ETF currency risk: How to handle it

ETFs invested in overseas securities expose you to currency risk. MoneyHub will explain this risk and guide you on how to protect yourself. 

ETFs let you own the world.

Within the space of a few funds, you can invest in every major country and publicly traded asset class, from traditional stocks to commodities, enabling you to harness the power of diversification, juice your returns and reduce volatility.

What’s less well understood is that overseas investing exposes you to currency risk. It makes no difference whether you use ETFs or direct investments. The most beautiful increase in value or dividend strategy is of little use if an unfavourable exchange rate cancels out the return or even drags it into negative territory.

There are indeed insurances against exchange rate fluctuations, so-called currency-hedged ETFs.

However, first, you should assess how much of your own investment is dependent on the development of foreign currencies.

What are ETFs?

ETFs, or Exchange-Traded Funds, have gained significant popularity among investors in recent years due to their flexibility and diversification benefits.

These funds enable investors to buy and sell a diversified portfolio of assets, including stocks, bonds, and commodities, on an exchange, much like individual stocks. The growing demand for ETFs can be attributed to their ability to provide exposure to a broad range of asset classes, sectors, and geographic regions, making them an attractive option for investors seeking to manage their currency risk and exchange rates.

For example, Estonian investors can use ETFs to gain exposure to foreign markets, such as the US dollar (USD) or the pound (GBP), and hedge against potential losses due to currency fluctuations.

What exactly is currency risk?

Currency risk is the impact of exchange rates upon your overseas investments. Let’s say you own US equities and the US dollar weakens against the euro by 5%, but the prices of US stocks don’t change.

The result is:

• Your US equities fall by 5% when their value is converted into euros, the currency you pay your bills in as an Estonian resident.

Currency risk can work in your favour, too. When the dollar strengthens by 5% against the euro (the US stock market is again unmoved), then:

• Your US equities rise by 5% when their value is converted into euros.

In both scenarios, a US resident investor would not see anything to get excited about. Their return is 0% over the period. But an Estonian investor either gains or loses 5% based purely on the fluctuation of the dollar-euro exchange rate.

That’s currency risk.

Exchange rates create opportunities and risks for ETF investors

Exchange rate fluctuations also add to and subtract from the local returns of overseas securities. For example, if US stock market prices dropped 5% while the dollar simultaneously lost 5% against the euro, then an Estonian investor would see a 10% total loss (-5% local return plus -5% dollar: euro return).

If the US stock market had increased by 5%, then an Estonian investor would have registered a 0% return – the local gain is wiped out by the adverse exchange rate move. Again, this works in reverse. If the dollar strengthened 5% in tandem with a US stock market 5% rise, then an Estonian investor would gratefully accept a 10% total return.

If the US market lost 5%, then the strengthening dollar compensates the Estonian investor for the loss, and they end up with a 0% return. Meanwhile, a US investor would be sitting on a 5% loss. The same applies to any security priced in a foreign currency. Your returns equal the change in the local value of the security, plus or minus the change in the exchange rate.

Currency risk can make a significant impact in the short term.

An overseas market can yield decent annual returns, but these returns are often nullified by a strengthening euro. The returns of specific strategies can be entirely overshadowed by the volatility of exchange rates, as seen with Emerging Market bonds denominated in local currencies.

Currency risk of ETFs: Should you fear it?

Your vulnerability to exchange rate volatility increases if you need to sell your investments in the short run. Exchange rate fluctuations can be violent, as the Trump tariffs aftermath has shown. Volatility is particularly dangerous for forced sellers who can’t just ride it out, so you may well want to protect your portfolio from currency risk if you must regularly draw down from it.

Longer-term investors have much less to worry about and may even benefit from currency risk. Studies show that exchange rate fluctuations make little impact on equity returns as time horizons lengthen.

Economists who advocate Purchasing Power Parity between countries believe that currencies reach equilibrium over time, and therefore, exchange rate fluctuations tend to net out. Many commentators believe that there is no expected return from taking currency risk, but that it can reduce the volatility of your holdings by reducing the correlation of returns between overseas assets held in different currencies.

In other words, global equities will naturally tend to hedge each other as rising currencies are offset by falling ones. It’s important to distinguish between equities and government bonds, however. The intrinsic volatility of equities means that exchange rate fluctuations are less relevant to your long-term returns.

