Impact of Australian Dollar Weakness on Currency-Hedged and Unhedged US-Focused ETFs

Highlights:

• Australian dollar recently dropped to its lowest level since early 2020

• Currency movements affect returns from US-focused ETFs listed on the ASX

• Hedged ETFs aim to offset currency changes, while unhedged ones do not

The Australian equity market offers access to international sectors, including the technology-heavy US indices, via locally listed exchange-traded funds. One common method for accessing these international equities is through ETFs tracking indices such as the NASDAQ-100. These ETFs are often structured in either a hedged or unhedged format, depending on the currency exposure.

When the Australian dollar fluctuates, particularly against the US dollar, these movements influence the performance of international ETFs. With the Australian dollar recently falling to levels not seen in several years, questions about the impact on ETF performance have gained attention.

Understanding Currency Hedging in ETFs

Currency-hedged ETFs are designed to neutralise the effect of exchange rate movements between the fund’s base currency and the investor’s domestic currency. In the case of US-focused ETFs listed on the ASX, the base currency is typically the US dollar, while the investor’s local currency is the Australian dollar.

By hedging, the ETF aims to track the performance of the underlying US index without the influence of fluctuations in the AUD/USD exchange rate. This means the return should closely align with the index’s actual performance in US dollar terms, even if the Australian dollar strengthens or weakens.

Non-Hedged ETFs and Exchange Rate Exposure

Non-hedged ETFs, on the other hand, retain the exposure to the underlying currency. This means the value of the Australian dollar against the US dollar plays a direct role in the performance of these ETFs when expressed in Australian dollar terms.

When the Australian dollar declines against the US dollar, unhedged ETFs tend to benefit, as each US dollar of assets becomes more valuable in Australian dollars. Conversely, a strengthening Australian dollar can reduce the Australian dollar value of the ETF, even if the underlying index remains steady or increases.

Illustrating the Difference with ASX-Listed US ETFs

To understand how hedging affects performance, two ETFs tracking the same US index can be compared—one with currency hedging and one without. For instance, both a hedged and an unhedged version may track the NASDAQ-100 Index, which comprises leading US-listed technology and growth companies.

In times when the Australian dollar weakens sharply, the unhedged version would typically show a stronger return in Australian dollar terms due to the conversion benefit. Meanwhile, the hedged version would reflect the performance of the NASDAQ-100 with less variation caused by currency shifts.

Currency Movements and Performance Differentials

Over time, the impact of currency movements can create noticeable differences in returns between the two structures. A significant depreciation in the Australian dollar adds a layer of performance to unhedged funds, whereas appreciation in the Australian dollar can result in lower relative returns for the same underlying index.

These variations become more pronounced during periods of heightened volatility in currency markets, such as during global economic uncertainty or domestic financial adjustments.

ETF Structure and Currency Positioning

ETFs focused on US equities provide exposure to companies not directly listed on the ASX. The choice between hedged and unhedged formats depends on whether the ETF aims to mitigate currency translation effects.

Both options reflect the same underlying assets but may perform differently based on changes in the exchange rate between the Australian and US dollars. These structural differences are essential for understanding the drivers of return for each ETF during periods of currency volatility.