FX hedging: Turning an accidental risk into a strategic choice

For UK and European investors, a stronger US dollar boosted returns on US equities through much of the 2010s and early 2020s. However, since early 2025, dollar weakness has reduced those returns, leaving unhedged overseas investors worse off than US-based peers holding the same assets (see Exhibit 1).

Similarly, the continued depreciation of the yen has significantly reduced returns for non-Japanese investors with unhedged exposure to Japanese equities (see Exhibit 2).

Such examples underline the importance of foreign exchange (FX) risk when investing abroad.

Over the past decade, investors have steadily shifted from home-biased equity portfolios towards a more global approach, often anchored around the US, the largest market. The motivation is clear: international equities offer broader opportunity sets, richer sector diversification, and reduced reliance on any single domestic economy.

However, the risks associated with this shift are often overlooked. In many multi asset portfolios, FX exposure isn’t intentionally chosen or deeply researched – instead, it is often a passive by-product of owning overseas assets.

Equity risk is generally expected to be rewarded over the long term. But FX risk offers no such assurance. Currency pairs can swing meaningfully over months or even years, driven by interest rate differentials, capital flows, or policy shifts – factors unrelated to equity fundamentals. As a result, investors may find themselves taking FX risk without any expectation of long-term reward.

How much does FX matter? Currency moves of 10% are not unusual and can add to or subtract from the home currency return of an unhedged foreign asset, regardless of the underlying equity’s performance. Therefore, FX can have a material impact on total returns and is a risk investors should take seriously.

Research on international asset pricing shows that exchange-rate and foreign inflation risk help explain variation in returns, but do not guarantee a positive expected premium for long-only foreign equity holders in their base currency. This is why, in our view, equity currency decisions should be framed primarily as risk management choices, rather than sources of expected return.

Typically, investors can choose one of two approaches – or a combination of both – to manage FX risk:

• The “wash out” argument – otherwise known as the “do nothing” approach: Some market participants argue that currency fluctuations “average out” over long horizons, reducing the need to hedge. There is some merit to this, as real exchange rates tend to revert towards purchasing-power parity over the long term.
  
  But these cycles can last for years, meaning FX can remain a persistent tailwind or headwind for unhedged returns (see Exhibit 3). If that works in the investor’s favour, it helps; if not, it can be a painful surprise.

• Currency hedge – the proactive strategic approach: The right answer to managing currency risk is rarely hedging 100% of equity FX. Equally, it is unlikely to be hedging 0%. FX can diversify equity risk because some currencies – notably the US dollar, Swiss franc, and historically the yen – have exhibited “safe-haven” properties during periods of market stress, tending to appreciate when global equities sell off, helping offset risk. Research from the IMF and NBER links the global financial cycle closely to dollar fluctuations, showing that unhedged exposure can sometimes lower portfolio volatility by offsetting equity declines. In Canadian and UK allocator studies, unhedged global equities have often been less volatile than hedged, because currency moves partly counterbalance equity swings. However, these outcomes are highly time- and currency-specific.
  
  Choosing a hedge ratio depends on an investors’ objectives, as well as the costs and currencies involved – with safe-haven currencies often requiring less hedging than more pro-risk peers, such as those linked to commodity exports or emerging markets.