How Mutual Funds Handle the Falling (Rising?) Dollar

When the U.S. dollar is falling sharply against most other currencies--as was the case in 2006--or rising just as strongly, we hear from plenty of folks wondering how various mutual funds are positioned. Are the funds fully exposed to currency movements or are they negating that exposure by "hedging" back into the dollar?

The answers aren't as simple as you might think. Sure, many funds that own foreign stocks just don't hedge at all. So, if they put 10% of their portfolio into Swiss stocks, say, they also have 10% of their assets in the Swiss franc. But plenty of funds take other approaches--and those methods get far more complex than simply going to the other extreme and hedging all the exposure back into the dollar all the time.

In an era when even a casual follower of the financial news will often hear alarming stories about the ups and downs of the dollar, euro, and yen--and when these movements are having a substantial impact on mutual fund returns--it pays to understand how funds handle this issue. You may prefer one approach or another. Equally important, knowing these details can help you interpret your fund's performance more accurately--and keep you from being surprised or unduly disappointed.

The Currency Effect
To put it simply, when a U.S.-based fund buys stocks on a foreign stock exchange, the fund pays for it in that country's currency. The stock moves up or down in that currency. But when the fund calculates its return, it must do so in dollars. So, if the foreign currency is worth more in dollar terms than it had been when the fund bought the stock, the fund--and its shareholders--get a bonus. The reverse is true when the foreign currency falls against the dollar.

In 2006, this phenomenon had a tremendous impact on fund performance. In fact, much of the well-publicized outperformance of foreign markets and international funds in 2006 owed to the rise in the euro, pound, and many other currencies. The euro gained about 10% against the dollar and the pound 12%; among the major currencies only the yen, which was roughly flat against the dollar, failed to join the party.

Different Ways to Play
The simplest approaches to take are being fully unhedged and being fully hedged. Most international funds take the first approach, with Fidelity's funds serving as a prominent example. They just buy the stocks and let the currency do what it may. Of course, such portfolio managers do typically take into account currency effects when evaluating stocks; for example, a company that relies heavily on exports to the United States might find its prospects damped when the dollar is weak. But these managers don't actively try to alter the resulting currency exposure.

Very few funds take the opposite approach.  Tweedy, Browne Global Value (TBGVX) is one that does, hedging virtually all its foreign-currency exposure back into the dollar.  Longleaf Partners International (LLINX) essentially does the same thing, though rather than simply counting up the assets it has in foreign stocks and hedging that amount, it makes a calculation to determine the true economic exposure of its holdings to currency movements. The result is technically less than a 100% hedge, but in essence it removes nearly all of the fund's exposure to foreign currencies. Similarly, the Mutual Series funds, though not always completely hedged into the dollar, tend in that direction.

A third approach is for a manager--or an associated currency team--to make active currency plays in an effort to bolster returns simply through currency trading. Very few stock funds do that. Among the few that do is  Oppenheimer Global Opportunities (OPGIX)--although even in that case, the extent of its activity is far below the level of a hedge-fund-like currency speculator.

"Hedging to the Benchmark"
The variety doesn't end there. Putnam's international funds go in another direction--"hedging to the benchmark." The firm tries to separate a fund's stock picks from its currency exposure, but rather than thinking of an all-dollar position as meeting that goal, it prefers to have currency weightings that match the fund's benchmark. For example, a manager may like a number of Japanese stocks and therefore have a portfolio weighting of 30% in Japan--far above the MSCI EAFE Index's weighting of about 21%. But why, Putnam reasons, should the fund be so overweighted in the yen if its managers have no view on the yen? So, a separate Putnam currency team uses derivative securities to adjust the fund's yen exposure to about 21%. (Some Putnam funds allow the currency team to also make small "bets" above or below that benchmark number, but you get the idea.)

Yet another approach is more common than it may seem, because managers and fund companies tend to downplay it. That's the tendency to not hedge currency exposure, except in certain cases when they do hedge some currency exposure. Often (but not always) this takes place with emerging-markets currencies, because of the added potential of extreme volatility in such currencies. For example, at one point the managers of  Julius Baer International Equity (BJBIX) had a (relatively) quite large 5% stake in Turkish stocks but felt that the Turkish lira, for various reasons, was vulnerable. They didn't want to sell the stocks, which they liked and which aren't all that easy to buy and sell quickly. But they didn't want all that exposure to the lira either. So, they hedged that particular currency exposure into the U.S. dollar.

Meanwhile, at  Oakmark International (OAKIX), lead manager David Herro rarely hedges--but that doesn't mean he never does. In what he considers extreme cases when currencies are not fairly valued, he'll take action by adjusting currency exposure. When pressed, other managers who say they don't hedge will, after a moment, mention a time or three in the past when they have done so.

Staying Out of the Dark
Knowing your fund's currency policy can help you better evaluate its performance. For example, one reason Longleaf Partners International had such a lackluster 2006 return in comparison to rival funds is that it had so little exposure to the foreign-currency gains that were bolstering the returns of those rivals. It also can help you decide which fund to own. If you're looking for a foreign fund specifically to diversify your U.S.-heavy portfolio, you might prefer an unhedged fund in order to get currency diversification as well (although a "hedged to the benchmark" fund would also provide that).

In short, we don't think you should pick a fund based on where you think the dollar is going. Such predictions are too tough to make accurately with any consistency. But we do think that, as with other areas of investing, knowing what you own and how it is likely to perform under different conditions is preferable to being in the dark.