Morningstar Advisor - Fall 2007 - (Page 42)

Spotlight: International Sound as a Loonie? By Dan Lefkovitz A little currency diversification goes a long way to curing the greenback blues. You’ve watched the dollar weaken for several years now. You’ve seen the value of some foreign mutual funds soar, in no small part because they hold securities denominated in appreciating currencies. Perhaps you’ve traveled to Europe and dropped $15 for a cappuccino. Now you’re wondering whether to shift assets out of the dollar. You could allocate more to foreign funds—only those that don’t hedge currency exposure, of course. But is it a good idea to be betting against the greenback? And even if it is, what’s the best way to get currency diversification? Hedged, Unhedged, or a Mix of Both? dollar. The fully hedged Tweedy, Browne Global Value TBGVX gained 23% in 1997, while the unhedged MSCI EAFE Index gained less than 2%. Tweedy beat 99% of its foreign fund peers. How times have changed. Tweedy has lagged its benchmark and most peers since 2002. Hedging has negated returns the fund could have earned simply by holding stocks denominated in strengthening pounds, euros, or Swiss francs. How much return? Consider that between mid-2002 and mid-2007 the unhedged version of EAFE gained an average of about 19% per year, while the hedged version gained roughly 14%. Because the trend in the fund world these days is to leave a portfolio’s currency exposure unhedged, most foreign funds are closer to 19% than they are to 14%. Fidelity, for example, has a policy of not hedging. Opponents of hedging say that it involves another layer of costs that eat into returns; it deprives an U.S. investor of currency diversification; and when done actively, it involves the tricky business of currency forecasting. Isn’t picking the right stocks challenging enough, ask the managers of unhedged funds? On the other side are the hedgers. Most of them, like Tweedy, Browne, are value investors. The hedgers say that they want returns to reflect stock-picking alone; they also argue that currency fluctuations introduce volatility, something they want to minimize. And they say that they don’t want gains to be eroded by depreciating currencies. It wouldn’t be fair to characterize the U.S. mutual fund landscape as polarized between a large group of unhedged funds and a few hedged ones. There are shades of gray. The managers of Longleaf Partners International LLINX, for example, determine how much of the portfolio to hedge by calculating its holdings’ “economic exposure” to currency. This recognizes the fact that many companies already hedge themselves. Morgan Stanley’s international value team hedges its currency exposure back to the EAFE benchmark index; so even if the portfolio overweights the United Kingdom, it won’t have more pound exposure than the EAFE. First Eagle and Mutual Series are two more value shops that start with a big hedge, as a means of limiting volatility, but will adjust the hedge based on their currency views. Indeed, many prospectuses give managers the freedom to hedge. One manager who takes advantage of this freedom is Frank Jennings, manager of Oppenheimer Global Opportunities OPGIX. Jennings, who holds a Ph.D. in currency economics, hedged his fund’s dollar exposure in 2005 and scored big when the dollar shocked everyone by strengthening. Watching the dollar’s fall against currencies like the euro, the British pound, and the Canadian dollar, lots of investors have become more aware of the useful role that currency diversification can play in a portfolio. Of course, currency diversification only seems like a good idea when the dollar is weak. And to understand how to get the benefit of diversification, you have to get a grip on currency hedging. Remember the 1990s, the era of the strong dollar? Back then, it was common for funds to hedge away their foreign currency exposure using various financial instruments. After all, an unhedged portfolio was exposed to currencies that were weakening against the 42 Morningstar Advisor Fall 2007

Table of Contents Feed for the Digital Edition of Morningstar Advisor - Fall 2007

Morningstar Advisor Fall 2007 Features Departments Letter from the Editor Inbox 10 Years After: Developing Markets Make Progress Research Briefs Investors Should Adjust Their Home Bias Few Mutual Funds Exhibit Serial Correlation Valuating ETFs, the Equity Analyst's Way It’s All About Location See the World (Differently) The Return of the Global Flexible Investor Map of International Value Sound as a Loonie? Fair Exchange In Their Own Worlds A Good Read Putting Their Heads Together Buying Protection Scoping Out Easy-to-Use Funds Finding Good Stewards Consumer Firms Go Global Mutual Fund Analyst Picks Undervalued Stocks Most Popular Variable Annuities New at Morningstar The Whole Wide World

Morningstar Advisor - Fall 2007

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