Currency Hedging Halved Bond Volatility. Equities: It Depends

Key takeaways

• An equally weighted global bond portfolio ran at 10.35% annualised volatility unhedged and 5.40% fully hedged for a sterling investor, 1975 to 2005.
• Vanguard found risk-adjusted returns on hedged global bonds were 2.9 times those of unhedged global bonds across five markets, 2000 to 2023.
• Over ten years to July 2026, hedging MSCI World raised volatility 2.0 points for a sterling investor and cut it 1.0 point for a dollar investor.
• Hedging MSCI Kokusai to yen cost 2.00 percentage points a year since 2001 while saving about 1.8 points of volatility.
• Vanguard's modelled hedge ratios fall from roughly 70-80% at 20% equity weight to 10-20% at 80% equity weight.

Two people buy the same global equity fund on the same morning, one in London and one in New York. The fund page offers a hedged version and an unhedged version. Neither of them knows which box to tick, and neither is being careless.

So which one would you pick? For the bond side of a portfolio the answer is about as settled as this subject gets. For the equity side it depends on where you live, and the sign of the answer flips between those two people.

Start with the number that makes the standard rule look obvious. For a sterling-based investor holding an equally weighted global bond portfolio from 1975 to 2005, annualised volatility ran at 10.35% unhedged and 5.40% fully hedged. Hedging cut the risk roughly in half. Run the same test on global equities and the gap narrows to 16.78% against 13.86%. Real, but nothing like as dramatic. The equity split itself is a shallower decision than the hedge: across a 14-year sweep, the UK equity weight barely moved portfolio volatility anywhere between 10% and 70%.

Those figures come from Campbell, Serfaty-de Medeiros and Viceira's study of global currency hedging, and they're the arithmetic behind the advice most fund providers give: hedge your foreign bonds, leave your foreign equities alone. Vanguard states the rule in almost those words in its 2026 research on multi-asset currency hedging. It's a good rule. It isn't a law, and the reasons it works matter more than the rule itself.

Currency risk doesn't scale with the asset

A basket of developed-market currencies moves against your home currency at something like 8% a year. That's the volatility Vanguard assumes in its hedging framework, and it's roughly stable across the major pairs. What isn't stable is the volatility of whatever that currency is attached to.

Investment-grade bonds are a low-volatility asset. In the Campbell sample, a fully hedged global bond portfolio ran at 5.40% a year. Bolt an 8% currency exposure onto a 5.4% asset and the currency becomes the dominant source of risk. Unhedged, the same portfolio ran between 8.39% and 12.08% depending on the investor's base currency. The bonds stopped behaving like bonds. That matters most inside a leveraged portfolio, where the bond leg is held at more than 100% of capital and any surprise in it is magnified.

Equities are different. A hedged global equity portfolio ran at 13.86% in the same study, and MSCI's own hedged World indices have sat close to 14% annualised over the past decade. Attach an 8% currency exposure to a 14% asset and the currency is a minority contributor. It can still matter, but it no longer drives what happens to you. The BIS made the same point in plainer language in June 2025: equity portfolios are hedged less often than bond portfolios because equity return volatility dominates currency return volatility.

It's worth being clear about what a hedge does mechanically, because it's easy to imagine it as a bet on the currency. It isn't. Selling each foreign currency forward converts a foreign-currency index into something that tracks the local-currency version almost exactly. Vanguard measured this from January 1988 to December 2025: MSCI World hedged to dollars, yen, sterling and Australian dollars ran at 13.9%, 13.8%, 13.9% and 14.0% volatility against 13.8% for the local index, with tracking errors of 0.31% to 0.89%. A hedged fund is the underlying market with the exchange rate stripped out, nothing more.

The currency hedging formula the rule is approximating

There's a one-line answer sitting underneath all of this. The variance-minimising hedge ratio equals one, plus the currency-asset correlation multiplied by asset volatility divided by currency volatility. Vanguard derives it in the appendix of its 2026 paper. Write it out and the rule of thumb falls straight out.

Take the bond case. Asset volatility of about 5%, currency volatility of about 8%, and a correlation near zero. The ratio of volatilities is 0.6, so even a fairly strong correlation barely moves the hedge ratio away from 100%. Now take the equity case. Asset volatility of 14%, currency volatility of 8%, so the ratio is 1.75. A correlation of minus 0.2 drops the optimal hedge ratio to 65%. A correlation of minus 0.5 takes it to zero.

That's why the answer is asset-dependent without anyone needing a currency forecast. Vanguard's modelled hedge ratios follow the same curve: roughly 70% to 80% for a portfolio with 20% in equities, falling to 10% to 20% for a portfolio with 80% in equities, across five investor domiciles. Hedge your bonds and leave your equities, and you land near those numbers by accident.

