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Can a Hedge Protect a Fund From the Euro's Avalanche?

To hedge or not to hedge? Europe-focused fund managers disagree.

The euro is in avalanche mode; has your mutual fund taken preventive measures?

The single European currency hit a record low against the dollar on Wednesday and slid further on Thursday to $0.8670. In dollar terms, it has declined 26% since its January 1999 inception and some 13% so far this year, dragging down many European companies and multinationals with substantial assets on the Continent. If you own a fund that invests primarily in stocks overseas or exclusively in Europe, the euro's slide has probably lightened your wallet.

The average Europe-focused U.S. mutual fund is up 1.2% year to date, compared with a 3.4% rise for the

S&P 500

index, according to


. Still, that disappointing performance has to be kept in perspective. The average foreign stock fund -- a category that includes funds that spread their investments throughout the world -- is down 5.9% for the year.

But mutual funds have the option of hedging against currency fluctuations. For investors in mutual funds, that raises the question: Should you be looking for a fund that hedges its currency bets or one that rides out volatile foreign-exchange fluctuations?

"A currency is one of the most difficult variables to determine over the short term, so we avoid hedging altogether," says Marc Chapman, co-manager of the $1.1 billion


Invesco European fund. The skipper acknowledges that the euro has taken "a quite significant toll" on his fund, which has returned 6.9% this year through Sept. 6, but he believes currency fluctuation is a short-term issue that balances out over the long run.

On the other end of the spectrum are the managers of the $3.3 billion

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Tweedy Browne Global Value fund. Co-managers Christopher and William Browne operate one of the few funds that fully hedges its currency exposure, dealing only in U.S. dollars. So far this year, it has paid off, and the fund is up 11.9%.

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"We and most of our clients eat, drink, sleep, dream and spend in dollars," co-manager William Browne told


in April. "It seems logical to hedge back to the dollar."

While Invesco never touches currency hedging and Tweedy Browne is all hedging all the time, in between these poles are funds, such as the

Matthews International Funds

, which selectively hedge currencies when the managers think it makes economic sense. While this practice sometimes lets managers avert declines in the euro or other currencies, if the currency strengthens, the fund has missed a substantial upside opportunity. Most funds don't hedge at all or do so on a limited basis.

Here's how currency fluctuations affect funds: A U.S. mutual fund that invests overseas must convert its dollars into other currencies before investing that money in other markets.

By exchanging dollars for another currency, a fund manager is taking on currency risk in addition to the risk built into owning stocks. If a particular currency weakens against the dollar, a fund could lose some return on investments denominated in that currency. Of course, if a particular currency strengthens against the dollar, a fund could make extra return. A gain or loss in a currency is added to or subtracted from the returns of the actual stock investments

Funds can hedge their exposure to foreign currency fluctuations by using forward contracts (similar to futures) to lock in a currency's value close to its current price. The downside, though, is that they give away the upside in exchange for downside protection.

The strategies employed by Invesco European and Tweedy Browne managers are opposite. However, both groups have the same goals in mind: to make money on portfolio stock holdings rather than currency swings.

William Browne said he doesn't "profess to have any ability to predict currencies," so he sticks to stock picking. Chapman, for his part, says: "We pick stocks from the bottom up for their growth prospects, not on short-term currency matters. We think our investors are focusing on the longer term as well."

Chapman also ventures a guess that his strategy will see an additional benefit going forward from a euro recovery. He says that heavy investment in dollar-denominated assets has hamstrung the euro, but that may change with Europe showing robust growth. If money starting flowing into Europe, any lift by the euro will add to returns.

Some studies show unhedged and hedged portfolios of foreign stocks return about the same over a time frame of 10 years or more. On its

Web site, Tweedy Browne cites two studies. One examines the performance of equities in six countries from 1975 through 1998, comparing the unhedged results to those hedged back to the U.S. dollar. Over that period, "the compounded annual returns on hedged and unhedged foreign equities were 16.4% and 16.5%, respectively," the study says.

The upshot: Long-term investors shouldn't choose or avoid an international fund based solely on whether it hedges currencies. Just look at the performance.