However, currency risk can have a disproportionately large impact on low-volatility global bonds.

Therefore, it makes sense for investors to hedge currency risk out of their bond allocation when they want that part of their portfolio to play its traditional role in dampening volatility.

What’s your currency risk exposure?

Before we look at your currency risk options, it’s a good idea to estimate your portfolio’s overall currency risk first. The MSCI World index illustrates how you can work this out. The index tracks the stock markets of 23 industrialised countries, and its implications for currency risk are significant. 

However, the USA dominates it.

About two-thirds of an MSCI World ETF is invested in US equities, and those assets are priced in US dollars. In other words, an Estonian-based investor’s MSCI World ETF holding is 60% exposed to the euro-US dollar exchange rate. Equities priced in pounds make up 5.8% of the index, so your overall currency risk is 94%. As you can see, 8% of the currency risk is against the yen, while there’s 0.3% exposure to the Norwegian krone.

ETF currency risk: your options

Currency risk doesn’t have to be a binary choice. There are several ways that you can manage your exposure:

• Avoid: Increase your asset allocation to your currency area, i.e., invest in euro-denominated equities, property, and bonds if you settle your bills in euros. The obvious downside is that you’ll be less diversified, as you’ll ignore pounds, yuan and dollar equities. Furthermore, dollar- and pound-denominated equities are dominated by global large-cap companies that generate most of their revenue abroad. For example, around 75% of the UK FTSE 100 firms’ earnings come from overseas, which means they are also heavily exposed to currency risk. When the pound falls, those foreign earnings are worth more in euros, which boosts the share prices of major players in the index and, in turn, the FTSE 100 or FTSE All-Share ETF.

• Currency-hedged ETFs: These products are a very cheap and straightforward way to neutralise currency risk. Currency-hedged ETFs use financial contracts to offset the effects of exchange rates on fund returns. Lisaks, the hedge is a form of insurance that cancels out the loss you experience from a falling overseas currency. Sadly, the contract also cancels any gains you experience from rising overseas currencies. You can’t have it all. The currency hedge means you experience approximately the same return as a local investor (hedges aren’t always perfect) and currency risk is largely removed from the equation. Read more about the pros and cons in our article on currency-hedged ETFs.

• Diversify: Splitting your assets between different assets and markets reduces your investment risk. The same applies to foreign currencies, as discussed above. Intriguingly, you can also benefit from your exposure to safe-haven currencies like the dollar and the pound. The dollar has historically exhibited a negative correlation with global equity prices. Because the dollar is the world’s reserve currency and is used as a store of value by corporations and ultra-high-net-worth individuals, its rising value can help cushion the blow of falling equities for non-US investors. Your risk also changes if you split your residence between different currency areas. If you live in the UK for part of the year and Estonia, say, for the rest of the year (or think you will) then you should hold assets in pounds and euros so that you can pay your bills in both countries without concern for currency risk. Diversification is also the answer if you fear the long-term decline of the euro – overseas assets are an ideal hedge against that scenario.

• Long-term investment: Financial theory and evidence indicate that stock market returns are driven by a country’s economic performance over the long term. Therefore, our ETF portfolios offer long-term investment strategies that enable you to harness global GDP growth opportunities, as opposed to the futile task of trying to predict short-term market fluctuations.

• Partial hedging: You can, of course, hedge out some currency risk but maintain enough to enjoy some benefit from currency diversification. The customary strategy for a long-term investor is to allow currency risk on the equity side of the allocation while hedging on the bond side, or investing purely in government bonds, such as those found in Germany, the UK, or the USA.

ETF currencies: cutting through the confusion

Many people are exposed to currency risk without realising it because there is a profusion of confusion when it comes to the currency labels applied to funds, which are not always straightforward and can only be understood with careful consideration. 

Let’s clear that up:

1. Underlying currency

Have you ever seen a World ETF that says its currency is dollars, while another version of the same product is labelled in euros?

That makes no difference whatsoever to your currency risk.

What counts is your exposure to the currency of the underlying securities traded in. This has two important implications. If a World ETF is labelled in US dollars (see the other terms below to understand why that happens), your currency exposure to the US dollar is still only 60%. Your 8% Yen risk isn’t somehow amplified by dollar risk too. An Estonian investor in Japanese securities is only concerned with the yen-euro exchange rate.

