Hedged and Unhedged Funds
Open Currency Fund leaves its foreign-currency exposure unhedged. Currency Shield Fund uses contracts to reduce part of the exchange-rate effect. Same companies, different euro results.
Why this matters for beginners
Hedged share classes are common, and the word hedged is often misread as safer. This is general education, not personal advice.
Main explanation
Currency hedging attempts to reduce currency movement, not remove investment risk. The underlying companies can still rise and fall.
Hedging may help when the foreign currency weakens against the investor's currency: the unhedged fund loses on the conversion, the hedged fund loses less.
Hedging may reduce gains when the foreign currency strengthens: the unhedged fund enjoys the extra conversion gain, the hedged fund gives much of it up.
Hedging has costs and may not match exposure perfectly. A simplified three-period comparison shows: underlying asset return, currency effect, hedge adjustment, hedge cost, and final euro return, each shown separately.
Example period: assets +8 percent in dollars, dollar weakens 5 percent. Unhedged euro return: about +2.6 percent. Hedged: about +8 percent minus hedge cost of 0.6 percent = about +7.4 percent.
Reverse period: assets +8 percent, dollar strengthens 5 percent. Unhedged: about +13.4 percent. Hedged: about +7.4 percent again. The hedge dampens both directions.
Hedged does not mean safer in every respect, and the preferred exposure cannot be determined from currency direction alone. Sometimes the honest answer is: not enough information.
Example using a real company
Over three fictional periods, Currency Shield Fund's euro returns stay close to the underlying asset returns, while Open Currency Fund swings further in both directions.
- →Dollar weakens: hedged fund ahead. Dollar strengthens: unhedged fund ahead.
- →Hedge cost: a small, steady drag that exists in both directions.
Common beginner mistakes
- ✕Reading hedged as low risk.
- ✕Assuming the better choice can be known from a currency forecast alone.
Key terms
- Currency hedging
- Using contracts to reduce the effect of exchange-rate moves on a fund's home-currency return.
- Hedge cost
- The ongoing cost of maintaining the currency contracts.
Key takeaways
- 01Hedging dampens currency moves in both directions and costs money.
- 02Your return depends on both the investment and the currency used to measure it.
Check yourself
- 01The dollar weakens 5 percent. Which fund does better in euros, hedged or unhedged?
- 02The dollar strengthens 5 percent. Which fund does better in euros?
- 03Does hedging remove investment risk?
- 04A friend asks which fund will do better next year. What is the honest answer?
Try the concept on a real company
When comparing two fund listings in the Analyzer's world, check whether one is currency hedged before comparing returns.
Educational examples only. Not buy or sell recommendations.