What it is: Currency-hedged ETF
ETFs with a currency-hedging component exist for both stocks and bonds. The currency hedge is designed to mitigate the risk of exchange-rate volatility on investments held in a foreign currency. These ETFs hedge that risk with currency forward contracts or agreements to buy or sell currency at an already agreed upon exchange rate in the future.
Investors could make a bet on currency-hedged equity ETFs if they believe the dollar will appreciate against the foreign currency.
When everything works out just so, equity ETFs with a currency hedge can offer supercharged returns. For example, the Wisdom Tree Japan Hedged Equity Fund went gangbusters in 2013, ending the year up nearly 42 percent, according to Morningstar.
It may be more notable as an exception; such outperformance isn't always the case, and exchange rates are less predictable than they may seem.
Plus, hedging may reduce diversification benefits in international stocks, according to CFP professional Jonathan Duong, CFA, founder and president of Wealth Engineers in Denver.
"When you hedge the currency out of it, you're actually making the fund move more similarly to U.S. stocks. The correlation is increasing since you've eliminated the currency risk," he says.
That's not the case on the bond side, however. "Bond funds should be low volatility. If you allow currency fluctuations, that wouldn't be the case," says Lazaroff. Hedging currency risks in bond ETFs offers investors diversification while smoothing out the volatility from exchange-rate shifts.
Why they're smart investments
In most portfolios, the bond portion is designed to be a counterbalance against the unpredictable nature of the stock market. Currency fluctuations can throw that out of whack. As much as two-thirds of the volatility of an international bond is the result of currency fluctuations, according to mutual fund giant Vanguard.
"If you have unhedged currency risk in the bond portfolio, it's that currency risk that's going to dominate the volatility rather than the benefits you get in the diversification from multiple interest rate curves and varying credit risk," Duong says.
By mitigating currency swings, investors enjoy the diversification without the exchange-rate noise -- going up and going down. Fluctuations due to exchange rates are basically canceled out: Investors won't realize gains from currency shifts, but their returns won't suffer either.
Things to think about
Investors should always read the prospectus and understand the types of investments they're buying. For instance, emerging markets bonds present a different set of risks than those of developed countries. Investing in emerging markets bonds through an ETF without the currency hedge would introduce all sorts of extra volatility into the bond portion of your portfolio -- typically the opposite of what you want it to do.
"If you don't know what you are doing and invest in riskier emerging markets bonds, for example, in an unhedged manner, the real risk is that the foreign bonds are declining and foreign currency is declining and stocks are going down. You end up with a perfect storm, so to speak, where nothing in your portfolio is stable," says Duong.