As the U.S. dollar continues to surge against most global currencies, financial advisers face three basic paths for navigating the punishing effects on international investments: Ignore it, get out of international markets or get busy hedging.
While the third option might sound like the most challenging, it is actually easy and available in several accessible forms, including mutual funds that do all the work for you.
For an illustration of how the dollar's recent strength is hitting U.S. investors, consider the ready-made example of two funds from Tweedy Brown Co.
Since the start of the year, the $453 million Tweedy Brown Global Value Unhedged Fund (TBCUX) has gained 2.4% through March 23. Over the last 12 months, it's down 1.4%.
But the $9.4 billion Tweedy Brown Global Value Fund (TBGVX), which actively hedges out the currency exposure, is up 4.6% this year and 6.6% over those same 12 months.
Source: Morningstar Inc
Until recently, the global currency differential wasn't something financial advisers or investors had to worry much about. But as the Federal Reserve continues to move counter to most global central banks — which are generally doing things that deflate their currencies — the dollar is soaring.
According to published reports, the dollar's run over the past eight months has been faster than at any point in the past 40 years.
The reason a runaway greenback hurts U.S. investors in international markets is that portfolio managers have to convert to local currencies to buy securities while the portfolio is priced daily in dollars.
MOST MANAGERS DON'T HEDGE
The majority of global mutual fund managers do not hedge currency exposure, which means the performance of the underlying securities will increase or decrease in proportion to currency moves.
“I think it's always important to hedge currencies, but now more so than ever,” said David Marcus, manager of the $273 million Evermore Global Value Fund (EVGIX).
“We're stock pickers and we're over 60% invested in international developed markets, so if I don't hedge, I feel like I'm making a currency call,” he said. “I don't want to fight against the currency, so I kill it by doing forward contracts on the whole portfolio's exposure to the currency.”
Mr. Marcus claims he is not trying to play the strong dollar so much as he is trying to neutralize the dollar's soaring separation from other currencies.
The Evermore fund is up 10.7% so far this year, compared with a 5.5% gain in its benchmark MSCI All Country World ex-USA Index, and a 4.6% gain for the world stock fund category, as tracked by Morningstar Inc.
Source: Morningstar Inc
While it is not easy to find the select few international mutual funds that are actively hedging currency exposure, Todd Rosenbluth, director mutual fund and ETF research at S&P Capital IQ, said a good place to start is by looking for recent outperformers.
Such a search fleshed out the $11.7 billion Thornburg International Value Fund (TGVAX), which has gained 9.6% since the start of the year.
Tim Holsworth, president of AHP Financial Services Inc., is a financial adviser who has been actively seeking out funds that can help his clients avoid the growing currency mismatch.
One of the funds that hit his radar is the $1.8 billion Deutsche Croci International Fund (SCINX), which is up 11.1% so far this year.
“It seems to me almost nobody is addressing this issue,” he said.
Mr. Holsworth added that the currency issue has some of his clients wanting to move entirely out of international funds, at least for now, but he is trying to convince them to stay diversified by using currency hedged international funds.
His new challenge is swapping out funds to get a manager who hedges currencies.
“As we move into international funds that hedge currencies, we might be giving up a better manager, but time will tell,” Mr. Holsworth said.
One reason more international funds don't hedge might have something to do with the pursuit of relative performance. Since benchmarks aren't hedging out the currency exposure, most of the funds are able to keep up without making the extra effort to avoid currency exposure.
“We're more absolute investors, and we want to beat the benchmark and protect our clients' money,” said William Fries, co-manager of the Thornburg International Value Fund.
“If you don't have the flexibility to hedge the currency you can be victimized by it,” he added.
Of course, you can also be victimized by hedging the currency, which is something that would show up in a sudden reversal by the dollar. In that case, benchmarks and the non-hedged portfolios would benefit from the currency exposure.
For advisers ready to roll up their sleeves in the world of currency hedging, some ETFs offer currency hedges to foreign equity markets.
The iShares Currency Hedged MSCI EAFE ETF (HEFA) has gained 12.5% this year and 21.7% over the past 12 months. Meanwhile the unhedged version, iShares MSCI EFA ETF (EFA), gained 8.5% this year and 4.8% over the past 12 months.
Similar exposure to Japan can be gained through the iShares Currency Hedged MSCI Japan ETF (HEWJ), which is up 14.1% this year, and 39.7% over the past 12 months. The unhedged version, iShares MSCI Japan ETF (EWJ), gained 14.5% this year, and 19.8% over the past 12 months.
“In theory, you could own both the hedged and unhedged ETFs and just tweak the exposure based on how you feel about the currency markets,” said Mr. Rosenbluth.
Most advisers would probably be better off leaving those kinds of moves to the portfolio managers, assuming you can find one that is hedging currencies.