Analysis of Pros and Cons of FX-Hedged (H) ETFs | Currency Fluctuation Risk and Opportunity Cost
FX-Hedged (H) ETF Pros and Cons Analysis
"Don't put all your eggs in one basket" is the adage of Asset Allocation. Likewise, in overseas investing, one must manage another variable: Currency Fluctuation Risk. The (H) symbol attached to the product name when investing in an overseas Exchange Traded Fund (ETF) signifies FX Hedging, meaning an attempt to minimize the impact of exchange rate volatility.
In this posting, we will analyze the pros and cons, as well as the actual costs, of choosing an FX-Hedged (H) product when investing in overseas ETFs to examine which investment situations it is suitable for.
Analysis of Pros and Cons of FX-Hedged (H) ETFs | Currency Fluctuation Risk and Opportunity Cost
1. Concept and Operating Principle of FX Hedging (H)
FX Hedging (Hedge) is a financial technique that pre-emptively eliminates the risk of loss or gain due to currency fluctuations. When investing in foreign stocks or ETFs (Exchange Traded Funds), changes in the value of the invested country's currency (e.g., USD) against the won, in addition to the price fluctuations of the underlying asset, affect the final rate of return.
FX-Hedged/FX-Exposed Types
- FX-Exposed Type (Unhedged): Directly exposed to exchange rate fluctuations, resulting in exchange rate gains or losses.
- FX-Hedged Type (Hedged, H): Utilizes financial products such as forward exchange contracts to fix the exchange rate at the time of purchase, removing the impact of currency fluctuations, and only the price change of the underlying asset is reflected in the rate of return.
For example, let's assume you bought a US ETF with 1 million KRW when the exchange rate was 1,000 KRW per USD, the index rose by 10%, and the exchange rate increased to 1,100 KRW. FX Hedging (H) blocks the exchange rate fluctuation risk in this manner, allowing investors to focus solely on the performance of the investment product itself.
| Classification | Index Return | Exchange Rate Impact | Final Return |
|---|---|---|---|
| FX-Hedged (H) Type | 10% | 0% | 10% |
| FX-Exposed Type | 10% | 10% | Approx. 21% (1.1 x 1.1) |
2. Key Pros and Cons of FX-Hedged ETFs
2.1. Pros: Reduced Volatility and Predictability
One can track only the performance of the target index or asset, regardless of sharp exchange rate fluctuations. This is the surest way to **minimize risk** when the direction of the exchange rate is difficult to predict. Especially for short-term investments or when an exchange rate decline is expected, it can avoid exchange rate losses, allowing for stable returns.
2.2. Cons: Increased Cost and Constrained Returns
FX-Hedged products are assigned a higher Total Expense Ratio (TER) compared to FX-Exposed products. This is because the FX Hedge Cost is reflected in the other expenses. This cost becomes significant due to the compounding effect during long-term investment.
Furthermore, the **KRW/USD exchange rate tends to appreciate long-term** for Korean investors, meaning FX hedging has the disadvantage of forcing the investor to forgo the additional profit opportunity of exchange rate gains that could be realized from a rising exchange rate.
3. Understanding the FX Hedge Cost
The FX Hedge Cost involves more than just transaction fees; it also includes the opportunity cost resulting from the interest rate differential (difference in benchmark interest rates).
Overseas investment involves exchanging different currencies, so the interest rate differential between the invested country and the home country is reflected in the FX Hedge Cost.
- Interest Rate Differential Reflection: The difference in interest rates between the invested country and the home country is reflected in the FX Hedge Cost.
- Example: If the interest rate of the invested country (US) is higher than the home country (Korea), an **additional cost** equal to the interest rate differential occurs when entering a forward exchange contract for FX hedging.
Therefore, this interest rate differential is embedded in the actual cost borne by the investor (FX Hedge Cost included in TER), becoming the main reason for the higher management fees compared to the FX-Exposed type.
4. Conclusion: Differentiating Strategies Based on Investment Goal
The choice between an FX-Hedged ETF and an FX-Exposed ETF should vary according to the investor's time horizon and goal. The pros and cons of the two types are summarized below.
| Classification | FX-Hedged (H) Type | FX-Exposed Type |
|---|---|---|
| Key Advantages | Elimination of exchange rate fluctuation risk, securing stable asset-specific return | Expectation of exchange rate gains upon currency appreciation, lower management fees |
| Recommended Investor | Short-term investor (within 1-2 years), when an exchange rate drop is expected | Long-term investor (5+ years), when an upward trend in the exchange rate is expected |
In conclusion, the FX-Exposed Type may be advantageous for investors who seek to benefit from a long-term appreciating exchange rate through **long-term investment**. However, for investors planning a **mid-to-short-term investment** of about 2-3 years, or those who judge the current exchange rate to be at a peak and want to completely exclude the risk of exchange rate loss, the FX-Hedged (H) Type can be a rational choice.
Ultimately, it is crucial to manage risk through appropriate distribution rather than absolute FX hedging or FX exposure, by comprehensively considering the characteristics of the underlying asset and the correlation with the currency.
If you want to learn more about the costs of FX-Hedged ETFs, please refer to this video:
👉 ETF Investing, Are the Fees for FX-Hedged Products Higher?
This video easily explains the concept of FX Hedge Cost in relation to interest rate differentials, which will help lay the foundation for ETF investing.
Key Summary:
FX hedging removes currency risk and increases stability, but it comes at the cost of FX hedge fees and the loss of exchange rate gain opportunities. Long-term investment generally favors FX exposure, while short-term favors FX hedging. A careful choice based on investment goal and duration is necessary.
The content of this blog is for reference in making investment decisions only, and all investment decisions must be made under the individual's judgment and responsibility. Under no circumstances can the information on this blog be used as legal evidence for accountability regarding investment results.
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