An investor buying a global equity fund makes one decision and acquires two exposures. The first is to the companies in the fund. The second is to every currency those companies report in.
The second exposure is rarely deliberate. It arrives as a by-product of the first, it is not mentioned in most fund marketing, and it can account for a meaningful share of what the holding actually does from year to year.
For anyone holding international equities from outside the United States, or holding non-domestic assets from anywhere, this is the largest position most people have never examined.
Why This Concerns Investors Who Don’t Trade Currencies
Most material answering what is forex trading addresses active currency positions: pairs, leverage, short-term direction.
The passive version affects far more people. A euro-based investor holding a global equity fund is long a basket of foreign currencies against the euro, in proportion to where the underlying companies report. That position exists whether or not anyone thinks about it.
The components worth separating:
- The equity return, in the local currency of each holding
- The currency return, from moves between those currencies and the investor’s own
- The interaction, since the two are not independent and their correlation shifts
- The hedging decision, which most funds have made already on the investor’s behalf
The fourth point is the one people miss. Choosing a hedged or unhedged share class is a currency decision, and it is often made by default.
How Much of the Risk Is Currency
The size of the contribution has been measured, and it is larger than most investors would guess.
Analysis by the International Monetary Fund found that exchange rate volatility contributes between 16 and 40 percent to the volatility of investing in foreign stock markets, while for bond portfolios exchange rate risk dominates overall volatility, contributing up to 95 percent of total unhedged return volatility.
Why Bonds Differ So Sharply
The contrast explains a common practice. Bond returns are relatively stable in local currency terms, so currency moves swamp them. Equity returns are volatile enough that currency is a contributor rather than the dominant factor.
That is why institutional practice tends to hedge foreign bond exposure as a matter of course while treating equity hedging as a genuine decision. The same logic applies at any scale.
What Hedging Does to Volatility
The evidence on whether hedging reduces equity portfolio risk is consistent, though the effect is smaller than the headline contribution figure suggests.
Research covering weekly data from 1981 to 2017 across the G-10 currencies found that the benchmark unhedged portfolio produced an average volatility of 16.5% while the fully hedged portfolio produced 14.9%, with volatility falling for nine out of ten foreign currencies.
An average reduction of roughly a tenth is real and modest. It is not the elimination of a third of portfolio risk, because currency and equity returns are correlated in ways that partially offset.
Why Hedging Isn’t Free
The costs are real and worth knowing before treating hedged share classes as the obvious default:
- Interest rate differentials determine the carry cost or benefit of the hedge, which varies by currency pair and over time
- Transaction costs apply as hedges are rolled forward
- Higher fund expenses typically attach to hedged share classes
- Cash flow requirements, since hedges settle and can require funding at inconvenient moments
- Basis risk, because the hedge covers the fund’s stated currency exposure rather than the underlying economic exposure of the companies
The last one is subtle and material. A company listed in one currency may earn most of its revenue in another, so hedging the listing currency does not hedge the economic exposure.
What to Decide
- Check what you currently hold, since most funds specify hedged or unhedged clearly
- Separate bonds from equities, given the very different contribution figures
- Consider the horizon, as currency effects have historically been more mean-reverting over long periods than over short ones
- Price the hedge, comparing expense ratios between share classes
- Decide once and document it, rather than switching after a period of adverse currency moves
The Horizon Question
The strongest argument against hedging equity exposure is time. Currency moves have historically shown more mean reversion over long horizons than equity or bond returns do, which means the contribution to volatility shrinks as the holding period lengthens.
The strongest argument for it is that most people do not hold for as long as they intend, and the intervening volatility is what determines whether they hold at all.
Neither argument settles it universally. What settles it individually is the horizon, the currency mix and whether the investor would rather take a currency position deliberately or by default. Most take it by default, which is the only outcome the evidence clearly argues against.
