The impact of currency movements on ETF returns

Currency movements can significantly impact the returns of foreign-denominated investments. A shift in the value of a foreign currency relative to the AUD can either amplify or reduce your overall return.

In this post, we explore how currency fluctuations affect investment outcomes. We’ll also look at how currency-hedged ETFs can help manage this risk and provide more consistent returns.

Why exchange rates constantly shift

Before diving into the numbers, it’s important to understand why currency rates move, the unique advantage held by the US Dollar (USD), and where the AUD typically trades. These factors can help establish some guidelines when considering whether to hedge your investments.

Currency values fluctuate daily due to a complex mix of factors, including interest rates, inflation, economic growth, capital flows, and geopolitical tensions.

The USD enjoys a significant advantage as the world’s primary reserve currency. It serves as a global safe haven, supported by the strength of the US economy and its dominance in international trade which often keeps the USD stronger than other currencies.

While these factors are important to understand for investors with international exposure, predicting future movements of the AUD and USD remains difficult. Since the AUD was floated by the Hawke Labor Government in 1983¹, it has averaged at around 0.7517 AUD/USD².

This “mean reversion” point is key for economists, traders, and investors. When the AUD deviates from its average—whether it reached parity in the 2010s or dropped to nearly 50 cents in 2001—it tends to gravitate back toward this historical point over time.

The effect of currency movements on international ETF returns

The total return of a foreign investment depends primarily on two things: the performance of the investment itself and how the currency exchange rate changes. Both the investment return and the currency movements work together to determine your final return.

Here’s a simplified formula to help you calculate it:

Total return = Local return of underlying security + Return of underlying currency vs AUD

Let’s look at an example where an international ETF steadily rises by 10% over the course of a year, and see how three different currency scenarios play out:

Source: Betashares. For illustrative purposes only.

• USD appreciates 20%: When the USD strengthens against the AUD, the total return jumps to 32%, thanks to the combined gains from the ETF and the stronger USD.
• No currency movement: If there’s no change in currency, your return remains at 10%, based solely on the investment performance of the ETF.
• AUD appreciates 20%: If the AUD strengthens by 20%, your total return drops to -8%, as the rise in the AUD would offset gains from the ETF.

In essence, if the underlying value of an ETF increases by 10% while the AUD falls by 20%, this could be the best-case scenario for achieving strong returns. Here’s why:

1. The value of the underlying security has increased.
2. The value of the foreign currency has risen relative to the AUD.

As a result, a USD investment is worth significantly more when converted back into AUD.

Case study: Nasdaq Future Global Sustainability Leaders Index

Let’s now take a look at a practical example of movements in one of the most popular index exposures we offer, Nasdaq Future Global Sustainability Leaders Index, which can be accessed via:

• ETHI Global Sustainability Leaders ETF (ASX: ETHI), and
• HETH Global Sustainability Leaders ETF – Currency Hedged (ASX: HETH).

The chart below illustrates the performance of both the hedged and unhedged versions of the index since May 2011, highlighting the impact of the steady decline of the AUD/USD on returns.

Source: Betashares; time period from May 3, 2011, to September 18, 2024. This chart measures the performance of the index and assumes dividends are reinvested; actual underlying ETF performance may vary due to fees. Past performance is not indicative of future returns. You cannot invest directly into an index.

Since reaching parity in the early 2010s (as shown on the right axis of the chart), the AUD has steadily declined to below 70 cents. This decline can be attributed to factors such as falling commodity prices, decreasing interest rates, and the global appeal of US markets due to their relative outperformance, partly driven by technology and other growth stocks.

As the AUD weakened, Australian investors in USD assets reaped significant benefits. The declining exchange rate meant that their USD-denominated investments gained value when converted back into Australian dollars, and this advantage is reflected in index returns, as shown below.

Source: Betashares; time period from May 3, 2011, to September 18, 2024. This table measures the performance of the index and assumes dividends are reinvested; actual underlying ETF performance may vary due to fees. Past performance is not indicative of future returns.

To hedge or not to hedge

The data in this case study clearly indicates that being unhedged benefited investors. However, does this mean you should exclusively choose unhedged ETFs?

Not necessarily. Take a look at the chart below. You can see a completely different story for the AUD/USD in the 2010s versus the 2000s.

Source: Betashares, OFX, Google Finance (as at 20 September, 2024). Past performance is not indicative of future results.

• The 2010s were advantageous for Australian investors in USD assets on an unhedged basis, as the AUD returned to its long-term average after reaching parity following the recovery of the US economy from the global financial crisis.
• In contrast, the 2000s were not favourable for unhedged investors, as the AUD/USD more than doubled over the decade. This surge was driven by significant capital inflows into Australia due to the commodity boom, rising interest rates, and China’s growth, making hedged investments a better option during this period.

Based on these observations, investors should consider several factors when deciding whether to invest in an asset class or market on a hedged or unhedged basis:

• Currency outlook: If you anticipate a weakening AUD, unhedged investments might offer higher returns. However, if you expect the AUD to strengthen, hedged options can help protect against losses. Assessing whether the AUD and the foreign currency is at an “extreme point” in the cycle can also be a useful factor.
• Time horizon: Longer-term investors may prefer unhedged investments to ride out currency fluctuations. On the other hand, short-term investors might favour hedged options to mitigate immediate risks.
• Cost of hedging: Hedged investments typically come with higher fees due to the added service of managing currency risk. It’s important to weigh the cost against the potential benefit of hedging.

These are general guidelines, not specific recommendations. While the chart above suggests that the AUD/USD often reverts to a more balanced level, this process can be gradual and is not guaranteed.

Investors may also consider a balanced approach by allocating part of their portfolio to both hedged and unhedged investments, creating a “50/50” exposure.

Ultimately, the decision to hedge should align with your risk tolerance and investment horizon, but it should always remain secondary to the quality of the underlying investment.

3 hedged ETFs to consider

With that in mind, what tools can investors use to gain exposure to foreign markets on a hedged basis, and how do the costs compare to unhedged ETFs? Let’s explore three options below.

1. HGBL Global Shares Currency Hedged ETF

Exposure: HGBL provides instant exposure to an index comprising approximately 1,500 companies from more than 20 developed market countries, making the fund a compelling candidate for a core portfolio allocation to global equities. Some of its top holdings include Apple, Berkshire Hathaway and Costco.

2. HETH Global Sustainability Leaders ETF – Currency Hedged

Exposure: Provides a portfolio of large, sustainable, ethical companies from a range of global markets including the US, Japan and Europe. Some of its top holdings include Toyota, ASML and Novo Nordisk.

3. HNDQ Nasdaq 100 Currency Hedged ETF

Exposure: HNDQ offers hedged exposure to high growth potential sectors under-represented in the Australian sharemarket including technology, healthcare, and consumer discretionary. Some of the fund’s top holdings are Amazon, Meta and NVIDIA.

References

1. National Museum of Australia
2. OFX – Performance calculated annually from 1990 to 2024