Does Your Foreign Fund Hedge Its Currency Bets?

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.