How Does Currency Risk Arise in Funds and ETFs?

Currency risk arises when the value of an investment fluctuates in the investor's own reference currency because the exchange rate changes. What matters for the actual currency risk is not the currency in which a fund or ETF is quoted or administered, but the currencies in which the underlying assets are valued and the reference currency in which the investor measures performance.

A simple example can illustrate this without using numbers. If a significant part of a portfolio is invested in assets valued in USD, the value of these positions for EUR investors already changes when the USD/EUR exchange rate moves, even if the assets remain unchanged in their local currency.

In practice, two effects overlap. First, the performance of the assets themselves, such as price movements in equities or bonds. Second, the conversion into the investor currency, which can amplify or dampen the outcome depending on the exchange rate move.

A common misconception is that the trading currency in the custody account is identical to the actual currency risk. Even if an ETF is traded in EUR, the underlying currency exposure may still lie predominantly outside the euro area if the holdings are valued in other currencies.

In practical terms, currency risk can only be assessed properly if two levels are considered separately: The investor's reference currency and the currencies of the assets in the portfolio. The base currency of the fund may be helpful for reporting purposes, but it is generally not decisive for the economic effect of currency risk. Anyone who fails to make this distinction can easily confuse a reporting or settlement currency with the actual risk driver.

What Is the Difference Between a Hedged Share Class and Active FX Management?

Currency hedging in funds and ETFs is usually implemented via specific share classes. Such a hedged share class aims to neutralise currency effects against a target currency as far as possible. This is generally done באמצעות standardised foreign exchange forwards or comparable instruments.

The key point is this: A hedged share class is mechanical in its intention. It is not designed to be "right" on currencies, but to keep exchange rate-related fluctuations as small as possible. Currency hedging is therefore an instrument of risk management, not a tool for return enhancement.

Active FX management is something different. FX stands for foreign exchange, in other words the currency market. In active FX management, the portfolio manager deliberately decides which currency risks should be retained, reduced or added. This can be part of an overall strategy, for example to manage portfolio risk or to act on views regarding currency valuations.

The difference is also visible in terms of transparency. In a currency-hedged share class, the hedging logic is typically defined in advance and intended to be implemented consistently over time. In active FX management, currency weights may vary depending on market views, which changes the sources of return more materially.

In practice, there are also different technical variants of share class hedging. Some approaches aim to hedge the share class value into a target currency, while others attempt to neutralise the actual foreign currency exposure of the portfolio against the target currency. Both variants can make sense, but they do not necessarily lead to identical results.

A typical misconception is that "hedged" automatically means currency effects are fully eliminated. In reality, there is almost always a small residual element, for example due to market movements between hedge adjustments, inflows and outflows, or changes in the portfolio exposure.

What Costs Does Currency Hedging Involve, and Why Does the Interest Rate Differential Play the Key Role?

Many investors first look for the cost of currency hedging in the ongoing management fee. That often falls short. In most cases, the dominant cost component does not arise from an additional fund fee, but from the structure of the forward markets.

In a hedging process, the foreign currency is typically exchanged into the target currency via forward contracts. The forward rate is not simply the current spot rate plus a small surcharge. Above all, it reflects short-term interest rate levels in the two currency areas. This interest rate differential is the core of what appears in the result as the ongoing carry of the hedge.

That means: Anyone hedging a currency with a higher short-term interest rate into a currency with a lower short-term interest rate will, in many constellations, bear a structural burden. Conversely, in certain interest rate environments, hedging may also be beneficial. Neither is a promise. Both are a mechanical effect of the interest rate differential, and this effect changes with the interest rate environment.

Alongside this interest rate effect, there are implementation costs. These include spreads on foreign exchange forwards, roll costs when the hedge is renewed regularly, and operational effects, for example the time lag between valuation and adjustment of the hedge position. These elements are real, but compared with the interest rate differential they are often not the main driver.

In ETFs, hedging is often visible through the deviation from the unhedged index variant. Investors then see a difference between the two variants and quickly classify it as an additional fee. In reality, it often mainly reflects the interest rate differential effect and the implementation mechanics.

A widespread misconception is that currency hedging is some kind of free add-on. It can reduce exchange rate fluctuations, but it systematically changes the outcome profile through the interest rate differential effect and through the hedging mechanics.

Which Regulatory Requirements Apply to Currency-Hedged Share Classes under UCITS?

