When investing in international ETFs, Australian investors face a choice: hold an unhedged ETF (exposed to AUD/foreign currency fluctuations) or a hedged ETF (where currency risk is neutralised using derivatives). This article explains the difference, when each approach may be appropriate, and the ongoing cost of hedging.
What Does “Unhedged” Mean?
An unhedged international ETF — like VGS — holds shares in foreign companies priced in foreign currencies (USD, EUR, JPY, etc.). When you buy VGS, your investment is effectively in US dollars, euros, and other currencies.
Effect on your returns:
- If the Australian dollar (AUD) weakens against the USD, your VGS units become worth more in AUD — a currency gain
- If the AUD strengthens against the USD, your VGS units become worth less in AUD — a currency loss
- These currency movements are separate from and on top of the share market movement
Example:
- VGS underlying index: flat (0% return)
- AUD/USD: falls 10% (AUD weakens)
- Your AUD return from VGS: approximately +10% (currency gain)
What Does “Hedged” Mean?
A hedged international ETF — like VGAD — uses currency forward contracts to lock in a fixed exchange rate for its foreign currency exposure. The effect is that currency fluctuations are largely eliminated — what you receive is close to the underlying share market return in local currency, converted at today’s exchange rate.
Effect on your returns:
- Foreign share market rises 10%: your hedged ETF returns approximately +10% (minus hedging cost)
- AUD rises 15%: your hedged ETF is largely unaffected by this
- AUD falls 15%: your hedged ETF is largely unaffected by this
The Cost of Hedging
Currency hedging is not free. The hedging cost is built into the MER or reflected in the fund’s tracking difference:
- VGS (unhedged): MER 0.18%
- VGAD (hedged): MER 0.21%
The additional 0.03% MER is part of the hedging cost. But the total cost of hedging also depends on interest rate differentials between Australia and the hedged currencies — in periods when Australian interest rates are significantly above foreign rates, the hedging cost can be meaningfully higher than the MER difference alone suggests.
When Does Hedging Help — and When Does It Hurt?
| Scenario | Hedged | Unhedged |
|---|---|---|
| AUD rises (e.g., commodity boom) | ✅ Protected | ❌ Reduces returns |
| AUD falls (e.g., global recession) | ❌ Misses currency gain | ✅ Gains from weaker AUD |
| AUD stable | Similar return (hedging cost is a slight drag) | Similar return |
| Global share market crash | Both fall sharply in AUD — hedged falls slightly less | Unhedged may fall slightly less (AUD often weakens in crises) |
The AUD as a Natural Hedge
Australia’s dollar is often described as a “risk currency” or “commodity currency” — it tends to weaken when global economic conditions worsen (recessions, market crashes) and strengthen during commodity booms.
This creates a natural partial hedge for unhedged international investors:
- When global shares fall, the AUD also often falls — so your unhedged international ETF falls less in AUD than the underlying foreign market
- When global shares rise strongly, the AUD often strengthens — partially offsetting gains
This dynamic means that, over long periods, unhedged international exposure has sometimes provided smoother AUD returns than the raw foreign currency returns would suggest.
Long-Term Research on Hedging
Academic and industry research generally finds that:
- For long-term horizons (10+ years), currency effects tend to mean-revert — unhedged and hedged portfolios produce similar long-term returns
- Hedged ETFs reduce short-term volatility but add the ongoing cost of hedging
- For shorter-term investment horizons, hedging reduces currency risk meaningfully
Many long-term Australian investors in VGS (unhedged) accept currency risk as a feature rather than a problem, relying on the long investment horizon to smooth currency effects.
Related Articles
Frequently Asked Questions
Should I choose VGS (unhedged) or VGAD (hedged)? Most long-term retail investors in Australia who hold VGS do so unhedged — accepting currency risk in exchange for a lower MER and the natural partial hedge that comes from the AUD’s correlation with global risk sentiment. VGAD (hedged) may suit investors with shorter time horizons or those who specifically want to eliminate currency noise from their international returns. Both are reasonable choices depending on your situation.
Do diversified ETFs like VDHG and DHHF hedge their international exposure? Partially. VDHG holds a mix of hedged and unhedged international funds. Approximately 60% of VDHG’s international share exposure is unhedged (through VGS-equivalent funds) and about 40% is hedged (through VGAD-equivalent funds). DHHF holds approximately 11% of its international allocation in a hedged fund (HGBL) and the remainder unhedged.
What happens to the hedging cost if Australian interest rates are much higher than US rates? When Australian rates are significantly above US rates (positive interest rate differential), Australian investors effectively “pay” to hedge AUD/USD — the forward exchange rate is structured so that hedging costs more than just the MER. Conversely, when Australian rates are below US rates (as happened 2009–2022), the hedging can have a small positive carry. This is the interest rate parity effect — it affects all currency hedging programs.
This article provides general financial information only. It does not constitute financial advice. For advice tailored to your situation, speak with a licensed financial adviser. You can find one through the ASIC financial advisers register or MoneySmart.