Beverly Goodman

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Does Your Foreign Fund Hedge Its Currency Bets?

Beverly Goodman

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."

Funds that hedge to the dollar generally do so because the managers think that the dollar is the best long-term bet -- as in, the strongest currency. Also, some managers want to simplify investment decisions -- hedging to the dollar means that investors only see how the managers' stock picks performed in dollar terms. Such a policy eliminates the "noise" of currency movements, according to Morningstar analyst Emily Hall, saving investors from determining what it means if the pound falls against the dollar at the same time the yen is rising.

There are drawbacks to this simplicity, though. The best reason to invest internationally is to diversify your portfolio -- so while domestic stocks languish, you could get a boost from foreign investments. But if those foreign investments are hedged to the dollar, they might perform more like domestic investments, thereby mitigating that diversification benefit.

How similarly foreign stock funds track domestic equities will also depend on their holdings, though, Hall notes. "International funds that hedge to the dollar but invest in small companies or make sector bets will still correlate less to the S&P 500 than unhedged funds that invest primarily in European blue-chips," she says.

So while hedging often indicates a more conservative bent, that's not always the case. A notable exception is Tweedy Browne's (TBGVX Quote)Global Value fund. Hedging to the dollar helps balance some of the fund's other risks, like heavy weighting in some sectors and a multicap strategy, Hall says.

Another drawback to hedging is the cost. "There are short-term benefits to be had from hedging," Valentine says, "and there are short-term costs to be incurred."

Unhedged funds have done well of late, given the weak dollar. And they do generally offer increased diversification. But they're not immune from the cycles that affect hedged funds -- the category suffered badly in the late 1990s, when the U.S. stock market was booming and the dollar was strong.

Still, though, many of the larger fund companies, such as T. Rowe Price and Fidelity, do not hedge any of their international funds. George Greig, manager of William Blair's (WBIGX Quote)International Growth fund, says he rarely hedges because, on a macro level, he expects the currencies in the foreign markets he's invested in to appreciate, and on the micro level, he allows the companies to hedge themselves.

Some funds will make ad hoc currency hedges, Hall says, but that's almost always to preserve a gain. "Most stock fund managers do not take currency bets," she says. "The vast majority of international stock funds are either hedged or unhedged. When managers hedge on an ad hoc basis, they're trying to protect gains, not boost returns."

Unlike stock funds, international bond funds use a variety of ad hoc hedging tactics, and are not necessarily entirely hedged or are not hedged. "International bond funds are driven by managers making macroeconomic calls," Hall says. "They're hedged according to how various economies are performing against one another. Currency calls are that part of macroeconomic analysis."

Currency calls are best left to the professionals, which is why you don't want to attempt switching between hedged and unhedged funds based on where you think the dollar is heading, particularly when you factor in the transaction costs, which will eat away (if not eliminate) any slight edge you get in the short term. Instead, choose an international fund based on the same criteria -- cost, tax efficiency, diversity, its role in your portfolio -- as you would a domestic stock fund.

"Mutual fund investors needn't concern themselves with the hedging issue," Valentine says. "It's one less thing to worry about when choosing a fund."