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The dollar has climbed in recent weeks, cheering American tourists who will pay less for souvenirs in Rome and Paris. But the currency shift is bad news for investors in international stock funds.

As the dollar rises, the value of foreign assets drops for U.S. investors, and fund returns suffer. Now some analysts expect that international funds will continue to face a currency headwind.

"As the European economy slows, the dollar will strengthen against the euro," says Charles Lahr, portfolio manager of Mutual Discovery Fund.

A currency handicap for foreign funds would represent a big change for investors. In recent years, the dollar has dropped sharply, a move that has enlarged fund returns. From May 2001 through the end of 2007, the Morgan Stanley Capital International EAFE index -- a popular foreign benchmark -- returned 10.5% annually. Roughly half that came from currency gains, according to fund company Dodge & Cox. During the same period, the

S&P 500

stock index returned 4.3%.

Seeing the sizable results overseas, many investors poured into foreign funds -- without recognizing the role of currency gains. Of the $6.5 trillion in equity fund assets in 2007, 25% were in overseas funds, according to the Investment Company Institute, the fund trade group. That was up from 13% of equity assets in 2000.

Soon, novice investors may be in for a shock if the dollar spikes and hurts foreign funds.

Only a handful of overseas funds would be unscathed by a dollar rebound. These protected funds hedge their currency exposure using forward contracts or other techniques. The contracts typically rise in value when currencies decline.

The hedgers fall into two groups: portfolios that remain largely hedged all the time and funds that hedge only when conditions seem to warrant action.

Among those that vary their hedge positions, a top performer is

First Eagle Overseas Fund

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. A diehard contrarian, First Eagle ranks as one of the few funds to make money during the downturn of 2000 and 2001. Six months ago First Eagle was unhedged. The portfolio managers figured that the dollar would continue weakening as the U.S. ran up big trade deficits.

Lately, the managers have shifted their views, deciding that the currency markets overreacted, and the purchasing power of the dollar has shrunk to unrealistic levels.

"A half-decent hotel room in Paris costs $350, and a comparable room in New York is $250," says First Eagle associate portfolio manager Abhay Deshpande. "That tells you that the dollar has gotten too cheap."

Some of the hedgers are deep-value investors, who pick depressed stocks and patiently wait for rebounds. Such funds hedge because they fear that a single currency blip could erase years of gains in a stock.

A notable deep-value choice is

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Mutual Discovery

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, a fund with big positions in Europe. While it normally hedges most of its currency exposure, the fund has shifted to being about fully hedged because of fears that the dollar is due for a rebound.

One of the most recent converts to hedging is

Dodge & Cox International Stock Fund

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. The fund had never hedged in the past, but in the annual report dated Dec. 31, the portfolio managers announced that they would be hedging exposure to the euro and pound sterling because the hazards of overvalued currencies had become severe.

The move was especially noteworthy because Dodge & Cox has long had a reputation for moving cautiously and avoiding complicated trading strategies.

Partly because it benefitted from currency gains in the past, Dodge & Cox outdid 98% of its competitors during the last five years, according to Morningstar. In contrast, funds that have hedged all along -- and achieved no currency gains -- do not appear impressive in the relative standings. But if the dollar spikes, the hedgers could rocket to the head of the pack.


Tweedy, Browne Global Value

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, a fund that ranks near the bottom of its Morningstar category for performance during the past five years. Tweedy stays hedged as part of its effort to deliver steady results. Most often the fund has succeeded, avoiding big losses in downturns and delivering decent returns in good times. While the hedging policy may prevent the fund from enjoying currency gains, it also protects against losses when the dollar rises.

Tweedy settled on the hedging strategy in 1993, when the fund began, because the portfolio managers decided that currencies could be riskier than stocks. Since World War II, the S&P 500 has recorded losses of more than 20% in only two calendar years. In contrast, currencies frequently suffer such big downturns. Tweedy has sought to protect shareholders from all the rough periods.

Tweedy contends that currencies move in cycles. For a period of years, the dollar falls, and foreign funds achieve currency gains. Then the dollar rises, and funds give back their currency gains.

"Over long periods, exposure to foreign currency does not add anything to returns," says Robert Wyckoff, a portfolio manager of Tweedy, Browne Global Value.

The huge majority of foreign funds disagree with the Tweedy approach. Many fund managers argue that the currency moves help portfolios, providing diversification for investors. Sometimes when U.S. stocks are falling, foreign currencies may be climbing.

Whether or not the dollar rises this year, both hedged and unhedged foreign funds can make fine holdings. But investors should be aware of the currency positions of their funds -- and understand that moves in the dollar may inflate or depress results.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.