To Hedge or Not to Hedge?

When glancing at the currency exchange rates, some of us may think back to happy times when the strong greenback allowed us to shamelessly order the most expensive pasta dish on the menu while in Rome. More recently, perhaps, we've sheepishly ordered tap water and skipped dessert at a Parisian bistro.

Putting travel dining aside, currency movements also affect your foreign holdings, for better or worse. So it's important to understand whether your funds' strategies incorporate currency hedging and what that can mean relative to the other mutual funds in your portfolio.

To illustrate, if a portfolio manager allocates 50% of a fund to Japanese stocks, then 50% of the fund's gains or losses will be yen-denominated. If the yen appreciates after the manager buys a Japanese stock, the fund's shareholders reap the extra gain. If the yen sinks, well, then shareholders take that loss on top of any movements in the stock price. However, that may not always be the case. If the portfolio manager hedges that yen exposure back to U.S. dollars through forward contracts or currency options, this takes the effect of the yen's movements out of the picture. It's rather hard to find these funds, but some managers may hedge away 100% (or almost all) currency exposure. Mutual Series and Tweedy Browne are examples of fund shops that have fully hedged funds.

Looking at the other side of the coin, most fund managers that invest abroad leave their currency exposure unhedged. Such is the case at Fidelity, so the funds' performance is driven in part by the strength or weakness of the Euro, Loonie (Canadian dollar), rupee, yen, yuan, etc. And managers with long-term investment horizons might not see any reason to hedge as currency movements tend to cancel each other out over the long run.

Otherwise, some managers make active currency plays with a certain portion of their portfolios' assets. In making a hedge, managers might examine things like short-term interest rates in the U.S. and abroad, economic growth levels, and how much comparable goods cost in two countries through purchasing power parity differentials. Foreign fund managers from Artisan, Julius Baer, and Oakmark have engaged in this type of hedging, in some cases focusing on hedging away currency exposure from emerging-markets countries, as it tends to be more volatile.

In short, the hedging strategies of fund managers fall into three camps: unhedged, partially hedged, and largely or fully hedged. Each of the three approaches has its own strengths and weaknesses. With that in mind, we thought it would be worthwhile to go over one prominent fund from each camp to help illustrate the pros and cons of each method.

 Mutual European (TEMIX)
Philippe Brugere-Trelat has run this Europe stock fund mostly hedged to the U.S. dollar since taking over mid-2005--the fund was 92% hedged as of June 2008. He inherited a solid fund from his predecessor, David Winters, whose strong stock-picking was further boosted by the greenback from 1999 through 2000 and during 2005. However, in 2006 the dollar fell against the Euro, offsetting some of the good stock selection. This fund's return of 26% for that calendar year, while impressive on an absolute basis, trailed nearly 90% of its Europe-focused peers.

Brugere-Trelat's cautious approach comes through in his knack for picking up stocks that look like bargains based on the firm's ability to generate strong cash flows. That has helped keep volatility down over the years, but so has management's policy of hedging away most currency exposure. Over the past 10 years, this fund has been the least volatile option in the category. Management's reluctance to try to predict currency movements by taking hedges on and off reflects their long-term outlook.

 Fidelity Spartan International Index 
The weak dollar means that unhedged funds have had the advantage in recent years, since the low interest-rate environment and sluggish economy in the U.S. have led investors away from the U.S. dollar and into stronger currencies. And so it's important to look at unhedged funds with a critical eye as the managers might temporarily appear more skillful than they are.

Fidelity Spartan International Index is a foreign large-blend offering that tracks the MSCI EAFE Index, and as it remains 100% unhedged, it has exposure to a whole host of currencies. To see when it's been advantageous to be unhedged to currency exposure, it's helpful to compare this fund's performance over the past 10 years with the returns of the MSCI EAFE Index returns in its local currencies. The latter approximates the returns of this index in a fully hedged form. The U.S. dollar's strength in 2005 shows through in the 29% return of this bogy for that calendar year compared with the unhedged Fidelity fund's 14% gain. And in all other calendar years since 2002, the unhedged mutual fund's returns trounced those of the fully hedged proxy.

One of this fund's advantages is its razor-thin expense ratio of 0.10% annually. That price makes it one of best bargains in the realm of foreign funds, and it's simply a good choice for investors who prefer the relatively less volatile returns provided by an index-tracking offering.

 Oppenheimer Global Opportunities (OPGIX)
In this case, the manager makes active currency bets, but that doesn't mean that the portfolio always has a hedge on its foreign currency. Here, the speculative nature of this type of strategy means that proven managers are a must. Manager Frank Jennings has run this world-stock fund for more than a decade, and he brings his experience as an international economist to the table. Over the years he's invested based on top-down calls and no asset class is off limits. His decision to partially hedge the fund's Euro and pound exposure towards the end of 2004 paid off handsomely when the U.S. dollar strengthened in 2005.

Remember that active currency bets can just as easily backfire. So a manager with a proven long-term record is a must when it comes to choosing a strategy that incorporates active currency hedging. In this case, Jennings' long-term record is hard to argue with. The fund's trailing 10-year annualized returns of 10.4% handily outpaces the typical fund's 5.8%. In return, investors have had to deal with some pretty scary performance swings--this fund has been one of the most volatile world-stock funds over the past 10 years.