Hedged vs. unhedged ETFs in Canada: key differences

Exchange-traded funds (ETFs) have become widely used financial instruments among Canadian investors seeking access to global markets. As interest in foreign investments grows, so does attention to how currency fluctuations may affect investment returns. One of the most discussed distinctions involves hedged vs unhedged ETFs.

When Canadians invest in foreign securities, such as U.S. equities or international bonds, they gain exposure not only to the underlying assets but also to currency movements. A weakening or strengthening Canadian dollar can influence the ETF’s performance in ways that extend beyond price movement in the underlying index.

This article examines hedged and unhedged ETFs, how currency hedging works, and how currency risk may affect investment returns.

Understanding currency exposure in exchange traded funds

When Canadian investors purchase an ETF that holds foreign securities, such as U.S. stocks or international bonds, they are exposed to:

• The price movement of the underlying securities

• Changes in the exchange rate between the Canadian dollar (CAD) and the foreign currency

For example, a Canadian investor buying a U.S.-focused S&P 500 ETF is exposed to:

• Performance of the S&P 500 index

• Movements between the Canadian dollar and the U.S. dollar

If the Canadian dollar weakens relative to the U.S. dollar, the value of U.S. holdings converted back into CAD may increase, even if the underlying index remains flat. Conversely, if the Canadian dollar strengthens, currency translation may reduce returns.

This interaction between investment performance and exchange rate fluctuations represents currency risk.

What is a hedged ETF?

A hedged ETF is designed to reduce or offset the impact of currency volatility between the home currency and the foreign currency in which the underlying securities are priced.

Currency hedged ETFs commonly use:

• Forward contracts

• Futures contracts

• Other hedging financial instruments

These tools attempt to neutralize currency exposure so that the ETF’s performance more closely reflects the local returns of the underlying index, rather than changes in exchange rates.

In Canada, many global ETFs offer CAD-hedged versions. For example:

• CAD-hedged S&P 500 ETFs

• CAD-hedged international equity ETFs

• CAD-hedged global bond funds

The objective of a hedged ETF is not to enhance returns but to reduce additional volatility stemming from currency movements.

What is an unhedged ETF?

Unhedged ETFs do not attempt to offset currency fluctuations. Their returns reflect both:

• The performance of the underlying foreign investments

• The impact of exchange rate changes

For example, if the Canadian dollar weakens while holding U.S. stocks, unhedged counterparts may show higher returns in CAD terms. If the Canadian dollar strengthens, the reverse may occur.

Unhedged ETFs maintain full currency exposure, meaning that investors participate in both the gains and losses caused by currency volatility.

Hedged vs unhedged ETFs: key differences

The following table outlines several distinctions between hedged and unhedged ETFs:

How currency hedging works in ETFs

Currency hedging in ETFs is designed to reduce the impact of currency fluctuations on investment returns. When Canadian investors hold ETFs that invest in foreign securities, returns may reflect both the performance of the underlying assets and changes in the exchange rate between the Canadian dollar and the foreign currency.

A currency hedged ETF typically seeks to offset this currency exposure through the use of financial instruments. The objective is to help align the ETF’s performance more closely with the local returns of the underlying index, rather than returns influenced by currency movements. According to fund provider disclosures and research from the Bank of Canada, exchange rate fluctuations have historically contributed to short-term return variability for foreign investments held by Canadian investors.

Common hedging tools

Currency hedged ETFs commonly use forward contracts. A forward contract allows two parties to agree on an exchange rate for a transaction that will occur at a future date. If the Canadian dollar strengthens or weakens, gains or losses on the forward contract may offset changes in the value of the foreign currency exposure.

Some ETFs may also use futures contracts with similar objectives. These tools do not eliminate market risk tied to the underlying equities or bonds. Instead, they aim to reduce the impact of currency volatility on the ETF’s performance.

Hedge ratio and hedge resets

Most currency hedged ETFs target a hedge ratio of approximately 100% of foreign currency exposure. This means the fund attempts to offset most, though not necessarily all, of the currency risk.

Hedge positions are typically reset on a regular schedule, such as monthly. Because portfolio holdings and market values change over time, the hedge may not perfectly match the underlying exposure at every moment. As a result, short-term differences between intended and actual hedge levels may occur.

Why hedging can create tracking differences

Currency hedging can introduce tracking differences relative to a theoretical fully hedged index. Implementation timing, transaction costs, and differences between spot and forward exchange rates may affect results.

Additionally, the cost of maintaining forward contracts can influence returns. These factors may cause a hedged ETF’s performance to differ modestly from both its unhedged counterpart and its underlying benchmark over time.

