Two funds hold the same foreign companies. One finishes the year up 9 percent, the other up 2. Neither one picked different stocks. The gap is currency, and whether the fund did anything about it. International exposure gets described as one category, but hedging is a variable inside it, and it changes what you own.
The Two Returns Hiding in One Fund
Every international fund pays you two returns at once, whether you asked for them or not. The first is what the shares did in their own currency. The second is what that currency did against the dollar.
Use illustrative numbers. You hold a fund of European stocks. Over a year those shares gain 10 percent measured in euros, and over the same year the euro falls 6 percent against the dollar. Your dollar return is not 4 percent. The two effects multiply, so 1.10 times 0.94 gives 1.034, a gain of about 3.4 percent. Reverse the currency move and the arithmetic becomes 1.10 times 1.06, or 16.6 percent, from identical stocks.
The site's currency exchange article makes the basic point that a gain abroad can vanish on the way home. A hedged fund is an attempt to keep the first number and delete the second.
What the Fund Sells Forward
A hedge is a promise to swap currency later at a price agreed now. The fund sells the foreign currency forward, meaning it agrees today to hand over euros on a future date and receive dollars at a fixed rate. The futures article covers the standardized, exchange-traded cousin of this. Currency forwards are the private bank-to-bank version, written for whatever amount and date the fund needs.
Nothing is paid up front. A forward is not an option and carries no premium. If the euro falls, the fund loses on its European shares once they are translated into dollars, and gains about the same on the forward, because it locked in the older rate. If the euro rises, the two swap places. The fund surrenders the gain to be rid of the loss.
You are not buying protection against a bad currency move. You are trading away both directions.
Why the Hedge Resets Instead of Holding
The hedge cannot be set once and left, because the thing it covers keeps changing size.
Most hedged index funds run on a monthly cycle. Near the end of each month the index sells one-month forward contracts, sized against the value of the foreign holdings at that moment. Those amounts stay fixed for the whole month. When the contracts expire they are replaced with new ones, which is called rolling.
Say European stocks rise 5 percent mid-month. The fund's euro exposure has grown, but the forwards were sized for the smaller old amount, so that extra slice is unhedged until the next reset. If stocks fall instead, the fund is over-hedged, having sold more euros forward than it now holds. A fund described as 100 percent hedged is exactly that on reset day and approximately that the rest of the time.
Some indexes reset daily rather than monthly, which shrinks the drift and raises the trading. Neither version is perfect.
The Cost Is an Interest Rate Gap, Not a Fee
The forward rate a fund locks in is not today's exchange rate. It is today's rate adjusted by the difference between short-term interest rates in the two countries.
That relationship is called covered interest rate parity, and it holds because breaking it would create free money. If you could convert dollars to euros, earn a higher European rate, and lock in the conversion back at today's rate, you would have built a risk-free profit out of nothing. Traders close that gap, and what moves is the forward price, until the round trip pays exactly what a plain dollar deposit pays.
So hedging has a price, and it is never quoted as a fee. It sits inside the exchange rate written into the contract, and it moves whenever central banks move rates.
Which Direction the Gap Runs
Take illustrative rates: 4 percent short-term in the United States, 1 percent in the foreign country. The three-point gap favors the dollar investor. Selling that currency forward locks in a price above today's spot rate, so the hedge adds roughly 3 percent a year on top of whatever the shares do. Desks call this positive carry.
Now flip the rates. If the foreign short rate is 4 percent and the US rate is 1, the forward price sits below spot, and the identical hedge costs about 3 percent a year.
The result runs against what the phrase "cost of hedging" suggests. For a dollar investor, hedging a currency from a low-rate country tends to pay you, and hedging one from a high-rate country tends to charge you. High short-term rates usually go with high inflation, which is one reason hedged emerging-market funds are uncommon.
None of that appears in the expense ratio. A hedged fund normally charges a little more than its unhedged twin to cover the trading, but the carry itself is buried in the performance figures.
Why the Volatility Case Is Stronger for Bonds
The usual argument for hedging is smoother returns, and it is much stronger for bonds than for stocks. The reason is arithmetic.
A major currency moving close to 10 percent against the dollar over a year is ordinary, not a crisis event. Set that beside what each asset class delivers on its own. A broad investment-grade bond fund produces low single-digit returns and moves in a narrow band, so a 10 percent currency swing dropped on top does not add to the risk, it takes over. The bond fund stops behaving like a bond fund and starts behaving like a currency bet with coupons attached.
Run the same test on stocks. International equities routinely move 15 or 20 percent in a year by themselves. The same currency swing is a real addition, but it is not the main event, so the case for paying to remove it is weaker.
That asymmetry is why several large fund families hedge their international bond funds by default and leave their international stock funds unhedged.
The Natural Hedge That Cuts Against Hedging Stocks
There is a second complication on the stock side. In some countries share prices move against the home currency.
Picture a Japanese carmaker that sells most of its output abroad. When the yen weakens, the dollars and euros it earns convert into more yen, reported profits rise, and the share price often rises with them. For an American holding an unhedged fund, two things happen together: a currency loss and a local share-price gain. They partly cancel each other. That partial cancellation already sits inside the unhedged fund, with nothing bought and nothing rolled.
Hedge the currency and you remove one leg while keeping the other. That works in your favor when the yen falls and against you when the yen rises and exporters get squeezed. A hedge is not simply subtracting noise from a return. It changes which risks you carry, and in an export-heavy market it can leave a portfolio more volatile rather than less. Research on the best hedge amount keeps landing on different answers for different countries.
The effect is strong in export-driven markets and weak in markets dominated by domestic banks, utilities and retailers.
Reading the Documents to See Which One You Own
Four places tell you, in rising order of effort.
The fund name is the first. Hedged versions usually announce it, with "currency hedged" or "hedged to USD" in the title. Many families run a hedged and an unhedged version whose names differ by one word.
The index name is better. A fund's prospectus summary states which index it tracks under principal investment strategies, and a hedged index almost always carries "hedged" in its own name, often with a percentage attached.
The holdings settle it. Any fund that hedges holds open forward foreign currency contracts, and those appear as line items in the schedule of investments in the annual and semi-annual reports, showing the currency, the notional amount and the settlement date. No forwards, no hedge.
The risk section confirms the intent. A hedged fund carries a currency hedging or derivatives risk disclosure warning that the hedge may not work as expected. An unhedged fund often says plainly that it does not hedge.
One more check is worth the minute. Some funds hedge only part of the exposure, or vary the amount by rule rather than holding it at 100 percent. The strategy section says so, and the word "hedged" in a name does not tell you how much.
