Currency-hedged ETFs are exchange-traded funds created to minimize the risks of fluctuating exchange rates in ETFs that have foreign holdings.
Many investment companies offer two versions of the same ETF with one version including a currency hedge. The latter ETF has the same holdings as the former, but it also includes derivatives purchased to protect–or hedge–against currency risk. The protections come at a cost, however, and hedged ETFs may have higher fees than non-hedged ETFs.
Since currency values fluctuate, exchange rates can affect the total return on an asset. While ETFs provide investors with a significant diversification, they don’t offer any protection against the investment risk created by foreign exchange rates. So purchasing an ETF focused on overseas markets creates an additional layer of volatility within the investment.
Currency shifts can boost or diminish returns on international investments — but they almost always make them more uncertain. If the local currency loses value against the ETF’s currency (in this case the dollar), that can offset returns for the dollar-based investor, even if the assets that make up the security’s returns go up in their own currency.
Since many ETF investors are not interested in forex trading, they can minimize their currency risk by purchasing a currency-hedged ETF, which can smooth out volatility related to foreign exchange rates.
Currency-hedged ETFs may have a slightly higher expense ratio than non-hedged ETFs, due to the cost of the futures contracts as well as potential expenses associated with the tools and people who develop the hedged currency strategy.
While a strong dollar may be good when you’re buying assets in a foreign currency, it can hurt returns on assets denominated in a foreign currency. Over the past decade, the strong dollar has meant that hedged portfolios tend to outperform those that weren’t hedged.
Here’s an example: If the dollar-to-foreign-currency conversion rate is 1 to 2, as in one dollar buys you two units of the foreign currency, and you buy 100 shares of a stock at 5 foreign currency units per share, it will cost you $250, or 500 foreign currency units. Now, let’s say those shares double, so that 100 shares are worth 1,000 foreign currency units instead of 500 and your investment is now worth $500, compared to the $250 you spent initially.
But if the dollar strengthened so that the conversion rate went from 2 foreign currency units per dollar to 4 foreign currency units per dollar, those 100 shares are still worth 1,000 foreign currency units but for a US investor, their $250 investment would have shown no gain. While this is an extreme currency fluctuation, it illustrates the reason that some investors might purchase currency-hedged ETFs.
How Does Currency Hedging Work?
Investors use two methods to hedge against currency risk: static hedging and dynamic hedging.
Static Hedging
Static hedging is the most basic kind of hedging. An ETF that uses static hedging has one strategy that it executes, regardless of market conditions. An ETF using this strategy would buy contracts in the future market that lock in a currency’s value relative to the dollar or set parameters around it.
The contract is an agreement to buy a currency at a future price, which has the same effect of cancelling out currency gains or losses if they move from the currency’s current value against the dollar.
Dynamic Hedging
Dynamic hedging may incorporate multiple strategies or change strategies as market conditions change. Dynamic hedging is not always in effect, instead the hedge is “put on” based on the judgment of the ETF manager. Sometimes this judgment reflects an algorithm or series of rules that looks at market conditions for determining when to buy and sell financial instruments that hedge currency exposure.
For example, an ETF might have a rules-based system that looks at the trend of a currency’s value against the dollar, the interest rates in both countries, and the overall value of that currency (namely if it’s more expensive than the dollar). Those data points and, specifically, how they change over time, would determine whether and how much to hedge the ETF at any given time
The Takeaway
Currency-hedged ETFs are one way to get exposure to foreign markets and protection against the currency risks that come with that type of investment, but they may cost more than non-hedged ETFs. It’s important for investors to understand how they work, as they start to build their own investment strategy and learn how to pick ETFs to include (if any) in their portfolio.
If you’re ready to start putting that strategy into action, a great place to start is the SoFi Invest investing platform, which offers personalized investment advice, a range of ETFs, and automated investing.
Start investing today.
Photo credit: iStock/Delmaine Donson
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
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You’ve probably been in one of these conversations, before. Someone who’s older, maybe a teacher or a family member, encourages you to start investing as soon as possible. It’s well-meaning advice.