Trade-offs that matter for Canadians

For Canadian investors accessing foreign markets, evaluating hedged and unhedged ETFs often involves examining how currency exposure, costs, and performance variability have interacted historically. Because returns are reported in Canadian dollars, exchange rate fluctuations between the Canadian dollar and foreign currencies may influence outcomes in ways that extend beyond the performance of the underlying securities.

Currency risk and return decomposition

Returns from unhedged ETFs can be viewed as having two components:

• The return of the underlying asset (such as foreign equities or bonds)

• The impact of currency movements relative to the Canadian dollar

For example, if foreign securities rise in value while the Canadian dollar weakens, CAD-denominated returns may reflect both effects. If the Canadian dollar strengthens, currency translation may reduce reported gains.

Currency hedged ETFs aim to reduce the currency component by using forward contracts or similar instruments. In this structure, performance may more closely reflect the local return of the underlying index, with less influence from exchange rate fluctuations. 

Costs and the “hedging drag” concept

Hedging can involve both direct and indirect costs. Direct costs may include transaction expenses and the ongoing management of forward contracts. Indirect costs may arise from differences between spot and forward exchange rates, sometimes referred to as carry costs.

Some fund disclosures describe the cumulative effect of these expenses as “hedging drag.” Over time, higher expense ratios and contract costs may influence net returns. However, the magnitude of these effects has varied depending on interest rate differentials and market conditions.

Tracking difference and variability over periods

Hedged and unhedged ETFs tracking the same index may diverge in performance over different periods. Currency movements can affect unhedged returns, while hedge execution timing and reset schedules may influence hedged results.

These differences have historically varied across short, medium, and long-term time frames. As a result, return patterns between hedged and unhedged series have not moved in parallel across all market environments.

Common misunderstandings

Misunderstandings that commonly affect hedged vs unhedged decisions

Hedging does not guarantee higher returns.

Currency hedging aims to reduce the impact of exchange rate fluctuations, but historical data shows that outcomes have varied depending on whether the Canadian dollar strengthened or weakened during a given period.

Hedging does not remove market risk.

A currency hedged ETF may reduce currency risk, yet the underlying equities or bonds remain exposed to market volatility, price movement, and broader economic conditions in global markets.

Hedging is not free.

Implementing forward contracts or similar instruments may involve transaction costs and ongoing management expenses, which can contribute to higher expense ratios compared to unhedged counterparts.

Currency moves can dominate short periods.

Over shorter time frames, exchange rate fluctuations have historically had a meaningful impact on CAD-denominated returns, at times amplifying or offsetting underlying asset performance.

Unhedged exposure is not the same as speculation.

Holding unhedged foreign investments reflects acceptance of currency exposure rather than a direct view on exchange rate direction.

Hedged products can show tracking differences.

Differences in hedge resets, contract timing, and implementation costs may cause performance to diverge from both benchmarks and unhedged series over time.

Pros and cons of hedges ETFs and unhedged ETFs

Hedged ETFs: commonly cited advantages and limitations

Commonly cited advantages:

• May reduce the impact of currency volatility on returns when foreign investments are converted into Canadian dollars.

• May provide returns that more closely reflect the local performance of the underlying index, rather than exchange rate fluctuations.

• May reduce short-term variability tied specifically to currency movements.

Commonly cited limitations:

• Often involve higher expense ratios due to the use of forward contracts or similar hedging tools.

• May experience tracking differences because hedge positions are reset periodically and may not perfectly match currency exposure at all times.

• May offset favourable currency movements during periods when the Canadian dollar weakens.

Unhedged ETFs: commonly cited advantages and limitations

Commonly cited advantages:

• Typically carry lower costs, as they do not maintain currency hedging programs.

• Allow full participation in currency movements, which have historically contributed meaningfully to returns during certain periods.

• Provide direct exposure to both underlying asset performance and foreign exchange fluctuations.

Commonly cited limitations:

• May introduce additional volatility from exchange rate movements.

• Returns in Canadian dollars may be reduced when the Canadian dollar strengthens relative to the foreign currency.

• Short-term performance variability may reflect currency swings rather than changes in underlying securities.

Conclusion: comparing hedged and unhedged ETF structures

Hedged and unhedged ETFs reflect different approaches to managing currency exposure within global investments. Historical data shows that exchange rate fluctuations between the Canadian dollar and foreign currencies have contributed to return variability over time. Hedging may reduce currency-related volatility, while unhedged exposure may reflect both asset performance and currency movements. Costs, tracking differences, and time horizon considerations can also influence outcomes. As global diversification continues to expand among Canadian investors, awareness of how currency affects ETF performance remains an important consideration when reviewing fund structures and long-term portfolio composition.