FX Hedging for International Portfolios: Best Practices
You have a lot of choices when you invest in a global market. You can take advantage of the growth of emerging economies, find good deals on companies in other countries, and invest in more than just your own country. But there is an unseen risk that comes with this global exposure: foreign exchange (FX) risk. If the Japanese yen falls against your home currency, a great stock pick in Japan could lose all of its value. This currency volatility is a big problem for investors around the world.
This guide will clear up any confusion you may have about FX hedging and show you why it's such an important part of a global investment strategy. We'll talk about the different kinds of currency risk you face, the most common ways that professional money managers protect themselves from these risks, and the best ways to protect your international portfolio from changes in currency values. When you learn these strategies, you don't want to get rid of all risk. Instead, you want to make an unpredictable force a manageable part of your investment plan.
The Two Faces of Currency Risk 🌍
We need to know about the two main types of currency risk that can affect your investments in other countries before we can hedge.
Direct Risk: This is the most clear type. When you buy a stock in a foreign currency, the value of that stock is always changing back to your home currency. Your investment's value in your home currency will go down if the foreign currency gets weaker, even if the stock itself has done well.
Indirect Risk: This is a less obvious but just as important type of risk. Changes in currency can affect how much money a foreign company makes. For instance, if a company exports most of its goods and its home currency gets stronger, its profits may go down because its products will be more expensive for people in other countries to buy. This can change the price of the company's stock, which will affect your investment.
FX hedging is mostly about reducing the direct risk, which means you can lock in the value of your foreign assets in your home currency.
Three Core Hedging Strategies 📊
Professional investors use complicated strategies, but individual investors can use a few simple ones to protect their portfolios.
1. Currency-Hedged ETFs
This is by far the easiest and most accessible way for most investors to protect themselves against currency risk.
How it Works: These are ETFs that put money into a foreign market, like Japan's Nikkei 225, but they use financial derivatives to cancel out the effects of changes in currency value. The fund manager does all the hedging for you, and the fund's returns are meant to show how well the underlying stocks are doing, not how well the currency is doing.
Example: If you want to invest in the Japanese stock market but are worried about the yen getting weaker, you could buy a Japan ETF that is hedged against currency risk. If the yen drops by 5% and the Japanese market goes up by 10%, your return would still be close to 10%. This is because the currency risk has been hedged out.
Best For: Most individual investors who want to hedge their global portfolios in a simple, low-cost, hands-off way.
2. Buying a Hedging Instrument Directly
This is a more hands-on way for investors who want to be in charge of their own currency exposure..
How it Works: If you own a lot of foreign stocks, you can buy a financial instrument that makes money when that foreign currency goes down. The most common way to do this is to buy a put option on the foreign currency or to go short on a currency futures contract.
Example: you have a collection of European stocks. You could buy a put option for the Euro. If the Euro loses value compared to your home currency, the put option will go up, making up for the loss in your stock portfolio.
Best For: Investors who have a lot of experience and a big international portfolio and want to have complete control over their hedge. They should also be okay with the risks and complexity of options and futures trading.
3. Asset Allocation and Natural Hedging
This is a less active but still effective way to hedge that looks at the overall structure of your portfolio.
How it Works: By putting your money into a variety of assets, you can naturally protect your portfolio. An American who owns both U.S. and Japanese stocks might also own U.S. Treasury bonds, for instance. If the world economy goes down, the Japanese yen may lose value, but the value of U.S. Treasury bonds may go up, which would naturally balance things out.
Best For: Investors who don't want to actively hedge but want to build a strong, diverse portfolio that can handle different market conditions. This is a basic idea in modern portfolio theory.
The Pitfalls of Hedging: What to Watch Out For ⚠️
While hedging is a powerful tool, it's not without its drawbacks.
Hedging Costs: Hedging is not free. Currency-hedged ETFs have a slightly higher expense ratio than their unhedged counterparts. Actively hedging with options or futures can also involve significant transaction costs. These costs can eat into your returns, so a hedge should only be used when the currency risk is significant.
Missing Out on Favorable Moves: A hedge works both ways. If the foreign currency you are invested in strengthens, your hedge will lose value, offsetting the currency gain in your portfolio. While this is a loss of a potential gain, it is a deliberate trade-off you make to protect yourself from the downside.
The "Tax Loss Harvesting" Loophole: The U.S. has a unique tax rule where you can use your crypto losses to offset your gains. This can be a major tax-saving strategy.
Conclusion
Investors can't avoid currency risk in a world that is becoming more global. FX hedging is a strategic solution that lets you lower this risk and keep your portfolio safe from currency swings that you can't predict. You can be a more disciplined and successful global investor if you understand these strategies. You can choose the simplicity of a hedged ETF, the precision of a direct hedging instrument, or the passive resilience of a well-diversified portfolio.
FAQ
Q: Should I always hedge my investments in other countries? A: Not always. Hedging costs money, and if the currency risk is low or you think the foreign currency will get stronger, it might not be worth it. Your own risk tolerance and your view of the market should guide your choice to hedge.
Q: What does it mean to have a forward contract? A: A forward contract is a personalized deal to buy or sell a currency at a set price on a later date. Corporations and institutional investors usually use it as a more complicated way to hedge.
Q: What is the function of a currency-hedged ETF? A: A currency-hedged ETF uses a "forward contract," which is a type of financial tool, to sell the foreign currency and buy the home currency. This effectively locks in the exchange rate for a while, so the currency doesn't affect the fund's returns.
Q: Is hedging a kind of betting? No. Hedging is a way to lower risk. Some people may use currency instruments to guess which way a currency will go, but the point of a hedge is to protect an existing position, not to make money off of a market move.
Disclaimer
This article is for informational purposes only and does not constitute financial or investment advice. The value of investments can fluctuate, and there is no guarantee of returns. Currency hedging involves costs and may not be suitable for all investors. Readers should conduct their own thorough due diligence and consult with a qualified financial advisor before making any investment decisions.
