Investing abroad requires a good grasp of currency, market variables

MUTUAL FUNDS

September 04, 1994|By New York Times News Service

Investing overseas is a two-part equation: the stocks or bonds you bought must perform well, and so must the currencies of the country where they were issued.

This year has proved to be a good lesson in the second half of the equation. The currencies of Japan and Europe soared against the dollar, lifting the returns of mutual funds invested there that had not hedged currencies back to the dollar.

But when the dollar strengthens, unhedged funds could make money abroad in local market terms but lose when the profits are converted into dollars. Hedging would allow the same fund to earn the market return but would neutralize the currency component.

Currencies are "volatile and unpredictable," said Mark W. Headley, director of international investments for Litman/Gregory in San Francisco. But whether it pays to erase their impact from your portfolio "is a very gray area," he added.

Mutual fund managers fall into three camps. Some accept currency risk because currency movements cannot be predicted and hedging is a big distraction from picking equities or bonds. More important, some managers argue, currency movements are neutral over long periods.

A notable proponent of this view is John Templeton, who started the Templeton group, which is now owned by Franklin. "If you intend to keep stock 5 to 10 years," it won't matter whether currency goes up or down, because what you are buying is a share in a business," Mr. Templeton said, and what counts is the success of that business.

But even he has had second thoughts. Eight years ago when he bought shares in Cifra, a large Mexican supermarket chain, he wavered in his conviction not to hedge, he said, because he thought Mexico's currency would fall. It did, but the price of groceries outpaced the peso's slide, "and in terms of American dollars, the stock price went up to 20 times what we had paid for it."

By contrast, Mr. Templeton does hedge short-term equity investments, which he defines as shares held less than five years, because currency volatility does not have sufficient time to play itself out.

As for fixed-income investments, "If you invest in bonds, you need to hedge because changes in the currency will change the value of the bonds," Mr. Templeton said.

For example, because British bonds are denominated in pounds, the principal is repaid in that currency when the bonds mature in 10 or 20 years. If the pound is down against the dollar at payment time, investors will lose money.

Nearly all overseas bond funds hedge their investments. The sole exception is the T. Rowe Price Overseas Bond Fund, which normally has very little exposure to the dollar, making it the top-performing overseas bond fund -- down 1.7 percent in 1994 through July, compared with 5.5 percent for its group. "If one hedges bonds all the time," said George A. Murnaghan, a vice president at Price, "you increase the correlation of overseas bonds to U.S. bonds, factoring out the currency potential and losing some diversification."

Even so, the Price Overseas Bond Fund was hedged in 1992-93, up to its legal limit. "On the fixed-income side, hedging is a more complicated question than on the equity side," Mr. Murnaghan said.

Hedging is done with forward contracts or currency options. These have two costs: dealer expenses and premiums pegged to differences in short-term interest rates. The bigger the spread in interest rates between two countries, the bigger the premium; therefore, the more expensive it is to hedge.

Some equity fund managers like David Herro of Oakmark International accept currency risk unless there's a compelling reason not to. Mr. Herro has hedged since the fund's inception two years ago, for instance, because "the economic evidence suggests that the U.S. dollar is strongly undervalued."

To decide whether to hedge, Mr. Herro, a value investor, looks at the differential in short-term interest rates here and abroad, relative economic growth levels and "purchasing-power parity" differentials -- the costs of similar goods in various countries.

His analysis was confounded this year as the dollar fell, hurting the fund's performance. He recovered somewhat in mid-July as the dollar firmed, but Oakmark International is still down 1.5 percent through July, compared with +1.5 percent for all foreign stock funds.

The third camp, which includes some excellent fund managers, can't decide whether hedging pays off. "Very mixed feelings," is jTC the way Jean-Marie Eveillard, who runs Sogen International and Sogen Overseas, describes his position.

Mr. Eveillard, who did not hedge currencies for 14 years, began just over a year ago, as he increased his exposure to foreign

equities. "It's one thing if the portfolio is 10 to 15 percent invested abroad, but something else if it's 25 to 30 percent, particularly in Europe," where currencies are not pegged to the dollar.

(Many Latin American and Asian currencies are dollar-linked, making hedging unimportant -- except during turmoil when the link might break down.)

In fact, studies show that currency swings have little impact on performance when overseas investments account for less than 10 percent of a portfolio. So Mr. Eveillard hedged two-thirds of his exposure to European currencies and "at least since the beginning of this year, that's been wrong," he said. The portfolio is still hedged, "probably," he said, "because of sheer inertia."

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