Foreign-Currency Risk: To Hedge or Not to Hedge?

For U.S. investors who own foreign stocks, bonds, and funds, these are anything but dull days. As if the tepid performance of foreign markets relative to the U.S. in recent years wasn't enough to consider, they now must factor in currency differences to an even greater degree than normal.

The dollar recently hit a 12-year high against the euro and an 8-year high against the Japanese yen and has been strengthening against many emerging-markets currencies as well. This may be good news for U.S. investors planning to travel abroad as their dollars will now stretch much further, but for those owning foreign stocks and bonds, especially those denominated in local currencies that have weakened relative to the dollar, it offers little reason to celebrate.

The question of whether to hedge currency risk when investing overseas is constant, of course, but perhaps more relevant now than it's been in years. Some foreign funds hedge against currency risk but others don't, seeing it as an opportunity to add another potential driver of total return.

Last week, we asked Morningstar.com readers on our International Investing discussion board whether they factor currency issues into their foreign-investing plans, either by buying funds that do the hedging for them or by hedging on their own. You can read the full conversation here.

Hedging Gets the Edge Many readers said they prefer to own hedged foreign funds so that they don't have to worry about currency fluctuations eating away at their gains.

A reader named closer said hedged foreign funds make up part of his or her portfolio and that he or she has been keeping close tabs on events in Europe in particular.

"Ever since the financial markets started pricing in the European Central Bank's bond-buying program, I started paying closer attention to the impact of foreign currencies, especially the euro, on my portfolio," said

closer

. "When it comes to bonds, it has been hard to beat some of PIMCO's funds, especially

For reader Darwinian, avoiding currency exposure is about avoiding a bumpy ride.

"The purpose of my bond funds is to suppress volatility, so I don't intentionally patronize bond funds unless they are restricted to dollar-denominated bonds," he wrote. "I also expect unhedged international equities to be more volatile. I hold sufficient allocations of these to add diversification, but not enough to significantly increase my overall portfolio volatility."

BMWLover said he sees opportunity in the current state of affairs, but only up to a point.

"I'll probably hold off on a couple of planned purchases to see if the rising dollar has a negative impact on the stock's price," he said. "I am also looking to Europe for potential buying opportunities as the trend in currency valuations will make for favorable buying conditions for the foreseeable future. That said, the currency issues are secondary to finding a solid company with good fundamentals to invest in."

Leaving It Up to the Manager Several readers mentioned that they like to leave the question of whether to hedge currency risk up to their fund managers.

"I am a long-term holder of

vandy73

. "I see hedging as a normal business activity, similar to, say,

Moatster said he or she prefers that a fund manager have the flexibility to hedge currency risk when appropriate.

"As [the band] Rush said in a song many years ago, 'if you choose not to decide, you still have made a choice.' The same goes for the impact of currency on foreign investments," the commenter wrote. "All else being equal, which it almost never is, I'd rather have a fund with the ability to hedge when the manager thinks it's a good idea."

In some cases, readers said they've only recently begun hedging against currency risk in their foreign holdings.

Mwleach was among those new to hedging currency risk. "The funds I have that invest in foreign stocks are all unhedged, and I have always preferred it that way," he said. His stance actually proved somewhat favorable, off and on, for decades, but not so much in recent years. "The dollar [is] running strong now, but I suspect that will one day change again."

And count erryl in the new-to-hedging camp as well.

"Normally, I don't take currency into account with my foreign investing," the commenter said. "For many years, currency fluctuations have been a net tailwind for foreign investing. Currently, all or at least most of the reasons for a weak dollar are surging in the opposite direction. I think there are good reasons to believe that Europe is now beginning to take the course that the U.S. has just gone down with quantitative easing, which seemed to improve the economy, weaken the dollar, and stimulate the stock market. Therefore, to invest significantly in Europe right now, I would hedge that investment against a weak euro."

For at least one soon-to-be-retired reader, garrettvandrews, currency considerations may lead to some tough choices.

"I loathe trading and have been aggressively international in a very few low-cost, no-load, unhedged, mostly actively managed mutual funds for years. I have done well but currency themes had no role in my decisions," he said. "However, I will be retiring soon and in a few years I will begin regular withdrawals from my IRA, 401(k), 403(b), all of which contain the above-mentioned unhedged international funds. That changes the entire ballgame, no? To the extent currency is unpredictable yet seriously affects total return, I might best selectively withdraw from any funds demonstrating a strong currency tailwind contributing to a very good total return. The likelihood of those two 'planets' remaining favorably aligned diminishes over [a] short time."

Meeting Somewhere in the Middle Of course, hedging against foreign-currency risk needn't be an all-or-nothing proposition, as skipperchg pointed out.

"I regard dollar-hedged foreign funds as an interest-rate play; nonhedged funds are a currency play," the commenter wrote. "I see that as two separate diversifications. I am a long-term investor in

A few readers said they decide whether to hedge currency risk based on current conditions. One, km0010, described the method he or she uses.

"I look at the relative returns of hedged and unhedged portfolios at various short-term periods and whether the price is above its 250-/200-/100-day simple moving averages," km0010 said. "For the long term, I like a 33% currency hedge. I've been convinced by Tweedy, Browne and FMI's arguments for hedging because they are investing in companies but not in the currencies. And, as several historical studies have shown, being exposed to foreign-currency movement doesn't really give you much in terms of higher returns, but you are very likely to increase your portfolio's volatility. ... However, being exposed to foreign currency increases your diversification as well. And it costs extra money to hedge that currency exposure. So, given both arguments for and against, I think doing both is reasonable."

In Favor of Currency Diversification While hedging away currency risk may be popular, at least for now, there also were those readers who argued in favor of the diversification benefits provided by the unhedged approach.

A comment left by audreyh1 was typical of this group.

"My international investments give me currency diversity as well as non-U.S. asset diversity," she said. "To me that's part of their benefit in my portfolio." She later added, "I actually do want the currency volatility as I rebalance my portfolio and volatility equals opportunity (if it is not so extreme as to be scary). Plus, hedging introduces costs."

FLstategrunt said he doesn't hedge for his stock holdings but holds both hedged and unhedged bond funds.

Another reader, newhandle, seemed unconcerned about the whole hedging issue.

"I don't invest in something I don't understand and to the degree my funds do take this into account, I have to leave this to the professionals," the commenter said. "Also, I have learned for me it's better to just keep my allocations and ride these things out."

Of course, whether to hedge against currency risk, like so many other decisions in investing, often comes down to the investor's time frame, as reader RetiredInvestor reminded us.

"I agree with newhandle and don't factor in currency in the near term," RetiredInvestor wrote. "My portfolio is invested for the long term, well over 10 years, and I can absorb some volatility in the short term. I invest in solid managers and let them worry about currency plays."

Some comments have been edited for clarity and brevity.