Declining Dollar Forces Funds to Make Tough Choices

Among the many concerns over the possibility the U.S. government would default on its debt was that the U.S. dollar would tumble. Or, rather, it would tumble further. The dollar already has spiraled downward against most currencies this year.

That's nothing new. The greenback often has fallen (or put another way, foreign currencies have climbed) over the past several years. At certain points, though, that process went sharply into reverse. How have fund managers responded to such currency shocks?

Many international funds never adjust their currency exposure. The managers confine their thoughts to evaluating how currency movements will affect the companies they own or are thinking of buying. But other managers do have the freedom to make direct currency moves. So, they must decide whether to "hedge" their funds' foreign-currency exposure into the dollar--and if so, which currencies to target, how much of each to hedge, and how long to leave that play in place.

More Common Than It Used to Be
Not long ago, nearly every international-stock fund was unhedged. Fund shareholders wanted the foreign-currency exposure, the thinking went, and managers could stay out of the dicey game of currency prediction and stick with their specialty, evaluating companies. What's more, buying the contracts to hedge currency exposure cost money. For all these reasons, many international funds still refrain from taking any currency positions.

What seems to have changed some managers' minds, though, is the extent and duration of the dollar's long-term decline as well as the increasing volatility in currency movements. These fluctuations can have a meaningful impact on the returns of U.S.-based international funds. In the past few years, therefore, more funds have at least occasionally hedged part of their foreign-currency exposure into the dollar.

How Three Funds Are Handling It Now
Created in May 2001,  Dodge & Cox International Stock  (DODFX) stood for most of its history in the "never hedge" camp. It hasn't drastically changed that approach, but a few years ago it shifted in practice to "will hedge in rare circumstances." Its managers hedged the fund's exposure to the euro and the British pound in late 2007 when those currencies traded at what the managers decided were unsustainably high levels. (The pound fetched more than $2 at that point.) For a few months these moves worked against the fund, but the managers were soon proved correct. As the euro and pound sank back to their historical ranges, the managers removed the hedges.

Recently the fund dove back into the currency-hedging waters. In this year's second quarter, the managers hedged the fund's exposure to the Swiss franc, which has shown remarkable strength as global investors have looked askance at both the euro and the U.S. dollar because of the financial, political, and economic woes afflicting their respective regions. One of Dodge & Cox International's managers, Diana Strandberg, told Morningstar recently that the Swiss franc had appreciated so much against the dollar that it had gone far beyond what could be considered a normal range. They expect it to fall back to more-typical levels against the dollar at some point. (Swiss stocks made up about 10% of the fund's portfolio at the end of June, so this isn't a trivial concern.)

Protecting against a sharp fall in the Swiss franc seems prudent. The risk in hedging against any currency, however, is that the currency will continue to climb. And that's what has happened so far. Since the managers have installed the hedges, the Swiss franc has continued to soar. It's very likely that the hedge has resulted in a loss so far. But the effect probably hasn't been large: Strandberg emphasized that the managers have not hedged the entire position. She added, though, that they stand ready to take further action if conditions warranted. It wouldn't be surprising if the amount of that hedge had increased in July as the Swiss franc has climbed even more.

 Oakmark International's (OAKIX) David Herro has been hedging to an even greater extent in recent years. And now, unlike Dodge & Cox, which has restricted its hedging to one currency for now, Herro is spreading his bets widely. At the end of the second quarter, he had hedges on the Swiss franc, Australian dollar, Japanese yen, Swedish krona, and euro. The amounts ranged from 72% of the franc exposure--the highest level reported in the past few years of the fund's near-continuous franc hedging--to 20% for the euro. Only the euro hedge was a new position; the others were of longer standing.

As with Dodge and Cox, those hedges could prove beneficial down the road but so far have almost certainly held back returns this year. Sibling  Oakmark Global (OAKGX), which has similar currency positions on a smaller portion of the portfolio, are more specific than Herro on the exact effect, reporting that Global's hedges cost the fund about 1 percentage point in returns in the second quarter of 2011.

Similarly,  IVA International's  managers concede that their hedges worked against them in the second quarter. That fund's managers, for whom partial hedging has long been standard practice, have currency hedges on against the yen, euro, pound, Australian dollar, and South Korean won, in amounts ranging from about 50% of the position (yen) to 19% (won). The Swiss franc is missing from that list, so the fund's small Switzerland position, 3.9% of assets at June's end, received the full benefit of the franc's stunning appreciation. That currency is up about 15% versus the dollar for the year to date.

Not a Tip Sheet
This review is not intended as a guide for individual currency trading. Even those who want to make currency bets--a difficult game to win, as many experts who've been stung over the years can attest--should note that these managers don't necessarily hold the positions outlined above at the present time. And even if they do, they can shift or reverse them at any time without providing notice until the end of the reporting period.

Therefore, the moves presented here merely offer an indication of how a few prominent managers are handling a challenging issue. Hopefully this review provides insights for all readers who own international funds and who might now be inclined to inquire how their own funds are handling currency questions. Many readers will have a more personal interest; each of these funds is widely owned. And knowing how funds are positioned is the best way to know what to expect and avoid surprises.