The dollar isn’t part of that equation. An ETF labelled in pounds doesn’t save you from currency risk either, unless it’s specifically EUR-hedged. Therefore, to understand your currency risk, you need to know which currencies an ETF’s underlying securities are traded/priced in and what implications this has for your investment.

2. Fund currency

This term is responsible for much of the confusion surrounding exchange-traded fund (ETF) currencies.

The terms “base currency” or “denominated currency” are also often used.

Crucially, these terms refer to the currency in which an ETF reports, not necessarily the currencies in which the underlying securities trade. The ETF reports its Net Asset Value (NAV) in the fund’s currency and distributes income in that same currency. Your broker will convert your income into euros, but will likely charge you an exchange rate fee for doing so.

The fund currency is generally based on the currency used for the underlying index, which is determined by financial regulations and order. The index currency is usually the same as the currency in which most of the index’s securities are traded.

3. Trading currency

The trading currency refers to the currency in which the ETF is bought and sold on a particular international exchange.

The units/shares of a World ETF may be traded in pounds because it’s listed on the London Stock Exchange (LSE) but that doesn’t alter the fact that you’re exposed to the currency risk of its underlying securities. Intriguingly, the LSE allows trading in multiple currencies, so it’s worth ensuring you invest in a euro-denominated version, where available, to avoid additional exchange rate conversion fees.

4. Currency hedging

You should choose EUR-hedged ETFs if you’re an Estonian resident investor who wants to eliminate currency risk as much as possible või reduce it significantly. Appropriate ETFs will usually have the term ‘EUR Hedged’ in their names, but always check the product’s factsheet or webpage to make sure.

If you can’t find any reference to EUR hedging in the ETF’s name or literature, assume it isn’t hedged. You’ll also notice that hedged ETFs are often a little more expensive than their unhedged counterparts. That’s because the hedge itself incurs costs.

Why do exchange rates fluctuate?

Exchange rates mainly result from the forces of supply and demand for national currencies. For example, the currency of a leading export nation is likely to strengthen over time due to high demand for its goods, all other factors being equal.

The currency markets also influence exchange rates.

Currency traders move swiftly to exploit any arbitrage opportunities.

The carry trade is a well-known example – traders borrow in a currency with a low interest rate and buy into a currency with a higher interest rate. The aim is to profit from the interest rate differential. However, arbitrage opportunities are usually fleeting and high risk, as exchange rates move to reset the market equilibrium between pairs of currencies.

Naturally, central banks influence the value of their national currency through monetary policy. You can see this playing out as countries recover from the Global Financial Crisis at different rates. The US led the Developed economies out of the crisis and has been able to raise interest rates faster than the Bank of England or the European Central Bank.

Hence, the US dollar has strengthened against the euro in recent years, benefiting Eurozone investors who held significant US assets. Other countries are known for playing a more active role in their exchange rate. China, for example, is thought to manage the rise of the Yuan to preserve the competitiveness of its export sector.

Some countries may peg the value of their currency to a stronger currency, in which case there’s no currency risk as long as the peg sticks.

Many Emerging Market economies also find it easier to raise finance if they issue their bonds in US dollars. This can lead to major economic turmoil if a country’s debt burden soars, as its currency then falls against the dollar, and overseas earnings fail to compensate.

Argentina is the cautionary tale par excellence here.

Currency exchange considerations

When dealing with currency exchanges in ETF investments, several key factors must be considered. First, investors should be aware of the current exchange rates and how they may impact the value of their investments.

It is also essential to understand the fees associated with currency exchanges, as these can eat into investment returns.

Furthermore, investors should consider the liquidity of the currency market and the potential for market volatility, which can affect exchange rates and investment values. For example, suppose an investor is investing in an ETF that tracks the performance of the US stock market. In that case, they should be aware of the exchange rate between the US dollar and their local currency, as well as any potential risks associated with currency fluctuations.

By carefully considering these factors and employing strategies such as currency hedging or diversification, investors can effectively manage their currency risk and exchange rate exposure, ultimately achieving their investment objectives.

The main takeaway is to recognise that the currency markets are among the most efficient and competitive in the world, offering investors a wide range of ETFs to choose from üle major global exchanges. Small investors lack both the speed and information necessary to prosper for long in this space.

Therefore, it is best to adopt a currency risk position on a strategic level that aligns with your long-term objectives.