Understanding Currency Futures for ETFs

What Are Currency Futures and How Do They Work with ETFs?

Have you ever invested in a US stock fund, saw the US market go up, but your returns in rupees were disappointing? The culprit is often the changing value of currencies. Understanding currency futures for ETFs can help you make sense of this. Currency futures are financial contracts where you agree to buy or sell a specific currency at a predetermined price on a future date. For investors in overseas ETFs in India, these contracts are a key tool used to manage the risk that comes from currency fluctuations.

Think of it like this: your investment in a foreign ETF has two parts. The first is the performance of the stocks or bonds in the ETF. The second is the exchange rate between the foreign currency (like the US dollar) and your home currency (the Indian rupee). If the dollar weakens against the rupee, your dollar-denominated returns are worth less when you convert them back. Currency futures help to protect, or hedge, against this risk.

A Simple Look at Currency Risk for Overseas ETFs in India

When you buy an overseas ETF, you are not just betting on the companies in that fund. You are also indirectly betting on the currency of that country. This is known as currency risk or foreign exchange (forex) risk. Let's look at an example.

Imagine you invest 100,000 rupees into an ETF that tracks the US market. Let's assume the exchange rate is 80 rupees for 1 US dollar. Your investment is worth 1,250 dollars.

• Scenario 1: Stronger Rupee (Bad for you)
  Your ETF performs well and grows by 10% in one year. Your investment is now worth 1,375 dollars. However, during that year, the rupee strengthens against the dollar. The new exchange rate is 75 rupees for 1 dollar. When you convert your 1,375 dollars back, you get 103,125 rupees. Your investment grew by only 3.1%, not the 10% you expected from the market. The strong rupee ate into your profits.
• Scenario 2: Weaker Rupee (Good for you)
  Again, your ETF grows by 10% to 1,375 dollars. But this time, the rupee weakens. The new exchange rate is 85 rupees for 1 dollar. When you convert your investment back, you get 116,875 rupees. Your total return is now almost 17%! The weak rupee boosted your profits.

This shows how much exchange rates can impact your final returns. Currency futures are the tool used to manage this uncertainty.

How Currency Futures Provide a Hedge

Hedging is like buying insurance. You pay a small price to protect yourself from a big potential loss. With overseas ETFs, you use currency futures to lock in an exchange rate. This reduces the uncertainty of currency movements.

If you own a US-based ETF, you are 'long' the US dollar. This means you benefit if the dollar gets stronger and lose if it gets weaker. To hedge this position, you would take an opposite, or 'short', position in USD/INR currency futures. This means you agree to sell US dollars at a future date at a price agreed upon today.

Here’s how it works together:

1. You own a US ETF, so you are exposed to USD.
2. The USD weakens against the INR. This reduces the value of your ETF in rupee terms.
3. However, your short position in USD/INR futures makes a profit. The profit from the futures contract helps offset the loss from the currency conversion.

This protection isn't free. There are costs associated with trading futures, and these costs are often passed on to investors through slightly higher fund management fees in what are called 'currency-hedged ETFs'. For more technical details on how these contracts work, you can refer to information provided by exchanges like the National Stock Exchange of India.

Hedged vs. Unhedged ETFs: A Clear Comparison

When you look for overseas ETFs, you will find two main types: hedged and unhedged. Your choice between them depends entirely on your goals and how much risk you are willing to take.

Unhedged ETFs

These funds do not use currency futures. They let the currency exchange rate float freely. Your returns are fully exposed to both the asset's performance and the currency's movement. Most overseas ETFs available to retail investors are unhedged because it is simpler and cheaper to manage.

Hedged ETFs

These funds actively use currency futures or other derivatives to minimize the impact of exchange rate fluctuations. The goal is to give you a return that is very close to the return of the underlying assets in their local currency.

Here is a simple table to help you decide:

An unhedged ETF gives you a diversified investment in another country's economy, including its currency. A hedged ETF tries to separate the investment in the assets from the investment in the currency.

What Should You Do?

Making a choice can feel complex, but it doesn't have to be. For most long-term investors in overseas ETFs in India, the decision can be simplified.

Many experts argue that over very long periods (10+ years), currency fluctuations tend to even out. A strong dollar one year might be offset by a weak dollar a few years later. For this reason, many long-term investors choose unhedged ETFs. They accept the currency volatility as part of international investing and focus on the growth of the underlying companies.

A hedged ETF might be more suitable if:

• You are investing for a shorter time frame, where a sudden currency swing could have a big impact.
• You have a strong belief that the foreign currency is going to weaken against the rupee.
• You are very risk-averse and prefer more predictable returns.

Before you invest, always read the fund's main documents, like the Key Information Memorandum. It will clearly state whether the fund is hedged or not. Understanding this small detail can make a big difference in your investment journey and help you align your portfolio with your financial goals.