Currency strategy for NZ investors: hedged vs unhedged and how to make a deliberate choice

In Week 1 of this series I flagged currency as the variable that most NZ investors carry without realising it. Every dollar invested in international assets through an unhedged fund is exposed to NZD movements. When the NZD strengthens, your international returns shrink in local currency terms. When it weakens, they expand. Over any given year, this effect can be larger than the return from the underlying investments themselves.

Most NZ investors have never made a deliberate choice about this. They are in whatever fund their platform defaulted them into, hedged or unhedged, and the currency exposure they carry is an accident of that default rather than a considered decision. This week I want to give you the framework to make that decision properly.

What currency hedging actually is

When a fund hedges its currency exposure, it enters into forward contracts to lock in exchange rates for a portion of its overseas holdings. The effect is to neutralise most of the NZD/foreign currency movement on those holdings — so the return you receive is close to the underlying asset return in local currency terms, regardless of what the exchange rate does.

Hedging is not free. The cost is driven by the interest rate differential between New Zealand and the currency being hedged against. When NZ interest rates are higher than US interest rates, hedging NZD/USD exposure costs money — typically 1% to 2% per year in recent years. When NZ rates are lower, the cost reduces or can even become a benefit.

For most of the past decade, hedging NZD/USD has carried a cost. That cost is a drag on returns that compounds significantly over long investment horizons.

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The maths over 20 years

To make the trade-off concrete: on a $100,000 international equity portfolio growing at 8% gross per year, a 1.5% annual hedging cost reduces the net return to 6.5%. Over 20 years, the difference in terminal value between the hedged and unhedged portfolio is approximately $140,000. Over 30 years it is more than $350,000.

That is a significant number. It is also not the complete picture, because the unhedged portfolio carries currency variance that the hedged portfolio does not. The question is whether the expected return premium from avoiding hedging costs justifies the additional volatility.

The case for hedging

The cost of hedging is real, but it is not the only relevant variable. There is a genuine case for hedging in some circumstances, and it is worth understanding rather than dismissing.

Currency variance is not just an upside risk. The NZD/USD has moved by more than 20% within single years, in both directions, over the past two decades. For an investor whose portfolio is a significant portion of their net worth, a 20% currency movement in an unfavourable direction is not just a number — it is a real wealth shock that affects behaviour. Investors who experience large drawdowns, even temporary ones driven by currency rather than underlying asset performance, are more likely to sell at the wrong time. Hedging reduces that risk.

The case for hedging is also stronger for investors with shorter time horizons. A 55-year-old investor with a ten-year horizon to retirement has less time to absorb currency volatility than a 30-year-old with a 35-year horizon. The expected cost of hedging over ten years is material but more manageable relative to the reduction in variance it provides.

The case against hedging

For long-term investors with 20-plus year horizons, the compounding cost of hedging is the primary argument against it. Over long periods, currency movements tend to mean-revert — the NZD does not trend indefinitely in one direction. The variance that hedging removes is largely temporary noise over a 30-year investment horizon, while the cost of hedging is permanent and compounds every year.

There is also a natural hedge argument. Many NZ investors have the majority of their income, their home equity, and their other assets denominated in NZD. Their international investment portfolio may be the only meaningful source of non-NZD exposure in their financial life. Hedging that exposure back to NZD increases their overall concentration in the NZ economy, which is the opposite of diversification.

How NZ fund providers approach this differently

It is worth understanding how the main NZ PIE fund providers handle currency, because the defaults are not consistent and the difference matters.

A framework for deciding

Rather than a single recommendation, here is a framework for working out what is right for your situation. The three variables that matter most are your investment horizon, your tolerance for short-term variance, and the proportion of your total net worth that sits in international assets.

The most important thing is to make a deliberate choice rather than accepting whatever default your platform or fund manager has set. Check whether your current funds are hedged or unhedged, understand what that means for your portfolio, and decide whether it matches your actual situation.

That brings us to the end of the first major arc of this newsletter. Over seven weeks we have covered why NZ investing is structurally different, which platforms suit which investor profiles, how to build a portfolio as a NZ investor, how to think about KiwiSaver strategy, and now how to approach the currency decision deliberately. From next week I will move into more market-facing territory: what the current economic environment means for NZ investors and how to think about the allocation decisions in front of us right now.