Does Your Foreign Fund Hedge Its Currency Bets?

The grass is always greener. ...

Foreign funds have been attracting a lot of attention of late. The vagaries of domestic equities, the run-up in the bond market and the falling dollar have all helped push $5.9 trillion into international funds this year -- more money than what went into any other stock fund, according to AMG Data.

But investors evaluating international funds are often stymied by the idea of currency hedging. But while the hedging mechanisms are complex, the concept of hedging to the dollar is simple: eliminate the inconsistency of floating currencies and keep everything in dollar terms. In the end, though, long-term investors have little to worry about -- returns end up essentially the same. It's more important that investors understand the concept, rather than use it to determine which fund to invest in.

There are notable advocates on both sides of the debate over whether to hedge or not. "On Wall Street it's like cat people vs. dog people," says Bill Valentine of money management firm Valentine Ventures in Bend, Ore. "But all of the academic studies have proven that over the long term, hedging won't increase your return."

When the dollar increases in value, funds that hedge to the dollar benefit. When the dollar decreases in value, as it has of late, funds that hedge to it lose out. The opposite is true of funds that don't hedge to the dollar -- they gain when the dollar loses and lose when the value of the dollar gains. So if you look at two identical portfolios, hedge one and not the other, over time the fluctuations of the dollar will render almost identical returns. "Hedging to the dollar is like coins in your pocket," says Valentine. "It all comes out in the wash."