On an academic level, you know that the younger you get started, the more you can allow the magic of compounding investment returns to work in your favor. You’re also committed to prioritizing your own financial health, and you feel inspired to work towards your own personal financial freedom.
Every new investor has to start somewhere, and there’s no better time than this year.
So, you’ve got the right idea, but you don’t have a playbook. No one taught you how to invest. You’ve heard of Roth IRAs and mutual funds, but how do you know that you’re doing the right thing?
Further, there are a lot of people with divergent opinions on the best way to invest. It’s hard to know where to go and who to listen to.
Much of learning to invest means learning to navigate the options and the conflicting advice and then distilling that down into a portfolio that makes the most sense for you and your goals.
Here are some suggestions for how to start investing in five easy steps.
1. Understanding the Options
While the universe of investment options sometimes feels limitless, it’s not. With knowledge of the core building blocks of investing, you’ll be better able to navigate the available options with ease.
Investors have a variety of options available to them, including: stocks, bonds, cash or money market funds, real estate, private equity, investment partnerships, and natural resources, like gold. These are assets, essentially, things that have economic value and can store wealth. Beginner investors may focus largely on stocks and maybe bonds.
Stocks
A stock represents a share of ownership in a company. Shareholders can make money in two ways: through the value of shares appreciating, and through dividend payouts. Although this is an oversimplification, the success of a stock will generally be correlated to the success of the underlying business. This is highly unpredictable, which leads to the volatile nature of stock prices overall.
Bonds
Bonds, on the other hand, are investments in the debt of a company or government. In this case, the bondholder is the lender, collecting a rate of interest on that debt. The terms of the contract are agreed upon at the outset. Therefore, they are typically less volatile as stocks, although they can lose value.
An investment portfolio generally includes a variety of assets, including both stocks and bonds, for diversification. The purpose of diversification is to minimize risk, especially over the long-term.
Exchange-Traded Funds (ETFs)
What about mutual funds and exchange-traded funds (ETFs)? Funds are pools of investments. It may be helpful to think of a fund as a basket that holds a bunch of investments, such as stocks, bonds, or real estate holdings. For example, an S&P 500 index mutual fund or ETF holds the 500 leading stocks in the US. Therefore, an investment in this fund is really an investment in the US stock market.
Funds are a popular and easy option for investors looking to get broad exposure to whichever market it is that you’d like to invest within. Depending on the fund, this could also be an affordable way to invest. It is a common misconception that you need to invest in individual stocks to be a good stock market investor.
2. Creating a Goals-Based Investment Plan
The decision on which asset class to be invested in, and in what proportions, is an important one. It is called asset allocation. Although it is tempting to dive right into trying to pick out the “best” stocks, it may be appropriate to first take a step back and ask whether stocks are appropriate given your goals.
The next logical question is this: How does one determine asset allocation? Start by determining what the goal or intended use of the money is. To determine your personal investment mix, conduct an examination of your financial goals, risk tolerance, and investment time horizon.
At its core, the asset allocation decision is one regarding your comfort level with the tradeoff between risk versus reward. In investing, risk and reward are intrinsically connected. In order to have the potential for more reward, you have to take more risk. Be leery of investment options that tout “all reward and no risk.” Unfortunately, such an investment may be too good to be true because risk is an inherent part of investing.
A couple of questions worth asking yourself are: What is my goal with this money? When do I need the money? Last, what kind of risk am I willing to take with this money? Then, take these answers and match them up with one or a handful of the available investment options.
It’s may be easier to wrap your noodle around when we consider two different examples of two investors:
Our first investor is saving up for a down payment on a home. They plan to use that money within one year. For them, the risk of losing any money in a potentially volatile investment outweighs the possibility of earning investment returns. Instead of investing, they decide to keep this money in cash, in a savings account.
Next, our second investor. They’re new to investing, with plans to begin investing in a retirement account. They want to focus on growth over the long-term. Because they have a long time horizon for their investments, they have the time to ride through any short-term volatility, so they are more comfortable with the risks of the stock market. They may build out a portfolio that is primarily invested in the stock market, and for diversification purposes, they may decide to include some exposure to bonds as well.