What hedging foreign bonds actually buys

The bond side of the rule is about as settled as anything in portfolio construction gets. Vanguard tested global bonds across five markets using monthly data from January 2000 to March 2023 and found the risk-adjusted returns of hedged global bonds were on average 2.9 times those of unhedged global bonds. Not 2.9% better. Nearly three times.

The same study asked the fairer question in reverse. How much extra return would unhedged bonds have needed to justify the extra volatility? For a 60/40 portfolio, between 0.4% and 1.8% a year depending on the currency. The realised currency returns over the period were smaller than that, and more often negative than positive.

Hedging also preserves the job you're holding the bonds for. In the worst quartile of months for global equities, hedged global bonds delivered a tight range of outcomes, while unhedged global bonds delivered a much wider one and frequently failed to counterbalance at all. That's the whole argument for holding high-quality bonds, and currency exposure quietly breaks it. It's worth reading alongside the broader question of which asset classes actually diversified during past crises.

One neat illustration of the mechanics: in the year to 30 June 2017, a euro-area investor in short-dated euro bonds earned minus 0.07%, while a US investor holding the same portfolio hedged back to dollars earned 1.63%. The difference was roughly the gap between Fed and ECB policy rates. Hedging doesn't remove the interest-rate differential — it embeds it in the forward contract.

The equity answer depends on where you live

Here's where the rule earns its keep, and where it gets uncomfortable. MSCI publishes hedged and unhedged versions of the same World index, so the comparison is clean. As at 31 July 2026, over ten years, the MSCI World hedged to sterling had annualised volatility of 13.95%. Unhedged in sterling it was 11.93%. If you're the buyer in London, hedging global equities raised your volatility by two percentage points.

Now the same index from a dollar base. Hedged to the dollar, 13.87%. Unhedged in dollars, 14.86%. Hedging lowered volatility by one point. Same index, same decade, opposite sign — and the only thing that changed was which of those two people you are.

The mechanism is straightforward. Sterling tends to fall when global risk appetite falls, so foreign assets gain in sterling terms exactly when domestic ones are suffering. In 2016 the MSCI World returned 6.01% hedged to sterling and 25.62% unhedged in sterling. In 2022 it was minus 18.49% hedged and minus 9.32% unhedged. The dollar behaves the other way: it strengthens in a flight to quality, so unhedged foreign equity amplifies a dollar investor's losses. Deepest drawdown since 2001 for the sterling investor was 48.22% unhedged against 56.16% hedged. For the dollar investor it flips: 57.82% unhedged against 54.44% hedged.

Put 2016 in money. Say you'd held a hundred thousand pounds in that fund — a round number, purely as an illustration. The hedged version's 6.01% hands you just over six thousand pounds for the year. The unhedged version's 25.62% hands you a bit over twenty-five and a half thousand. Nineteen thousand pounds of difference, from a box you ticked once on a form, on a fund holding identical shares. Then 2022 ran the other way: minus 18.49% is a loss of about eighteen and a half thousand, against roughly nine thousand three hundred unhedged. Same box, same fund, and you'd have been delighted with it one year and sick of it the next.

Campbell's data shows the same asymmetry in a longer sample. From 1975 to 2005, a Canadian investor's unhedged global equity portfolio ran at 13.74% against 13.86% fully hedged — the hedge slightly increased risk. A Swiss investor's ran at 19.19% unhedged against the same 13.86% hedged. Commodity-linked currencies behave one way, safe havens the other.

Four bases, one asset class, annualised volatility of a global equity portfolio measured in the investor's own currency:

The hedged column barely moves. The unhedged column does. That's the practical meaning of the rule: hedging hands every investor much the same equity risk, and leaving the currency alone hands each one a different risk.

Scale matters too. Vanguard's figures for 31 December 2025 put foreign-currency exposure in a market-cap global equity portfolio at 30% for a US investor and 96% for a UK one. A US investor barely has a currency decision to make. That makes the hedging question inseparable from how much of a portfolio's equities sit outside the home market, since the only way to eliminate currency risk entirely is to stop investing abroad.

And if you aren't American, the currency decision is really a dollar decision. MSCI's World index carried currency weights of 72.85% dollar, 8.47% euro, 5.73% yen and 3.38% sterling at 31 July 2026. Hedging that index from a sterling base is, three-quarters of the time, a decision about sterling against the dollar. The aggregate position is enormous. The BIS put the notional value of outstanding FX derivatives at $130 trillion at end-2024, with almost 90% of contracts referencing the dollar on one side, and non-US investors held more than $17.6 trillion of US equities and $13.6 trillion of US bonds in March 2025. Whether that exposure raised or lowered the risk of a holding depended on the base currency it was measured in, which set the sign of the currency leg.

