rewarded with higher gains if you opt not to hedge. 

Let's see what happens if we widen the lens beyond the past five years. To do this, we'll look at the 10-year returns on the MSCI World ex Australia 100% Hedged to AUD Index. It offers a close estimate of the performance Aussie investors can achieve by hedging global shares compared to the unhedged MSCI World ex Australia Index. 

The results, shown in the table below, highlight that over time there is less of a difference between hedged and unhedged returns. That said, the unhedged gains trump the hedged returns. 

Returns on global shares - hedged v unhedged  

Source: MSCI World ex Australia 100% Hedged to AUD Index. Net returns to 31 December 2024 

Hedged versus unhedged - what to consider  

Just as it's impossible to predict share market movements over the short term, currency markets are notoriously unpredictable. 

If you have a strong view that the Aussie dollar is likely to rise over the short term (thereby eroding returns), you may want to consider a hedged ETF. 

In most cases though, hedging is used to manage risk rather than magnify gains.  

If you're not comfortable about currency risk, which may be the case if you are nearing, or in, retirement, a hedged ETF can eliminate much of the potential downside. 

Similarly, if you are looking at asset classes known to bring stability to a portfolio, such as fixed income ETFs, hedged options can further lower your risk profile. 

The thing to be aware of is no matter how currencies move, the extra costs of hedging are a sure thing. 

The upshot is that there is no one-size-fits-all solution that is right for every investor. The question of whether or not to hedge depends very much on your investment goals, your investment timeframe, and your appetite for risk. 

It's also helpful to remember that a globally diversified portfolio can be an effective way to manage currency risk and reduce volatility - with or without hedging.   

Key takeaways 

• Investing overseas brings diversification benefits but it also introduces currency risk. 
• Hedged ETFs can overcome currency risk but they typically come with higher fees. 
• Over the long term, the gap between hedged and unhedged returns narrows. 
• The decision to hedge can be driven by your appetite for risk and/or your need for stable returns.  
   

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