UCITS is the European regulatory framework for many retail funds and ETFs. Its objective is to create a uniform framework for investor protection, risk limitation and transparency, including rules governing the use of derivatives.

As a general rule, share classes of a sub-fund are based on one common portfolio. Differences between share classes must not lead to a situation in which the investment objective and the key risks of the sub-fund effectively diverge. In this context, share class-level currency hedging is one of the few permissible forms of a derivatives overlay structure, because it relates to the currency layer and not to an independent investment strategy.

In practice, the hedge ratio of currency-hedged share classes is typically managed within a tight range. A common range is one in which underhedging should not fall below 95% and overhedging should not exceed 105%, measured against the portion of the share class value to be hedged. This reduces the risk that a hedge unintentionally turns into a speculative position.

Counterparty risk also matters. If the hedge is implemented through over-the-counter derivatives with a counterparty, UCITS rules limit the permissible risk exposure to that counterparty. In many cases, the upper limit is ten percent of fund assets if the counterparty is a credit institution, and five percent in other cases. These limits are intended to prevent a single default from dominating the fund structure.

In addition, rules on overall risk measurement for derivatives apply. Many UCITS funds use an approach that measures derivatives exposure as global exposure and limits it to 100% of net asset value. Alternatively, risk measurement may be based on value at risk, where a limit of 20% of net asset value plays a central role in the case of absolute VaR. For investors, the method itself is less important than the fact that derivatives use and hedging must be embedded in a formal risk controlling framework.

A typical misconception is that share class hedging is a freely designed extra. In reality, under the UCITS framework it is subject to clear requirements, must be described in advance and is monitored through defined risk limits.

For Whom Does Currency Hedging Make Sense in Funds and ETFs, and When Does It Not?

Whether currency hedging makes sense depends less on a general "pro or contra" view and more on the role that currencies are intended to play in the overall portfolio. Currency hedging reduces exchange rate fluctuations, but it also causes systematic costs and should therefore be used depending on the investor's risk profile, investment horizon and the strategic role of currencies in the portfolio.

Hedging can make sense when the objective is strongly focused on stability in the investor's own spending currency. This applies, for example, when a portfolio is structured to meet foreseeable payment obligations and currency fluctuations could undermine that objective. The shorter the horizon, the less time there is to sit through exchange rate moves, and the more important result stabilisation becomes.

The type of investment also matters. In bond exposures, the currency component can be large relative to the expected fluctuation of the interest rate component. In that case, currency hedging can help ensure that the risk/return profile is driven more by interest rate and credit factors and less by currency swings.

A blanket hedge is less obvious in long-term, globally diversified portfolios if currency fluctuations are accepted as part of diversification. Currencies can stabilise or destabilise the portfolio at times without automatically leading to a clear rule for action. Anyone investing for the long term and able to tolerate fluctuations may also consciously maintain open currency exposure if it fits the portfolio alignment.

The cost aspect remains central. If the interest rate differential between the target currency and the foreign currency is unfavourable, hedging can represent a noticeable structural burden over longer periods. The question is then not only whether fluctuations are reduced, but whether that reduction is proportionate to the ongoing effects of the hedge.

In practice, a sober assessment helps, and it can be made without forecasts. Which currency is the reference for spending and obligations? How high is the tolerance for interim fluctuations? And should currency be consciously borne as an independent risk factor, or kept as neutral as possible? Anyone who does not answer these questions often makes an implicit decision and later wonders about sources of return that were never intended.

A widespread misconception is that there is one "right" standard solution, for example always hedging or never hedging. In reality, currency hedging is an instrument of portfolio management whose benefit depends on which risk is to be reduced in the portfolio and what structural price one is willing to accept for it.

Conclusion: Use Currency Hedging Selectively as a Risk Instrument

Currency hedging in funds and ETFs makes sense when exchange rate fluctuations materially impair the desired risk profile and the degree of planning certainty in the investor's own reference currency. It can help concentrate the sources of return more strongly on the actual investment idea, for example on interest rates, credit spreads or corporate development rather than on currency moves.

At the same time, currency hedging is not a source of return per se. It changes the outcome profile through the interest rate differential effect and through implementation mechanics, and can therefore create systematic burdens that may vary significantly depending on the interest rate environment.

All in all, currency hedging makes sense when it is embedded in a clear portfolio alignment: Appropriate to the investment horizon, the risk profile and the question of whether currency should play a strategic role in the portfolio or be deliberately neutralised.