Hedging currency changes which risk you are taking

Holding foreign assets means holding foreign currencies. Hedging that exposure is often described as reducing risk, and it is more accurate to say it exchanges one risk for another.

What the hedge does mechanically

A hedged fund enters contracts that offset currency movement between the asset's currency and the investor's. Gains and losses on the currency are cancelled out by the contracts.

The hedge is reset periodically, usually monthly, because the value of the assets moves and the contracts must be resized to match. That resetting is where imprecision enters.

Between resets the hedge is approximate. Sharp asset movements leave the position over- or under-hedged until the next adjustment, which produces residual exposure.

The cost depends on interest rate differences

Hedging is not free, and its cost is driven largely by the gap between short-term interest rates in the two currencies rather than by a stated fee.

When rates in the foreign currency are higher, hedging back generally costs money. When they are lower, it can add to returns. The direction is not fixed.

That means the cost of a hedged holding varies over time for reasons unrelated to the assets. It is a real drag or benefit and it is not visible as a charge.

The exposure that remains

Hedging the currency a fund is priced in does not hedge the currencies its underlying businesses operate in. A company earning worldwide revenue carries exposure regardless.

This is why hedging equity exposure is less clear-cut than hedging bonds. Equity returns are dominated by business performance, which already reflects currency movement indirectly.

For bonds the case is different in kind. Currency movement can be larger than the return the bonds themselves produce, which changes what the holding is contributing.

Matching the currency of future spending

The framework that makes the decision tractable is asking what currency the money will eventually be spent in. Assets held to fund domestic spending have a currency mismatch if unhedged.

The longer the horizon, the less that mismatch dominates, because currency movements have historically been less directional over long periods than over short ones.

Someone spending in more than one currency, or expecting to move country, has a genuinely different problem, and the answer depends on circumstances rather than on a general rule.

Hedged and unhedged behave differently in a fall

Currency movements sometimes offset asset falls and sometimes amplify them, depending on which currencies are involved and what is driving the fall.

Investors who chose hedging for its lower volatility can find that lower volatility absent precisely when it was wanted, because the relationship is not stable across episodes.

The practical implication is that the choice should be made on the currency of future spending and the cost, not on how the two versions behaved in a particular past period.