NEW YORK (
) -- The big drop in the dollar this year has annoyed tourists who must pay more for foreign wine and hotel rooms. But the weakness in the greenback has been welcome news for investors in foreign funds. The funds get a boost when overseas assets are worth more.
Since the beginning of the year, foreign large blend funds, those that invest in both growth- and value-style stocks, have returned 30%, compared with 24% for U.S. large blend, according to Morningstar. Much of the advantage enjoyed by foreign funds can be explained by the performance of the dollar, which has fallen 9% against the euro this year.
To benefit from rising values abroad, some financial advisers urge clients to buy foreign currency funds or stock funds that stand to gain from weakness in the dollar. Should you bet on foreign currencies? Perhaps. With the U.S. running enormous budget deficits, there are good reasons to think that the dollar will drop even more.
Even if there is no sudden dollar collapse, many investors may want to hold a variety of currencies for diversification. But keep in mind that forecasting the direction of currency markets can be difficult. At a time when most experts think that the dollar will fall, the consensus could prove wrong and foreign funds would suffer.
To appreciate the challenges of managing currency, consider that funds follow a variety of strategies. Most foreign funds make no effort to shield investors from currency markets. Top funds that avoid hedging include
Fidelity International Discovery
Vanguard Total International Stock Index
If an unhedged portfolio holds Japanese companies, such as
, the value will rise along with the yen. But shareholders will suffer when the yen slips. While currency exposure can make portfolios more volatile, many financial advisers accept the risk because it comes with greater diversification.
In another approach, a handful of cautious foreign funds shelter investors entirely from the influence of currency swings. These hedge their bets by using currency forward contracts or other techniques.
Among the funds that hedge are
Tweedy Browne Global Value
. When the dollar falls, the funds won't get a boost. But they won't suffer when the dollar rises. Insulated from the volatility of currency markets, both funds rank as sound low-risk choices.
Longleaf Partners International
and Tweedy Browne Global Value had long hedged their portfolios. But, recently, the funds changed their policies. Longleaf announced it would remove hedges in 2010, while Tweedy said it would open a new fund that would be an unhedged version of its existing portfolio. "The companies realized that many shareholders no longer want the hedges," says Gregg Wolper, a Morningstar analyst.
Wolper says some shareholders may prefer eliminating the hedges to profit from a declining dollar. But others seek to customize their own hedging strategies using exchange traded funds. Say a shareholder worries that the euro has become overvalued. The investor can short
CurrencyShares Euro Trust
, an ETF. If the euro falls, the gains in the ETF position would offset losses in the euro holdings, and the investor would be sheltered from currency risks.
While some funds hedge all the time and others never do it, a third group moves opportunistically, putting on hedges when values seem out of line. The opportunists include
Dodge & Cox International Stock
First Eagle Overseas
During the early part of this decade, First Eagle was unhedged and benefited from the decline of the dollar. But in 2007, the portfolio managers became concerned that the dollar had gotten too cheap. Worried that a sudden rebound would punish the portfolio, the fund has been hedging from 30% to 70% of its positions lately. "We don't want to be exposed to an extreme outcome," manager Abhay Deshpande says.
First Eagle has currently hedged 60% of its euro position. That way the fund will be partly sheltered if the euro suddenly drops. If the euro climbs, First Eagle will receive some of the benefit of a stronger currency.
Investors who want to protect against a decline in the dollar can hold a currency fund, such as
Merk Hard Currency
, a mutual fund that owns a basket of currencies from countries that seem to have strong monetary policies. During the past three years, the fund has returned 8.9% annually, outdoing 91% of currency funds. Manager Axel Merk favors countries that are commodity producers, since they are likely to maintain balanced budgets and strong currencies. Big holdings include currencies from Norway, Canada and Australia.
Another way to profit from the falling dollar is to own natural-resources funds, which invest in shares of commodity producers. To appreciate why commodity shares can offer shelter, consider that as the dollar falls, it's more expensive for an American to buy an ounce of gold or a barrel of oil. That makes commodity stocks more valuable.
To participate in commodity markets, consider
RS Global Natural Resources
, which has returned 15% annually during the past decade, outperforming 87% of natural-resources mutual funds. Manager MacKenzie Davis prefers companies that are low-cost producers. "We want companies that can be profitable even if commodity prices don't climb," Davis says.
A favorite holding is
, a natural-gas producer. Other positions include
, a giant producer of aluminum, coal and iron ore. Shares of such companies should thrive if the dollar continues falling.
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.