Currency Hedging: Hedged vs Unhedged ETFs and How to Analyze Them

DISCLAIMER

The analyses and opinions presented here are purely for information. They do not constitute investment recommendations. Before adopting any strategy it is essential to consult a financial adviser.

Introduction and Objectives

Investing in international markets allows diversifying the portfolio, but exposes the investor to exchange rate risk. For example, a European investor who purchases an ETF on the S&P 500 index quoted in dollars will get a return that depends both on the index’s performance and on the euro/dollar exchange rate. As Vanguard points out, even if a US equity index rises by 10%, the return in pounds (or euros) can be different because the amount to be converted at redemption is influenced by the exchange rate. To manage this variable, there are “hedged” ETFs (with currency hedging) that try to neutralize the effects of currency movements. “Unhedged” ETFs, on the other hand, leave the currency exposure open.

The aim of this article is to explain how currency hedging works, what are the advantages and disadvantages of hedged ETFs compared with unhedged ones, and to illustrate, through an updated analysis in Python (available on Google Colab), the differences in returns between the two types in recent years. We will do this while maintaining an informative but rigorous tone, with references to institutional studies and showing a graphic example.

Video deep-dive: A video has been published that explains the concept practically. You can watch it here: https://www.youtube.com/watch?v=x3S1ZbtwnNk.

Why Do Exchange Rates Move?

Exchange rate fluctuations depend on numerous macroeconomic factors: interest rate differentials, inflation, political stability, economic performance and global shocks. In general, a currency tends to appreciate if the country offers higher interest rates or greater expected growth, because investors move capital there seeking higher returns; it depreciates, instead, if the economy slows or inflation is higher. These oscillations do not necessarily cancel out over the long term: periods of persistent strength or weakness can last many years, making it difficult to predict the endpoint.

What is a Hedged ETF and Why Use It

A hedged ETF and the unhedged version invest in the same basket of securities; the difference is that the hedged ETF uses forward contracts (or other currency derivatives) to lock in the future exchange rate and neutralize the effect of fluctuations. This allows the investor to replicate the performance “in local currency” of the index, without the return depending on the strengthening or weakening of the foreign currency. However, hedging also removes the possibility of benefitting from favorable currency movements.

Vanguard explains that it offers currency-hedged share classes mainly for bond funds, since bonds serve to reduce portfolio volatility and currency risk can negate that benefit. On the other hand, the company does not offer hedged share classes for equity funds intended for UK retail investors, because equities are already riskier and the currency’s contribution can be neutral in the long term. Morningstar notes that currency hedging reduces volatility, but over the long term the effect on total return is moderate: from January 2001 to September 2022 the MSCI ACWI ex USA hedged index slightly outperformed (23,968 USD vs. 21,936 USD on 10,000 USD invested) the unhedged index, and only from June 2022 onwards. Moreover, hedged ETFs have higher costs (0.30–0.40% vs <0.10% for unhedged), can generate capital gain distributions due to the monthly rollover of forward contracts and do not completely eliminate currency risk.

Pros and Cons Summarized

• Exchange risk: reduced thanks to forward contracts (hedged) vs full currency exposure (unhedged), with the possibility of additional gain or loss.
• Volatility: lower in hedged ETFs (they do not suffer currency volatility) vs higher in unhedged, especially in periods of strong currency variation.
• Costs: hedged ETFs have higher fees and hedging costs vs generally lower costs in unhedged.
• Long-term return: on average similar, with differences related to interest rate differentials and costs (hedged sometimes slightly lower or higher depending on periods).
• Typical use: hedged more common on bond funds and for those who want to reduce total risk; unhedged typical on equities for investors willing to accept currency swings.

Quantitative Analysis Methodology (Python Code)

To empirically assess the impact of currency hedging, a Python notebook (available on GitHub) was created that downloads historical prices for some ETF pairs and the EUR/USD exchange rate via the yfinance library. The analysis considers three cases:

• European S&P 500 – unhedged version (IUSA.AS) and hedged (IUSE.AS).
• MSCI World – unhedged version (IWDA.AS) and hedged (IWDE.AS).
• US Treasury 20+ Years – ETF of long-duration bonds unhedged vs the hedged version (DTLE.L).

The code:

• Downloads adjusted close prices for the ETFs from 2019 to today (updated end of August 2025).
• Calculates a third reference series (“Perfect Hedge”) by multiplying the price of the unhedged ETF by the EUR/USD rate, simulating a theoretical hedge without costs.
• Calculates cumulative returns and compares them.

The notebook produces comparative charts and calculates the annualized spread between the real hedged ETF and the perfectly hedged ETF, highlighting the inefficiency of the real hedge (hedging costs, interest rate differences). The results we report below come from the notebook update in September 2025.

Results: Hedged vs Unhedged in Recent Years

S&P 500 ETF

For the S&P 500 index the hedged version offered an even more obvious advantage. Between October 2022 and September 2025 the hedged ETF IUSE.AS went from 1 to about 1.67, versus about 1.46 for the unhedged version IUSA.AS; the perfect hedge would have reached about 1.75. This differential (about 20% in favor of the hedged) is due to the strong depreciation of the dollar versus the euro since Q4 2022: the European investor who hedged the currency avoided the loss tied to the dollar drop. In previous years, when the dollar was strengthening, unhedged ETFs often outperformed; the recent reversal underscores how hedging convenience depends on currency dynamics and should be evaluated case by case.

