Gain some control over an often powerful force.
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If you take the time to leaf through one of those big, densely written fund prospectuses that arrive in your mailbox every now and then, you'll see a long section called "Risks" that attempts to lay out every possible way the fund could end up disappointing you. A fund that invests in foreign securities may include "currency risk" on that list. Sometimes that idea lands under a broader discussion of "foreign investment risk."
But what is currency risk? How important is it? What steps do fund managers take to address it, and how should individual investors think about it?
How Currency Moves Affect Returns
Currency strategies can be complex. In the prospectus sense, however, currency risk is straightforward: It means that currencies rise and fall over time. If you own securities denominated in foreign currencies, when those currencies lose value versus the U.S. dollar, you'll get lower returns from the securities than if the currency values had stayed flat or risen. For example, shareholders of a stock fund that has not hedged its currency exposure could lose money even if the stocks in the fund's portfolio rise in the local market.
It can work the other way, as well. If foreign currencies are strong versus the dollar, as nearly all were in the first half of 2010, then shareholders of unhedged funds get an extra bonus.
How Funds Cope With Currency Risk
Most fund firms don't offer pairs that are equivalent in nearly all respects, save currency exposure. In fact, on the stock side, very few funds are fully hedged into the dollar. It's much more common for international stock funds to be completely unhedged.
The reason is that managers typically say they would rather concentrate on stock selection, or investigate sector or regional themes, rather than try to guess where currencies are going. Many fund firms also say that their shareholders have told them one reason they own international funds is to get foreign-currency exposure for diversification purposes. Such shareholders don't want any hedging.
That said, occasional hedging has become more common in recent years. For example, at a certain point a fund manager may think the pound has become far too strong, given current economic conditions and its historical range. So, the manager will hedge that exposure until the pound falls to a more reasonable level (he hopes). At that juncture he'll revert to an unhedged stance.