The case against hedging equities at all

So why would anyone leave the currency risk sitting there? The strongest objection to any of this isn't about volatility. It's that hedging costs money, and the cost can be far larger than the volatility it saves.

Hedging with forwards locks in the interest-rate differential between the two currencies. If your home rate is below the foreign rate, you earn that gap. If it's above, you pay it. The BIS defines the hedging cost precisely this way: the percentage gap between forward and spot rates, which equals the interest-rate differential adjusted for the cross-currency basis. Now suppose you'd been a Japanese investor over the past two decades. That gap has been brutal.

MSCI's Kokusai index makes it concrete. As at 31 July 2026, since January 2001, the version hedged to yen returned 5.33% a year against 7.33% for the same index in local-currency terms. Hedging cost 2.00 percentage points a year. What did it buy? Ten-year annualised volatility of 14.20% hedged against 15.97% unhedged — about 1.8 points of volatility. The Sharpe ratio since 2001 was 0.42 hedged and 0.55 unhedged. A Japanese investor who hedged global equities paid a lot and ended up worse off on a risk-adjusted basis.

That's not a hypothetical. Japanese life insurers cut their hedge ratio from about 60% in 2021 to 40% in 2024, and Taiwanese life insurers were near historic lows at roughly 65% in late 2024. High dollar rates made hedging expensive, and they responded. It's the same interest-rate machinery that drives the yen carry trade and Japan's intervention record.

Vanguard puts realistic all-in hedging costs at 0.25% to 0.50% a year, made up of transaction costs of up to 0.17% plus fund expenses. It also calculates a break-even: on an equity portfolio with 20% volatility, a 1.9-point volatility reduction would justify paying up to 0.76% a year. That maths works when the currency exposure is genuinely risk-adding. It doesn't work when the carry cost is 2.00 points, as it was for a yen investor. How much any of it matters to a whole portfolio depends on the weight of the sleeve carrying it, which is what portfolio currency exposure measures.

The counter-argument cuts both ways, though, and being honest about that matters. Vanguard's own rolling ten-year figures show hedging reduced developed equity volatility by an average of 1.7 percentage points across the markets it studied from 1981 to 2025. On average, hedging equities helped. The dispersion is the problem: outcomes ranged from a 7.1-point volatility reduction in Japan for the decade to 2016 to a 3.5-point increase in Australia for the decade to 2010. Nobody knew in advance which they'd get. So the case for leaving equities unhedged isn't that hedging never works. It's that the benefit is unreliable, the cost is certain, and the currency is a small share of your equity risk either way.

What would change the conclusion

Four things, and the first has already happened once.

Correlations flip. Before the 2008 crisis the euro looked like a safe-haven currency, which implied euro-area investors should hedge their foreign exposure. That relationship reversed afterwards and has since hovered near zero. Vanguard's 54-year sample shows ten-year currency-equity correlations swinging across a wide band in every market it examined. Any hedging policy that depends on one correlation holding can spend a decade being wrong.

Rate differentials converge or invert. The Japanese result above is mostly a story about near-zero yen rates against much higher foreign rates. If that gap closes, hedging yen exposure gets cheap and the calculation changes. The reverse applies if your home rates are high: you've been paid to hedge, and you'd stop being paid if the gap narrowed.

The risk measure changes. Everything above uses volatility of total portfolio returns. But what if your liabilities are in a foreign currency, or you plan to spend a chunk of your money abroad? Then you have a different problem entirely, and unhedged foreign assets may be the hedge rather than the risk. It's the same distinction that separates standard deviation from the drawdown an investor actually experiences.

Better forecasting arrives. Campbell's study tested whether varying currency positions with interest-rate differentials beats a fixed policy. It barely did: 12.45% volatility conditionally against 12.51% unconditionally, on an equity portfolio. Their conclusion was that there's little evidence risk-minimising investors should adjust currency positions in response to interest differentials. Anyone selling you a tactical hedging edge is arguing against that result.

Two caveats on the evidence itself, and they bound everything above. MSCI's hedged Kokusai index launched in November 2005, so figures running back to 2001 include back-tested data. And every number here is sample-dependent — the Campbell window ends in 2005, the Vanguard bond study ends in March 2023, and the MSCI figures are a snapshot at 31 July 2026. A different decade produces different volatility comparisons, which is the whole reason the rule is framed around relative volatility rather than realised correlations.

What survives all of it is the asymmetry. The bond case is robust across every base currency, every study and every window: currency volatility swamps bond volatility, so hedging preserves what the asset is there to do. The equity case is genuinely close, and where you live decides it.