MSCI World ETF

The updated analysis from October 5, 2022 to September 8, 2025 shows that the hedged version IWDE.AS outperformed the unhedged version IWDA.AS. If an initial investment of 1 is normalized to October 5, 2022, at the end of the period the hedged ETF would be around 1.62, while the unhedged version would be around 1.49; the perfect hedge (IWDA.PerfectHedged) would reach about 1.78. The performance difference between hedged and unhedged (≈ 13%) reflects the euro’s strengthening versus the dollar in the period; however, the currency hedge does not fully replicate the ideal hedge, because it incorporates hedging costs and does not cover 100% of the quota denominated in currencies other than the dollar.

US Treasury 20+ Years Bond ETF

On the bond front, the hedged ETF on long-duration US Treasuries recorded an average gap of about 1.6% per year relative to the perfect hedge. During the euro appreciation phase (end of 2022) the hedged advantage was temporary, but over longer horizons the unhedged ETF tends to catch up and surpass the hedged counterpart, also thanks to reinvested coupons and the interest rate differential.

The following image shows how the cumulative returns of the three series (unhedged, hedged and “perfect hedge”) progressively diverge over time.

Predicting the Exchange Rate: Prophet Experiment

To assess whether hedging is convenient in coming years, the notebook uses the Prophet library to forecast EUR/USD. Trained on historical data, the model predicts a downward trend in the exchange rate, with a confidence interval (80%) between 1.00 and 1.15 in the next year. The mean absolute error of 6% and the standard deviation of the error of 8 cents indicate considerable uncertainty. Assuming an exchange rate at 1.15, the investor choosing the hedged ETF would obtain a potential advantage of only 2–3 percentage points over the unhedged version; if instead the euro does not strengthen, hedging would entail an unnecessary cost. The prediction therefore provides no certainties, but suggests that currency swings can turn out to be either an ally or a foe.

Potential and Limits of the Python Model

The presented analysis is completely reproducible: the notebook uses only open-source libraries (yfinance for downloading data, pandas and numpy for calculations, matplotlib for charts). It is possible to modify the observation period, change the ETFs analyzed or include further indices (e.g. emerging markets) to explore other currency exposures. The method of calculating the “perfect hedge” by multiplying the price of the ETF by the exchange rate can be applied to any instrument, provided data are available.

Compared with available market analyses (often based on long-term averages or synthetic indices), this approach allows assessing precisely the effect of currency on specific ETFs, highlighting the real costs of hedging and the trend of the differential across different periods. It is not a complex machine learning algorithm: there is no predictive model of allocations, but a simple statistical calculation. Nevertheless, it is an example of how an investor can use quantitative tools to make more informed decisions.

Comparison with Other Methodologies

There are more sophisticated algorithms (for example neural networks or LSTM models) that try to predict exchange rate movements or to optimize a portfolio considering multiple variables simultaneously. These models can capture non-linear patterns and complex interactions, but they have two limitations: they require large amounts of historical data and their forecasts can easily be invalidated by unforeseen economic shocks. In this context, the simplicity of the model used (perfect hedge and direct comparison) can be an advantage: it is transparent, easily verifiable and does not hide implicit assumptions. As Morningstar points out, the effect of hedging oscillates in cycles and over the long term the performance difference narrows, while costs and taxes can erode benefits. Therefore, a sophisticated approach might add marginal benefits relative to a simple periodic assessment.

Final Considerations

• Currency hedging reduces volatility: those who do not want to see their investments influenced by currency movements can opt for hedged ETFs. This can be particularly useful in the short term or for bond investments.
• In the long term, extra return is limited: historical data and quantitative analyses show that hedged and unhedged tend to have comparable returns; hedged often is slightly disadvantaged due to costs. The potential advantage depends also on interest rate differentials.
• Costs matter: hedged ETFs have higher fees, potential capital gain distributions and transaction costs related to rolling forward. Over time, these items can erode returns.
• The choice depends on expectations and horizon: if a strong appreciation of your currency is expected in the short term, hedging can offer protection; if instead it is believed that the foreign currency will remain stable or weaken, leaving the currency exposure can increase returns.
• Currency diversification: another way to manage currency risk is to invest in ETFs denominated in multiple currencies or in different currencies (e.g. dollar, yen, Swiss franc), creating a multicurrency portfolio. This topic will be explored in future articles.

Ultimately, the decision to choose a hedged or unhedged ETF should be based on your risk profile, beliefs about exchange rate direction and time horizon. However, hedging should not be ruled out due to higher costs alone, as multiple factors need consideration. The quantitative tools presented make it possible to concretely evaluate the effects of hedging, but they do not replace professional judgment. For this reason it is advisable to consult an expert before implementing any strategy. For further explanation please watch the deep-dive video on the YouTube channel.

Useful Resources and Code

• Colab Notebook (updated): HedgedvsUnhedged.ipynb
• Deep dive video: https://www.youtube.com/watch?v=x3S1ZbtwnNk
• Morningstar analysis on the effectiveness of currency-hedged ETFs.
• Vanguard insight on hedged share classes and the advantages/limitations of hedging.
• Harvest ETF article on the characteristics of currency-hedged ETFs.