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Currency-Hedged ETFs: When They Make Sense and When They Are an Unnecessary Cost
Key takeaways
- Currency-hedged ETFs use derivatives to neutralize exchange rate movements.
- Hedging typically costs an additional 0.3–1% per year compared to the unhedged version.
- For horizons beyond seven years, hedging usually reduces the net return.
- Hedging makes sense with a short time horizon or a specific need to eliminate exchange rate swings.
- CZK-hedged variants are rare — most ETFs hedge against the euro.
Currency-hedged ETFs (hedged ETFs) are funds that use forward contracts or swaps to neutralize the influence of exchange rate movements — the investor thus receives the return of the underlying assets without the currency component.
How Hedging Works Technically
The fund manager regularly enters into forward contracts that lock in the exchange rate between the currency of the underlying assets and the target currency of the fund. If a fund holds US equities and is hedged into EUR, the forwards offset gains and losses from USD/EUR movements. The result: returns correspond to equity performance, and exchange rate movements disappear. For this service the manager charges a premium, which shows up as a higher TER or cost component.
What Hedging Costs
The cost of hedging depends on the interest rate differential between the currencies. If interest rates in the US are higher than in the eurozone, hedging USD exposure into EUR is expensive — the investor pays the rate differential for every year. Typically this amounts to 0.3 to 1.5% per year depending on the currency pair and market conditions. In an environment of high interest rate differentials, hedging can eat into a significant portion of the equity return.
When Hedging Pays Off
- Investment horizon shorter than 5–7 years — exchange rates do not have time to revert
- Planned withdrawal at a specific date (e.g. purchasing property in 3 years)
- Very high sensitivity to year-on-year portfolio volatility
- The bond component of a portfolio — here exchange rates make up a larger share of total return
The Reality for the Czech Investor
CZK-hedged ETFs are rare on the market — the overwhelming majority hedge against EUR or USD. A Czech investor therefore typically faces a choice: an EUR-hedged ETF (locking exposure into EUR, not CZK), an unhedged ETF (accepting currency risk), or consciously working with currency risk as part of the strategy. Given the historically stable CZK/EUR exchange rate, the unhedged variant is the more optimal choice for the vast majority of long-term investors.
FAQ
What is a hedged ETF?
A fund that uses forward contracts to neutralize the impact of exchange rate movements. The investor receives the return of the underlying assets without the currency component. A premium is charged on top of the fund's regular fees for this service.
How much does currency hedging cost?
It depends on the interest rate differential between currencies — typically 0.3 to 1.5% per year. In an environment of high US interest rates, hedging into EUR or CZK can be considerably more expensive.
When does hedging make sense?
With a short horizon (up to 5 years), when withdrawal is planned at a specific date, or for the bond component of a portfolio. For an equity investor with a 10+ year horizon, hedging usually reduces net returns.
Do CZK-hedged ETFs exist?
The offering is very limited. Most hedged ETFs hedge into EUR or USD. A Czech investor therefore typically has to either accept currency risk or choose an EUR-hedged variant, which eliminates USD risk but not CZK/EUR movements.