• Investing in global markets gives you more opportunities, but it also means you are exposed to currency fluctuations.
• Currency hedging can help minimise risks associated with exchange rate movements.
• Bond funds and ETFs can benefit from currency hedging.

Investing in global markets gives you access to more economies, sectors and companies (therefore, diversifying your portfolio or spreading your risks), but it also means you are likely to be exposed to currency fluctuations.

Therefore, even though you invest with us in pounds, some of our funds will have a different base currency. If you invest in a fund that tracks the US S&P 500 index, for example, your money would be converted into US dollars before we invested it on your behalf.

Likewise, if you wanted to sell, the proceeds of the sale would need to be converted back to pounds.

Exchange rates are constantly fluctuating in response to global economic and market conditions as well as supply and demand. As we know, £100 doesn’t equal $100 (though it may well do at some point before changing again!).

These fluctuations can introduce some discrepancies into your returns. You might see, for example, that the S&P 500 index of leading US shares rose by, say, 10% one year but then notice that the return on your own S&P 500 index investment was only, say, 8%.

A big reason for these discrepancies is currency fluctuations. The cash must be converted to sterling before being returned to you.

Taking the above example of investing in an S&P 500 index fund, if the US dollar weakened against the pound, you would get back fewer pounds when you sold your investment (thereby decreasing your return).

However, if the dollar strengthened relative to sterling, you would get more pounds per dollar when you sold (thereby increasing your return). We explain this in further detail here.

What is currency hedging and when should you use it?

You’ll see that some of our funds that are based in a foreign currency have a ‘hedged’ share class available, though not all of them. Hedging means the fund manager seeks to to minimise the risks associated with changes in exchange rates.

We offer hedged share classes for most of our bond funds, and now our bond exchange-traded funds (ETFs), because we believe this type of fund benefits the most from currency hedging.

Many investors use bond funds to provide balance in their investment portfolio, given that bonds have historically provided more stable (but often lower) returns than shares over the long term.

By hedging bond fund investments back into your home currency, you are removing the additional uncertainty around currency fluctuations. While these exchange-rate movements could work in your favour, as we explained above, they could also count against you – and in doing so, reduce the benefit of holding bonds in your portfolio to reduce the overall risk.

It is worth remembering that, while a hedged fund can remove the volatility caused by currency movements, it also means it could sometimes underperform its unhedged equivalent. However, when we hedge bond funds and ETFs we are looking to minimise investment risk, as that’s an important role of bonds in a portfolio, rather than maximise returns.

Shares (or equities), by contrast, are inherently more risky than bonds and are primarily there to drive your investment returns. So being invested in them usually means being comfortable with a higher level of risk, which is why it’s more normal for investments in shares to be left unhedged.

How does currency hedging work?

With hedging, managers typically use derivatives (a type of financial contract) to offset exchange rate movements. The contracts typically lock in a pre-determined exchange rate at which the manager can buy or sell the foreign currency at a future date.

This reduces the risk that exchange rates will move against investors. However, it can’t completely remove the risk.

Vanguard has been managing the hedging of currency fluctuations for over 30 years. When it comes to bond investments in particular, we believe that currency hedging can support the role of bonds in a portfolio without taking undue risks.