As you can probably tell, there’s no one “right” asset allocation for any one individual, nor is there a universal formula for determining asset allocation. Investors who are learning how to start investing may want to take some time thinking about what allocation makes the most sense for them.
3. Opening an Account
Here’s another common misconception about investing. A Roth IRA and a 401(k) are not investments. These are accounts, just as a brokerage account, that hold investments. Retirement accounts, such as a Roth IRA or 401k, simply have special tax treatment.
Which account you decide on depends on a few factors. First, what are you investing for?
If you are investing for the long-term, then a retirement account may be most appropriate. Retirement accounts can either be opened individually or through your employer. If your employer offers a plan, this could be a good place to start. (And yes, picking funds or a strategy within a 401(k) or 403(b) counts as investing.)
If you are self-employed or do not have a plan through work, you may want to open an individual retirement account. Some options include a traditional or Roth IRA, Solo or Individual 401(k), and SEP IRA.
Because these accounts come with some tax benefits, they also have their own special rules, like when you can withdraw money and limits on how much money can be contributed each year. To determine which type of account that makes the most sense for your personal situation, you may want to speak with a tax professional.
If you would prefer to invest with more flexibility, you may want to open a brokerage or other general-purpose investment account. Though those accounts do not have the tax benefits of a retirement account, they also don’t have restrictions on when the money can be accessed and no penalties for withdrawals before retirement age.
No matter which account type you choose, remember: this is just an account. After opening the account, it will be funded with cash, likely by hooking up an existing checking or savings account. Once the account is funded with cash, that money can be used to buy investments.
If you are opening your own investing account (as opposed to using your workplace retirement plan), you will have to choose a brokerage account or online investing platform. When choosing your account, it helps to pay attention to the fees charged by the platform. Investing costs can dig into your potential returns. SoFi knows that new investors don’t want to pay a bunch in fees just to get in the game. There are no commissions on the SoFi Invest® platform.
4. Deciding How Much to Invest
This may sound oversimplified, but start with whatever you’re comfortable with, knowing that this money will be subjected to some amount of risk. Generally, this should be money that you won’t need in the near-term. That said, one of the greatest features of investing in the modern era is that you can get started with any amount.
There are a few ways to look at this. The first is to consider where you’re at in your own financial journey. It is often recommended that people first work on saving up an emergency fund and paying off credit cards and high-interest debt. And if COVID-19 has taught us anything, it’s that having a firm financial foundation is incredibly important. If you have yet to build up a sufficient safety net or maintain expensive debt on your personal balance sheet, this could be a good place to focus.
It’s easy to get hung up on the “invest versus pay off debt” decision. Here’s a simple place to start: compare interest rates. On debt, it’s the interest rate that you’re paying. On investing, it’s on the interest that you could potentially earn. So for example, if you’re deciding between aggressively paying off a private student loan with a 12% rate of interest or investing at what you expect could be a 7% rate of return, perhaps this makes your decision for you.
That said, it’s not as if you have to be completely debt-free in order to start building wealth. Instead, take some personal inventory. If you feel like you’re missing out on achieving investment and compound returns, then perhaps you’ll want to make investing a priority. If you feel like you’re being weighed down by debt, then maybe you’ll want to give expedited debt pay-off your energy.
If you have arrived at a place of debt repayment that feels manageable, you may want to consider investing as a piece of your overall budget. (Ever hear someone say, “pay yourself first?” This is what they are referring to.) One popular budget, called the 50/30/20 budget, recommends allocating 20% of income towards saving and investing. If you’d like to reach a place of financial freedom sooner than this, then you may want to consider saving more, as a percentage of your overall income.
5. Selecting Investments
Now the fun part of learning how to invest; choosing the actual investments in a portfolio.
Hopefully, you’ve given some thought to which asset class you’d like to invest in. For example, stocks. Then, there are lots of different options to invest within the stock market: You could pick out individual stocks, or stock-based funds, whether mutual funds or ETFs.
With funds, it is possible to invest in categories of the stock market that are very broad, such as the entire global or US stock market, or that are narrower, such as technology stocks. Building simple portfolios of just two or three broad, diversified funds has been a popular method for investors. This is called “passive” or “set it and forget it” investing.
