Currency Hedging: Should You Buy “Hedged” International ETFs?
Currency Hedging: Should You Buy “Hedged” International ETFs?
EXECUTIVE SUMMARY
- The Mechanism: When you buy International Stocks (e.g., Japanese Toyota), you are actually making two bets: 1) Toyota stock goes up, and 2) The Yen strengthens against the Dollar. If the Yen crashes, your stock gains can be wiped out.
- The Solution: Currency Hedged ETFs (like HEFA or DBJP) use forward contracts to neutralize the currency fluctuation. You get the pure return of the foreign stock market in US Dollars, regardless of exchange rates.
- The Strategy: Hedging is critical when the US Dollar is rising (Strong Dollar). However, unhedged exposure is a better diversifier during US inflation because foreign currencies often act as a hedge against a dying Dollar.
Most investors ignore currency risk until it hits them. In 2022, Japanese stocks rose +5% in Yen terms, but US investors in unhedged ETFs (EWJ) lost -15%. Why? Because the Yen collapsed against the Dollar. Currency Hedging is the “noise cancelling headphone” of investing. It isolates the signal (stock performance) from the noise (FX volatility). According to Team BMT Analysis, understanding this mechanic is the difference between being a tourist and being a global investor.
Scenario: You invest in European Stocks (Euro). The Euro falls 10% against the Dollar.
- Unhedged ETF (e.g., VGK):
Stock Return: +8% (in Euros).
Currency Return: -10% (Euro vs. USD).
Net Return to You: -2%. (You lost money despite picking good stocks). - Hedged ETF (e.g., HEDJ):
Stock Return: +8% (in Euros).
Currency Impact: 0% (Neutralized).
Net Return to You: +8%. - BMT Protocol Verdict: In a strong dollar environment, Hedged ETFs act as a shield, preserving your local market gains.
Performance Gap: Hedged vs. Unhedged (2014-2015)
| Strategy | Total Return (Strong Dollar Period) |
|---|---|
| Unhedged Europe (VGK) | -6.0 |
| Hedged Europe (HEDJ) | 14.0 |
*Chart Note: During the massive Dollar rally of 2014-2015, Hedged investors outperformed by 20% simply by removing the currency anchor.
CRITICAL SCENARIO: The “Cost of Carry” Trap
When hedging becomes expensive.
| Condition | Interest Rate Environment | Hedging Cost |
|---|---|---|
| US Rates > Foreign Rates | US (5%) vs. Japan (0%) | You get PAID (+5%) to hedge |
| US Rates < Foreign Rates | US (1%) vs. Brazil (10%) | You PAY (-9%) to hedge |
Execution Protocol
Look at the DXY (Dollar Index) trend.
Rising DXY (Strong Dollar): Buy Hedged ETFs (HEFA, DBJP).
Falling DXY (Weak Dollar): Buy Unhedged ETFs (EFA, VXUS).
If you don’t want to predict currencies, split your international allocation.
50% VXUS (Unhedged – for diversification).
50% DBEF/HEFA (Hedged – for volatility reduction). This creates a “Half-Hedged” portfolio that is robust in all FX scenarios.
Hedging Emerging Markets (Brazil, India) is usually too expensive due to their high interest rates (negative carry). Stick to hedging Developed Markets (Europe, Japan) where rates are lower than the US.
Fail Condition: Buying a hedged Emerging Market ETF creates a massive drag on returns due to the interest rate differential.
WEALTH STRATEGY DIRECTIVE
- Do This: Use Hedged ETFs for your Japan/Europe allocation while US interest rates remain higher than foreign rates. You get the “Carry” bonus plus risk reduction.
- Avoid This: Ignoring currency risk in your Bond portfolio. International Bonds (e.g., BNDX) should always be hedged. Currency volatility is too high for a “safe” asset class like bonds.
Frequently Asked Questions
Why is VXUS unhedged?
Standard index funds (VXUS, VEA) are unhedged by default because it’s cheaper and provides “true” diversification. If the US Dollar crashes, unhedged foreign assets skyrocket in value, protecting your purchasing power.
Does hedging reduce volatility?
Yes. Currency adds a layer of random volatility on top of stocks. Hedged international portfolios typically have a Standard Deviation 15-20% lower than unhedged ones.
What is the ticker for Hedged EAFE?
HEFA (iShares Currency Hedged MSCI EAFE) or DBEF (Xtrackers MSCI EAFE Hedged Equity). For Japan specifically, DXJ or DBJP are popular.