Hedging is one of the best ways for an investor to protect their portfolio from currency risk, which is the risk of an investment losing value due to fluctuations in the foreign exchange market. This is especially the case today, when the U.S. dollar has risen significantly against international currencies. The strengthening U.S. dollar has had a pronounced negative impact on investing in other parts of the world outside of the United States.

In response, many investors have hedged their portfolios against currency risk, and exchange-traded funds, or ETFs, do the same. This article will discuss why currency hedging matters, and highlight a few currency-hedged ETFs from which investors can choose.

Fluctuating exchange rates can have a dramatic impact on an international investment, even if the underlying investment itself performs well. For example, if an international investment returns 5% in a given period, but the U.S. dollar strengthens 6% against that investment’s local currency, then the investment will actually lose 1% of its value.

This is why many ETF issuers have created currency-hedged ETFs. These currency-hedged ETFs often use derivatives to protect investors against currency risk. To mitigate currency risk, currency-hedged funds hold their unhedged counterpart plus currency forwards.

Let’s take a look at some of currency-hedged ETFs based on broad geographic markets. For investors interested in investing in the eurozone, WisdomTree offers the WisdomTree Europe Hedged Equity Fund (HEDJ A-), which has returned 12.34% year-to-date. This ETF is similar to the iShares MSCI Eurozone ETF (EZU A-) but also employs derivatives to hedge against currency risk. The HEDJ fund has outperformed the EZU fund by more than 11 percentage points year-to-date. This demonstrates the positive effect that currency hedging can produce for investors when the U.S. dollar strengthens.

This disparity is equally strong when it comes to the emerging markets, which can exhibit even greater levels of currency risk than developed nations. For example, the Vanguard Emerging Markets ETF (VWO A) has declined 9.09% year-to-date. A currency-hedged alternative with similar holdings is the iShares Currency Hedged MSCI Emerging Markets ETF (HEEM). This ETF is down a more modest 4.37% year-to-date. Once again, currency hedging has produced about five percentage points of outperformance.

Another key aspect of currency-hedged ETFs is that their expense ratios are fairly low. Both the HEDJ and HEEM exchange-traded funds carry expense ratios of 0.58% and 0.68% per year, respectively.

Currency hedging is a very important topic right now as investors can suffer poor returns due to currency risk. When investing in international markets through ETFs, currency-hedged variations allow investors to protect their portfolios from that risk. The HEDJ and HEEM ETFs are two examples of currency-hedged ETFs that may outperform their non-hedged counterparts if the U.S. dollar continues to strengthen in the months ahead.

For more currency-hedged ETFs, please have a look at our list here.

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