It is also possible to build a diversified portfolio with narrower funds or even individual stocks, but this may require substantial research and curation.
When purchasing funds, investigate whether they are actively managed or indexed. An index fund, as it sounds, mimics some index that measures the performance of the market. For example, a “total US stock market index fund” may be built against the Russell 3000 index, which measures the performance of all stocks in the US. The point is to return whatever the returns of the broader US stock market. Because there is no active manager, the management fee embedded within index funds tends to be lower than the fees on actively managed funds.
Investors opting to buy individual stocks, may want to consider businesses that they believe will produce some sort of future stream of income, either by an increase in the share value or through the dividend payment. Consider reviewing the following: a stock’s price-to-earnings ratio, industry competition, strength of balance sheet, the company research and development, and product pipeline. These factors can help investors determine the value of an investment.
New investors may want to consider buying stocks or ETFs on a platform that offers zero-cost trading, like active investing with SoFi Invest. Fees can eat away at the potential performance of an investment and act as a barrier to entry. Luckily, there are lots of low-cost options for new investors just getting started.
The last option is to use an automated investing service that buys funds for you. This may be an especially compelling option for new investors who want some help building out their first portfolio in a thoughtful, diversified, and goals-driven way. SoFi Invest also offers an automated investing platform.
Be proud of yourself for starting the journey. Invest in a strategy that makes sense for you, starting with any dollar amount.
SoFi Invest is an easy, fast, and no-fee way to get your money working harder for you.
The future is here, and while the flying cars that were promised haven’t arrived yet, the finance world is speeding full-force into the future with everything from wireless payment apps on our phones to entirely decentralized finance systems.
Decentralized finance, known as DeFi for short, is a fundamentally new financial system that moves monetary control away from centralized banks and towards public blockchains.
Put more simply, DeFi has the potential to change the underlying mechanics of financing and banking, as well as how people access financial services, by using the internet and smart devices instead of going through a centralized bank.
What Is Centralized Finance?
In order to understand DeFi, it is helpful to understand how the traditional financial system works. In general, the current US financial system is largely controlled by central authorities.
For example, some aspects of the financial system are controlled by the Federal Reserve (sometimes referred to as “The Fed”). The Federal Reserve, which serves as the nation’s central bank, was created in 1913 after several financial panics caused people to withdraw their money from decentralized banks. Mass withdrawals of money caused banks to fail and incited more financial crises.
In response to these crises, the US government created the Federal Reserve, which acts as a centralized banking system and attempts to stabilize the economy through means such as managing national monetary policy and regulating banks. Banks, which are regulated by the Fed, also have their own controls and regulations on how finances are conducted.
For example, a bank might require a driver’s license to open a checking account or a certain credit score to take out a loan.
Simply stated, whether buying groceries with a debit card or saving for retirement, most of our financial transactions go through a bank, lender, investment company, or financial institution that is highly regulated.
Why DeFi?
While centralized banking was created in order to foster economic stability, it has come with restrictions on how people can access financial options, and with criticisms that putting financial control in the hands of a central body can create more risk if that central body gets it wrong. For example, what if the Fed decides to print too much money and inflation explodes or interest rates shut out people from accessing credit lines?
Or what about credit rates in general—if people take financing out of regulated contexts, could consumers see higher interest rates on their investments?
For example, as discussed above, most financial transactions take place through intermediaries: A bank account is required in order to use a debit card. An account at a financial institution is required in order to earn interest on money.
A broker is required in order to invest in the stock market. Each of these intermediaries is a product of the centralization of the nation’s financial system—and each intermediary potentially minimizes consumers’ financial earnings.
In the most elemental way, when money is deposited in a savings account, it earns interest. The interest that money earns is funded by the financial institution where the account is located. That financial institution earns money by lending depositors’ money to borrowers, who pay interest to the financial institution.
But the interest rate earned on a savings account is not the same as the interest rate the financial institution charges the borrower. Because it is acting as an intermediary between saver and borrower, the financial institution controls both interest rates.
But would both savers and borrowers get a better deal if it was possible to make secure financial transactions without an intermediary like a bank or other financial institution?
