Are Mutual Funds Losing Faith in the Dollar?

• By Gregg Wolper
• On 7:00 am EDT, Tuesday October 6, 2009

For years, one of the easiest questions for a Morningstar fund analyst was, "Which foreign-stock funds consistently hedge all of their currency exposure into the dollar?" The answer usually surprised the questioner. Leaving aside small or obscure funds or index-linked offerings, only three funds fit that description: Mutual European (NASDAQ:MEURX - News), Longleaf Partners International (NASDAQ:LLINX - News), and Tweedy, Browne Global Value (NASDAQ:TBGVX - News).

Now that number has shrunk even further. Why?

Rumblings from Below
Most international-equity funds are completely unhedged. Portfolio managers buy their stocks--usually directly on foreign stock exchanges using foreign currency--and that's that. As a result, the portfolio's returns are fully exposed to the movements of those foreign currencies. The managers typically explain that their shareholders prefer that arrangement, saying that they own the fund not only to diversify into foreign stocks, but into foreign currencies as well.

Two weeks ago, Longleaf Partners International joined this crowd, announcing it would drop the currency-hedging strategy that it had maintained since its 1998 inception. Once its current hedging contracts expire, the fund will be completely unhedged. (Technically, the fund has only hedged the portfolio's "economic exposure" to foreign currencies, rather than simply installing a 100% hedge, but the bulk of the portfolio was always hedged.)

Staley Cates, one of Longleaf International's managers, told Morningstar he and his colleagues made the change because shareholders overwhelmingly had voiced their preference for an unhedged approach. They either wanted full exposure to foreign currencies, or they wanted to make the hedging decisions themselves.

Like Longleaf International, Tweedy, Browne had always fully hedged the economic exposure of its Global Value fund. And it had always made clear that it believed in the advantages of that approach. Last week, though, a Tweedy official told Morningstar the firm would bring out a new fund, identical to Global Value except that it will be unhedged. The original hedged Global Value will continue to operate as is. So in this case, investors will be able to choose whichever version they prefer.

Tweedy officials essentially gave the same reason as Longleaf for this move: More and more shareholders wanted the option of an unhedged portfolio, fully exposed to foreign currencies.

It's worth noting that this won't be the first unhedged Tweedy foreign fund. Tweedy, Browne, Worldwide High Dividend Yield Value (NASDAQ:TBHDX - News), which appeared in September 2007, started out hedge-free and remains that way.

Not a One-Way Trend
These moves by well-established firms that had long taken the hedged approach might make it appear as if there's a broader trend away from hedging--or a trend away from the dollar--among international-stock mutual funds. The reality is more complicated. Not long ago, in fact, we saw the opposite movement. In 2007 and early 2008, at times when the greenback seemed extraordinarily weak, a number of funds that typically didn't worry about adjusting their currency exposure instituted substantial (albeit temporary) hedges into the dollar. Oakmark International (NASDAQ:OAKIX - News) and Dodge & Cox International (NASDAQ:DODFX - News) were prominent examples. For the Dodge & Cox fund, the move into the dollar was the first time it had taken such a step.

It's much too early, therefore, to conclude that equity mutual funds in general are souring on hedging of any kind.

Performance-Chasers?
That said, it's true that aside from brief runups like the one experienced late last year, the dollar has been broadly in decline for years, and many astute observers expect that long-term trend to continue. Neither Longleaf nor Tweedy mentioned that as a reason for their decisions. There's no reason to think it did play a direct role, either. After all, it would be tough to think of many fund shops less likely than Longleaf or Tweedy to make important investment decisions based on a current trend or popular consensus.

That doesn't mean, though, that the dollar's long downward trend (including a recent decline in 2009) didn't account at least partly for the clamor the firms heard from shareholders in favor of an unhedged approach. In most recent years, these funds' returns would have been stronger, sometimes substantially so, had they been reaping the benefit of foreign-currency gains like most of their rivals.

It's hard to criticize shareholders--or their advisors-- if such thoughts entered their minds when asking for a change of policy. On the one hand, it's always risky to assume that past or current trends will continue well into the future. The chances of getting in at the wrong time are great. On the other hand, the case for a long-term decline in the dollar's value does have reasonable arguments behind it. That doesn't mean it will happen, but at least the case isn't as flimsy as it typically is for apparent trend-chasing ideas, such as the view that a new invention or development will justify absurdly high prices for certain types of stocks.

Conclusion
Investors who still want to own foreign stocks without taking on the currency exposure can still buy Tweedy's original Global Value, or Mutual European. (Other funds from Mutual Series, such as world-stock fund Mutual Discovery, also hedge most of the foreign part of their portfolios.) A small fund that combines index-tracking with complex bond strategies, PIMCO International StocksPLUS TR Strategy (U.S. Dollar Hedged) (NASDAQ:PIPAX - News), also offers (mostly) hedged foreign-stock exposure.

Think twice before deciding you want all your foreign exposure hedged into the dollar, though. One doesn't have to fully subscribe to the "long-term decline" theory to feel a bit uncomfortable having everything one owns, and everything one earns, based in dollars. After all, the worth of that currency will continue to change every day based on factors that are usually difficult to predict--and often even more difficult to explain or understand.

Gregg Wolper does not own shares in any of the securities mentioned above.

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