Investors poured more than $50 billion into global bond funds over the past five years on a compelling sales pitch: higher yields and lower risk from spreading their investment around the world. And with the dollar on a long-term decline, global bond funds should have beat the domestic variety hands down, since many foreign bonds were denominated in appreciating currencies.
But most of the funds failed to deliver the goods. World bond funds on average performed only about as well as domestic bond funds in the five years ending Feb. 28, according to Morningstar Inc. In part, their returns were undercut by losses in Latin American and other emerging-market debt. But even those that stuck to higher-quality issues didn't make the gains that investors might have expected.
What happened? The dark little secret is that most of these funds hedged foreign currencies back into dollars when they should have held onto marks and yen. Hedging, says Mark W. Riepe, vice-president of Ibbotson Associates, an investment consulting firm, "turns your foreign bonds into a portfolio of synthetic U.S. bonds. We generally don't recommend hedging currency exposure." The best-performing world bond fund for the past five years is the unhedged T. Rowe Price International Bond Fund, with an average annual return of 12%, as opposed to 8% for its peers.
RALLYING. The dramatic plunge of the dollar that began in 1994 is highlighting the gap between the funds that hedge and those that don't. Last year was disastrous for bonds, as interest rates rose everywhere. But funds that bought bonds denominated in appreciating currencies--and left them unhedged--weathered the storm well. Franklin/Templeton German Government Bond Fund delivered 9.6% in total, vs. -8.2% for the average world bond fund. Other unhedged bond funds--State Street Research International Fixed Income C, Benham European Government Bond Fund, and T. Rowe Price International Bond--were more diversified and had lower returns (table).
So far this year, bonds are rallying, and so are many of the hedgers' funds. But the unhedged funds are making the biggest gains of all. Even so, many of them remain small and undiscovered. The German government bond fund, up more than 12% so far this year, has less than $20 million in assets.
The falling dollar is also boosting foreign currency funds, but they, too, labor in obscurity. Like U.S. money-market funds, they buy very short-term securities. Franklin/Templeton Hard Currency Fund, up 15% in 1994 and 8% this year, has only $115 million.
Fidelity Investments runs three pure foreign currency money-market funds--in marks, yen, and sterling--yet does not put any of its classic marketing oomph behind them. The three funds together have only about $30 million. "We have them as a convenience to sophisticated investors," says Scott Kuldell, who manages the currency funds. "We don't want a lot of people in these funds who don't understand the risks." Perhaps so. But when it comes to volatility, the currency funds have less than half that of Fidelity Select Precious Metals & Minerals. And the currency funds have done a better job of protecting investors from inflation than gold funds.
NO REGRETS. Then why haven't U.S. mutual-fund investors figured this out? "People think that currencies are risky and should be avoided," says Donald P. Gould, who started the currency and German government bond funds and then sold them to Franklin/Templeton. "Individually, these funds are volatile. Putting them in a portfolio of funds does not add to investors' total risk."
Fund managers know that but hedge anyway to avoid having to explain a currency loss to shareholders. That could happen if the dollar rallies. "Strategically, we're bears on the dollar," says Mark Turner of the Putnam Global Government Income Fund. "But we're hedging now because of the extreme valuation in the yen and mark." Adds Gary P. Brinson of Brinson Partners Inc., a global money manager: "A hedge is insurance. I don't regret having bought fire insurance if my house doesn't burn down."
Yet even Brinson admits that long-term investors who can stomach price swings will be better served by leaving their currencies exposed. As long as the dollar remains under pressure, that will certainly be the case.
Funds that Ride the Falling Dollar
FUND TOTAL RETURN* 1995** 1994 1993 BENHAM EUROPEAN GOVERNMENT BOND 10.1% 1.5% 14.9% FIDELITY DEUTSCHE MARK PERFORMANCE 10.5 16.4 1.2 FIDELITY YEN PERFORMANCE 12.1 12.6 13.1 FRANKLIN/TEMPLETON GLOBAL CURRENCY 4.5 8.1 6.0 FRANKLIN/TEMPLETON HARD CURRENCY 8.0 15.0 4.7 FRANKLIN/TEMPLETON HIGH-INCOME CURRENCY 4.1 10.2 -2.6 FRANKLIN/TEMPLETON GERMAN GOVT. BOND 12.1 9.6 5.2 T. ROWE PRICE INTERNATIONAL BOND 8.7 -1.8 20.0 STATE ST. RESEARCH INTL. FIXED-INCOME C 10.8 4.3 13.6
*Appreciation plus reinvestment of dividends and capital gains, before taxes **Through Mar. 21