These are some of the questions about centralized finance that supporters of decentralized finance think that DeFi can answer without necessarily losing the stability created by a centralized bank.
What Is Decentralized Finance?
At its most basic, the idea behind decentralized finance is that it would truly put money in an individual’s control. While it might seem like there is individual control over money though robust banking options, checking and savings accounts, financial management apps, and ATM access, each of those things actually requires turning over that money to an institution and trusting that intermediary to manage it. The underlying goal of DeFi is to give actual control by using blockchain technology and open source coding to do the same types of transactions that currently take place largely through financial institutions.
Blockchain technology is a term commonly used in relation to cryptocurrency. At its most basic, blockchain can be thought of as a secure logbook that records transactions but is not controlled by a centralized institution. Rather, accountability in the blockchain is ensured because the “chain” is not editable and is stored in many places instead of in one centralized institution.
If this sounds familiar, it may be because blockchain serves as the “building blocks” of cryptocurrency like bitcoin. To understand DeFi, however, it is only important to understand that blockchain is secure, automatically generated, and able to be examined and tracked, just like a physical ledger. And unlike banks, blockchain is stored on users’ computers, which means that it’s not controlled by a central authority like the Fed.
In order for cryptocurrency like bitcoin to exist, it needs a secure ledger to track it—that’s blockchain. So is DeFi just a synonym for bitcoin and other cryptocurrencies? Not exactly. While cryptocurrencies are decentralized when it comes to issuance, transfer, and storage, they are still centralized when it comes to access and management.
Specifically, you still need to access cryptocurrencies through centralized exchanges, and many cryptocurrency projects are managed through companies which functionally act as that intermediary that DeFi seeks to eliminate. Some cryptocurrencies even tie their worth to physical currencies like the US dollar to attempt to provide stability.
DeFi takes crypto to the next level by attempting to give the benefits of cryptocurrency without the need to tie access and management through centralized access points or companies, which can obscure the open nature of these transfers and potentially lead to abuse of the system.
DeFi is a network of open-source apps based on blockchain that allow users to engage in financial acts in an entirely peer-created, peer-reviewed, open-source world, which is all based on the security of blockchain.
Because everything within the DeFi crypto universe is open source, users theoretically have the control to engage in a wide variety of financial transactions with the assurance provided by the underlying blockchain technology.
How Can Decentralized Finance Be Used?
There are many ways that DeFi crypto is and could be used. One popular way that it is being used currently is with open lending protocols. While the name sounds complicated, open lending protocols essentially seek to eliminate the centralized middleman between lenders and borrowers.
For example, instead of one person putting their savings in a bank and another person applying for a loan from that bank, two people could use a DeFi open lending protocol to lend and borrow money with open-sourced, agreed-upon contracts created by the DeFi system and stored in unalterable public blockchains.
DeFi can also be used for things like international and peer-to-peer payments. Currently, if one person wants to send money to another person, options may be limited to a third-party service or a bank in order to transfer the funds. Currently, these services take time—it may be hours or even days between when a sender transfers money and when someone else receives it.
Additionally, these services can be expensive. Whether paying a fee to a bank for a money transfer or paying to use wire services, sending money from place to place can add up.
DeFi is one possible answer to routing money from person to person because it allows individual people to transfer money to each other securely and instantly without relying on centralized third-party providers.
Getting Started With DeFi and Cryptocurrencies
DeFi is starting to take off, but it remains to be seen whether it will truly become an alternative to traditional banking. One sure thing, however, is that cryptocurrencies are becoming cemented in the financial system. An easy way to buy cryptocurrencies without needing to be a financial expert is with SoFi Invest®.
SoFi Invest® empowers members to trade stocks, ETFs, and even cryptocurrency. SoFi’s crypto offerings currently include Bitcoin, Etherium, and Litecoin, and can be accessed directly in the SoFi app.
Easily add cryptocurrencies to your savings plan with SoFi Invest® along with traditional investments like stocks and ETFs. A separate cryptocurrency wallet, or even cryptocurrency experience, is not necessary before getting started.
Learn more about getting started with crypto using SoFi Invest®.
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments. Limitations apply to trading certain crypto assets and may not be available to residents of all states.
External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
