The Guessing Game Called HedgingToddi Gutner
U.S. investors in the Warburg Pincus Japan OTC and the DFA Japanese Small Company funds were taken on a roller-coaster ride last year. In the first half of 1995, the Warburg Pincus fund plummeted 24.61%, and the DFA fund fell 16.19%. Warburg Pincus rebounded the following six months, up 31.22% from July 1, and DFA bounced back with a 15.06% gain. Behind the dramatic difference in results between the funds: currency exposure.
While stock performance alone rules returns in domestic markets, international investing is subject to both share-price movement and changes in how strong or weak the dollar is relative to other currencies. When, for example, a U.S. mutual-fund manager buys shares of a Japanese company on the Tokyo Stock Exchange, he or she must first convert the fund's dollars into yen at the going exchange rate. Say that over the next year, the stock price stays the same, but the yen weakens against the dollar. Suppose, too, that the manager sells the shares for yen and then converts them into dollars. Those yen buy fewer dollars than before. So investors lose money even though the stock price didn't change. If in the same scenario the yen had strengthened, the Japanese currency would buy more dollars, and U.S. fund holders would profit.
LOST REWARDS? Portfolio managers can limit currency exposure by hedging. Such a strategy employs futures and options to protect a foreign investment from the negative impact of a rising dollar. Trouble is, if the dollar falls relative to the yen or German mark, for example, then a hedged investor has reduced returns.
That's what happened to the 100%-hedged Warburg Pincus fund in the first half of 1995. Japanese equities were declining, so the fund did worse than the fully exposed DFA fund because it didn't have the stronger yen to offset stock losses. While it's true that Warburg Pincus rebounded more than DFA in the second half, most fund managers hotly debate the hedging issue and would argue that aggressive use of the technique reduces potential gains from currency exposure over time. "We look at currency risk as part of the opportunity of overseas investing," says Mark Mobius, a portfolio manager for the Templeton funds, which have a policy of never hedging. In fact, of the 189 international and global equity funds that Morningstar tracks, only 24 hedge consistently. Members of that minority offer similar reasoning for bucking the trend. Says Christian Wignall of G.T. Global funds: "We think we can add value with hedging."
That's no easy feat, though. The biggest risk is that an ill-timed hedge could backfire. "Hedging is a guess about currency movements, and usually you're wrong," says George Murnaghan, executive vice-president at Rowe Price Fleming, the international arm of T. Rowe Price. In 1994, GAM Europe fund hedged against an anticipated decline in the German mark. When the mark went up instead, it lost more than 3%, compared with a 3% gain for European funds overall.
Hedging also has a monetary cost, which includes transaction fees as well as the short-term interest-rate differential between the two countries. One note: It is best to hedge against a currency of a country whose interest rates are less than those of the U.S. Of course, hedging costs then have to be covered by increased returns. What's more, many foreign multinationals whose stocks these funds invest in, such as Unilever and Nestle, are already hedged against currency swings. "You may be working at odds with these companies," notes Mobius.
Investors also need to realize that currencies move in cycles. That's one reason investing overseas should be for the long term--at least three years. So ultimately, currency swings shouldn't matter. Avi Nachmany, research director at Strategic Insight, a mutual-fund consulting firm based in New York, reports that the dollar is at a 25-year low against the yen and European currencies. With a weak dollar, why hedge?
MARKET TIES. Keep in mind that when it comes to global investing, moderation is the key. "While you don't want a lot of currency exposure, you do want some to diversify your portfolio," advises Andrew Lohmeier, Morningstar's foreign currency analyst. As global financial markets are increasingly linked, currency movements become more important because they act independently.
Despite the drawbacks of hedging, circumstances can warrant the tactic occasionally. A specific event taking place overseas might propel a manager to make a short-term currency bet. Right now, for example, Justin Scott, manager of Putnam Europe Growth, is 30% hedged in Europe. He believes that some currencies may be excluded from the European Monetary Union. "That will pressure them to fall," he says.
Perhaps the best advice for investors is to pick international funds that limit their hedging. To find out about the policy, call the fund company or manager for clarification. And if you won't feel comfortable unless you have no currency risk at all, overseas investing may not be for you.