Why Unhedged ETFs Can Lose You Money

Why Are Your Overseas ETF Returns So Low?

You did your research. You found one of the best overseas ETFs India offers to invest in the US market. You saw the S&P 500 index climb 10% this year. But when you check your portfolio, your investment is only up 2%, or maybe it's even in the red. It feels confusing and unfair. You made the right call on the market, so why isn’t your money growing as you expected?

The common belief is that if the foreign stock market goes up, your investment in an ETF tracking that market should go up by the same amount. Unfortunately, there is a hidden factor that many new investors miss: currency risk. The culprit behind your disappointing returns is likely that you invested in an unhedged ETF, and the exchange rate moved against you.

Understanding Unhedged International ETFs

Before we break down the problem, let's get our terms straight. An Exchange-Traded Fund (ETF) is a basket of stocks or bonds that trades on an exchange, just like a single stock. An overseas or international ETF holds assets from another country. For an Indian investor, an ETF that holds US stocks is an overseas ETF.

The key word here is unhedged. When an ETF is unhedged, it means the fund does not take any steps to protect your investment from fluctuations in the currency exchange rate. You are exposed to two different movements:

1. The price change of the assets (the stocks) in the fund's portfolio.
2. The change in the exchange rate between your home currency (Indian Rupee) and the foreign currency (US Dollar).

Your final return in rupees is a combination of these two factors. They can work together to boost your returns, or they can work against each other and drag them down.

How Currency Movements Can Erase Your Gains

Let's walk through a clear example. Imagine you want to invest in a US stock market ETF.

Suppose you invest 83,000 rupees. At the time of investment, the exchange rate is 1 US dollar = 83 rupees. Your money is converted to 1,000 US dollars to buy units of the ETF.

Now, let's look at two possible scenarios a year later.

Scenario 1: The Rupee Strengthens

The US market has a great year, and your ETF units, valued in dollars, go up by 10%. Your initial 1,000 dollars is now worth 1,100 dollars. Great!

However, during the same year, the Indian economy does very well, and the rupee strengthens against the dollar. The new exchange rate is 1 US dollar = 80 rupees.

When you convert your 1,100 dollars back to rupees, you get:

1,100 dollars x 80 rupees/dollar = 88,000 rupees

Your investment grew from 83,000 to 88,000 rupees. That's a return of about 6%. The market gave you a 10% return, but the currency movement took away 4% of your profit. This is how a good investment can deliver disappointing results.

Scenario 2: The Rupee Weakens

Again, the US market goes up by 10%, and your investment grows to 1,100 dollars.

But this time, the rupee weakens against the dollar. The new exchange rate is 1 US dollar = 86 rupees.

When you convert your 1,100 dollars back to rupees, you get:

1,100 dollars x 86 rupees/dollar = 94,600 rupees

Your investment grew from 83,000 to 94,600 rupees. That's a return of nearly 14%. In this case, the currency movement worked in your favour, adding an extra 4% to your market gains.

Example Box: Your return is a combination of market performance and currency change. A 10% market gain can result in very different outcomes depending on the INR-USD exchange rate.

Key Reasons Unhedged ETFs Can Hurt You

The risk of currency movements isn't just a theoretical problem. Here are three reasons why it can be a major issue for your portfolio.

1. A Stronger Home Currency

This is the most direct risk. If the Indian Rupee strengthens significantly against the US Dollar, Euro, or Yen, the value of your foreign investments falls when measured in rupees. This can happen if India's economic growth outpaces that of other countries or if the Reserve Bank of India takes steps to support the currency. You can find official data on currency and forex markets on the RBI website.

2. Sudden Economic Shocks

Currency markets are volatile. A surprise interest rate change by a central bank, unexpected inflation numbers, or major political events can cause exchange rates to swing wildly. Your investment thesis about a company or an industry might be perfectly correct, but an unpredictable currency event can wipe out your profits in the short term.

3. Hidden Compounding Costs

Even small, steady movements can have a big impact over time. If the rupee appreciates by just 2% every year against the dollar, that's a 2% headwind your foreign investment has to overcome annually. Over a decade, this steady drag significantly reduces your total compounded returns.

The Solution: Hedged vs. Unhedged ETFs

If you want to invest in foreign markets without worrying about exchange rates, the solution is a currency-hedged ETF. The fund manager of a hedged ETF uses financial instruments called derivatives to lock in an exchange rate. This process aims to remove the impact of currency fluctuations on your returns.

With a hedged ETF, your return will much more closely match the return of the foreign index it tracks. If the S&P 500 goes up 10%, your return should be very close to 10% (minus the fund's fees), regardless of what the rupee-dollar exchange rate does.

Should You Always Choose a Hedged ETF?

Not necessarily. While hedging removes risk, it comes with its own trade-offs.

First, hedging costs money. The process of using derivatives adds to the fund's operating costs, which means hedged ETFs usually have higher expense ratios. This extra fee will slightly reduce your returns over time.

Second, you miss out on potential currency gains. Historically, the Indian Rupee has tended to depreciate against the US Dollar over the long term. For investors in unhedged US ETFs, this trend has provided an extra boost to their returns. If you choose a hedged ETF, you give up that potential upside.

Your choice depends on your investment strategy. If your goal is short-term tactical exposure to a specific market and you fear your home currency will strengthen, a hedged ETF is a sensible choice. If you are a long-term investor and see currency exposure as a form of diversification, an unhedged ETF might be better.

Before investing in any overseas ETF, read its documents carefully. The name will often indicate if it is hedged. Understanding this single detail can be the difference between achieving your financial goals and facing unexpected losses.