Investing in international assets can improve portfolio diversification and broaden the pool of available opportunities. However, it introduces currency risk too. There are two key features of currency exposure. Currency risk, due to the volatility of the asset class, can significantly affect portfolio returns. Since currency exposure from international assets is expected to yield zero returns, managing this risk may help lower volatility and boost overall returns.
When gaining exposure to international assets via publicly traded funds, a common way to manage currency risk is to subscribe to the currency-hedged share class of a fund. Although this may seem an efficient and cost-effective option, our analysis shows that hedged share classes are often neither.
Why hedged share classes are an inefficient way of managing currency risk
We have identified three key inefficiencies:
- Hedged share classes often only hedge the US dollar (USD) risk in the portfolio and leave other, smaller currency risks unmanaged. This leaves residual currency risk that can be significant, depending on the allocation of assets and the volatility of the unmanaged currency component.
- If investors hold several funds with international exposure, holding numerous hedged share classes can lead to implementation inefficiencies and higher transaction costs. This is because investors do not benefit from any netting across different currency exposure positions. This is a particular issue if the assets in the various funds have a low, or negative, correlation.
- Currency risk is typically managed using derivatives, such as FX forwards, which require periodic funding of profits and losses at regular settlement intervals. An equity manager would need to maintain a cash buffer to meet any losses that arise, which leads to a structural reduction in exposure to the underlying equity index. This has two direct implications: firstly, cashflows or collateral requirements managed at the individual investment level are not optimal and create additional drag; secondly, the fund manager of the hedged share class would be consistently under-investing in the underlying asset in order to maintain appropriate cash buffers for the FX hedges.
It should also be factored that sometimes asset managers do not provide a hedged share class for certain funds, typically due to limited investor demand or capacity constraints. This is particularly true for funds investing in international illiquid assets.
By contrast, a dedicated currency manager can manage all exposure, regardless of portfolio composition or its liquidity. In our view a significant benefit here is that such a manager can be responsible for managing all currency risk at the overall portfolio level, after working out the net currency exposures from the full underlying list of international asset exposures. This approach can lead to more comprehensive and efficient currency hedging as well as more efficient management of the collateral pool.
Fees for currency hedged share classes
Fees for currency-hedged share classes can be both expensive and opaque. We have seen fees that are 1bp to 2bp more than currency managers typically charge. Furthermore, as neither management fees nor trading costs are clearly monitored, there is a risk of non-competitive trading costs. Our experience is that a dedicated currency manager can offer transparency and achieve lower transaction costs through curated trading relationships when compared to fund structures.
Performance drag
Most importantly, currency-hedged share classes can often experience significant performance drag relative to their benchmarks. To demonstrate these hidden costs, we analyse a simple UCITS S&P 500 ETF, which has a USD (unhedged) and a sterling (GBP) hedged share class. Considerable care has been taken to select a fund for which we can reasonably isolate the differences in observed returns from currency hedging. However, as illustrated below, there may be other additional factors which are not visible or fully transparent to share class investors.
Figure 1 below shows the impact of passively hedging USD back to GBP – the ‘Insight Benchmark’. This assumes hedging using one-month forwards with no management fees or transaction costs, adjusted for a conservative 10% cash collateral pool with a 0% yield. The ‘Hedged Share Class’ line shows the actual difference in historical returns between the USD share class (unhedged) and the GBP hedged share class of the fund.
Figure 1: Cumulative performance of associated hedging implementation effects from a US Equity ETF hedged and unhedged share class and its impact relative to a 100% hedged passive benchmark1
The fluctuation in both lines primarily reflects the impact of hedging the underlying USD risk of the assets.
The difference between the two shows there has been persistent underperformance from share-class currency hedging relative to a standard passive approach. In the example, between January 2019 and September 2025, the performance drag was approximately 76bp per annum above what could have been achieved by passive currency hedging with a currency manager.
Performance drag may result from management fees, bid-offer execution costs, or a relatively mechanistic currency-hedging approach employed by many passive managers with patterns known across the market (and so potentially easy to anticipate). In the arena of passive investments, it is ironic to note how much focus is given to tracking error, yet how silent nearly all parties are regarding the comparatively large frictional costs of currency-hedged share classes.
Conclusion
While currency-hedged share classes aim to manage currency risk in international investments, our analysis indicates they may not be as efficient or cost-effective as expected. As can be seen above hidden costs can reach 76 basis points per year.
We believe a better approach is to employ a specialist currency manager. One that can implement a bespoke currency program which will be more effective and cost efficient and will provide full transparency on costs.
