A Spanish investor who buys an S&P 500 index fund is not only betting on American companies. They are also taking a position on the exchange rate between the euro and the dollar. This second risk — currency risk — rarely appears explained in fund factsheets, but it can add or subtract several percentage points of return in any given year.
Understanding how currency risk works does not require hedging it or ignoring it. It does require being aware that it exists.
What Is Currency Risk
When you invest in assets denominated in a currency different from your own, your final return depends on two independent factors: the performance of the asset in its original currency, and the change in the exchange rate between that currency and yours.
If the asset rises 10% in dollars but the dollar depreciates 8% against the euro, your gain in euros is barely 2%. If the dollar appreciates 8%, your gain in euros reaches 18%. The underlying asset has not changed — what changed is the exchange rate.
This mechanism is currency risk. It operates in both directions: it can amplify your gains when the foreign currency appreciates, and it can erode them or turn them into losses when the foreign currency depreciates. For a European investor who holds a significant portion of their portfolio in US-denominated assets, this risk is permanent and material.
The EUR/USD exchange rate is one of the most closely watched in the world. Historically it has ranged between 0.85 and 1.60 dollars per euro over the past few decades, with periods of relative stability alternating with sharp movements of 15% to 30% over a few years. These swings are not marginal: they are comparable to the average annual return of many asset classes.
How It Affects Your Investments in Practice
Consider a concrete example. Imagine that in January 2022 you invest 10,000 euros in a fund tracking the S&P 500 in dollars. By year-end, the index had fallen approximately 19% in dollars. However, the dollar had appreciated roughly 12% against the euro during that same period. The result for the European investor was a loss of less than 10% in euros — significantly smaller than the index’s decline in its original currency.
In the opposite direction, a European investor in the S&P 500 during 2017 saw the index gain more than 20% in dollars but only around 5% in euros, because the dollar fell substantially that year.
These discrepancies are not exceptions: they are the norm over one-to-three-year time horizons. Over the long term, the effect tends to smooth out, but in the short term it can be very significant.
Currency risk is not only a problem for equities. It also affects international fixed income, foreign REITs, global sector ETFs, and any asset denominated in a currency other than the euro. In fixed income, where gross returns are lower, the relative impact of exchange rate movements is even greater.
Currency Hedging: Pros and Cons
Currency hedging is the mechanism that allows investors to neutralize the effect of exchange rate movements on an investment. Hedged ETFs and funds use derivative contracts to lock in a future exchange rate, thus eliminating exchange rate uncertainty from the outcome.
An ETF tracking the S&P 500 with euro hedging — typically identified by the terms “EUR Hedged” or “EUR H” in its name — delivers a return in euros very similar to the index’s return in dollars, without the exchange rate affecting the result.
This sounds ideal. However, hedging has a direct and significant cost:
The cost of hedging. Hedging the exchange rate has a price, roughly equivalent to the interest rate differential between the two currencies. When US interest rates are higher than eurozone rates — as was the case during 2022 and 2023 — hedging the dollar against the euro can cost between 2% and 4% per year. This cost is deducted directly from the hedged fund’s return. If the index rises 10%, the hedged fund may return 6% or 7% in euros after hedging costs.
The complexity of hedging. The hedge is renewed periodically — typically monthly — and is not perfect. During periods of high exchange rate volatility, small deviations between the expected and actual return can occur.
You don’t capture exchange rate gains. If the dollar appreciates against the euro, the hedged fund does not capture that additional gain. Hedging is symmetric: it eliminates both the risk and the opportunity.
When Does Hedging Make Sense
The answer depends on three factors: the time horizon, the type of asset, and the interest rate differential between currencies.
For long time horizons, most research concludes that exchange rates tend to revert toward equilibrium over the long run. An investor with a 20- or 30-year horizon has fewer reasons to hedge currency in equities: the cumulative cost of hedging over two decades can easily exceed the risk it was meant to eliminate.
For equity assets, the expected return is high enough to absorb exchange rate volatility without it radically changing the long-term outcome. In fixed income, where returns are lower, currency has a proportionally much greater impact, and hedging is usually better justified.
When the hedging cost is low, covering the currency makes more sense. When the interest rate differential between currencies is large — as when US rates exceed European rates by more than two or three percentage points — the cost of hedging can become prohibitive.
The practical rule most advisors apply: do not hedge currency in long-term equities; do hedge in international fixed income, where the relative impact of exchange rate movements is more significant relative to the expected return.
The Long-Term European Investor Perspective
The European investor who invests in the S&P 500 or a global index such as the MSCI World holds exposure to dollars, pounds, yen, Swiss francs, and other currencies. This geographic diversification also implies currency diversification, which can itself be a way to reduce risk compared to concentrating all wealth in euros.
The euro is not a guaranteed appreciating currency. Over the past twenty years there have been prolonged periods in which the euro weakened against the dollar, and others in which the opposite occurred. Maintaining exposure to multiple currencies means not depending entirely on the evolution of the euro, which in turn depends on ECB monetary policy, the European economy, and other factors outside any individual investor’s control.
On the other hand, an investor who lives and spends in euros ultimately needs euros. If at the time of retirement or fund withdrawal the dollar has significantly depreciated, the value of their portfolio in their functional currency will be lower. This real risk does not disappear by ignoring it.
What to Do in Practice
For most European private investors with long-term horizons, the most widely recommended practical guidance is as follows:
For global equities, accept the currency risk without hedging. The long-term cost of hedging tends to erode returns more than it stabilizes them, and the geographic diversification that comes with international exposure has value in itself.
For international fixed income, evaluate hedging case by case. An unhedged US Treasury bond ETF can have volatility in euros similar to an equity fund, which undermines its function as a lower-risk asset in the portfolio.
Be aware of what percentage of your portfolio is exposed to each currency and review periodically whether that distribution still makes sense for your objectives. A portfolio with 80% in dollar-denominated assets is an implicit bet on the EUR/USD rate, whether intended or not.
Currency risk is not a design flaw of international investing: it is the price of accessing broader markets. Ignoring it does not eliminate it. Understanding it allows for more informed decisions about how much exchange rate risk is being assumed and when it is worth reducing it.
