WITH INFLATION FEARS

mounting, the Federal Reserve is under pressure to somehow boost the greenback when it meets next week. That could mean a dollar rally is in the offing, which raises a question for investors in international stock funds: To hedge or not to hedge?

For the past several years, U.S. investors have looked abroad in search of better returns. And they've gotten them thanks in part to the rise of other countries' currencies. In just the last two years, $392 billion has gone into international stock funds whereas $5 billion has left U.S. stock funds. But if or when the dollar rebounds, as many on Wall Street think it needs to in order to tame rising oil prices, many of these funds could take a hit. This is because U.S.-based funds have to calculate their returns in dollars, although foreign stocks rise or fall in their own currencies. If a country's currency is worth less in dollar terms than it was when a fund bought a particular stock, then the stock's returns will be lower in dollar terms as well.

"Some investors were attracted to international funds because of foreign currency gains, which were rising sharply over the past few years. Whether or not that continues is anyone's guess," says Morningstar analyst Gregg Wolper. His view is that, "It's not a good idea for most people to even think about currency exposure when they choose a fund."

Few overseas funds fully hedge their exposure to foreign currencies back into the dollar, given the ongoing lure of global growth. Most funds hedge only parts of a portfolio or specific currencies. Then there are the rare few that are very, very hedged.

The folks at Tweedy Browne Global Value argue that over the long term there's little evidence that having exposure to foreign currencies improves returns. The fund has fully hedged just about all of its positions since its inception in 1993. The exceptions are major multinationals that do significant business in the dollar, such as Nestle or Unilever, which can be partially hedged.

Not surprisingly, the Tweedy fund's performance hasn't looked great in recent years. Year to date, the fund is down 13% whereas the benchmark for foreign stocks, the MSCI EAFE Index, is off 11%. But over the longer term, Tweedy's annualized 10-year return of 8.78% beats the unhedged index's 6.82% gain through May 31.

"Some people suggest that foreign currency is a diversifier, but we don't go abroad looking for diversification. We go abroad looking for cheap stocks," says Bob Wyckoff, a manager of the fund. "Our thinking is, if we can eliminate the speculative component of investing internationally and it doesn't cost us anything over long periods to do it, why not hedge it out?"

A different strategy is in place over at Putnam Investments. Shigeki Makino, who manages the Global Equity Fund, says the goal is to negate "unintended bets" on foreign currencies. Makino does this by matching a fund's exposure to its benchmark's. For instance, if a fund owns a lot of Japanese stocks it also has a lot of exposure to the yen. To get rid of that implied bet on the yen, the fund has a team of currency specialists use financial tools to bring it back down to match the benchmark's yen exposure. In some cases, the currency team can take it a little above or below the benchmark, but not by much.

"The idea is you can get hurt without doing any currency hedging because of bets implicit in the portfolio," Makino says. "We want to get rid of unintended bets and make modest active bets where we think we have value."

That said, Makino doesn't expect a major dollar rally anytime soon. He points out that the Fed isn't the only central bank talking tough about inflation and if anything the Fed has been slower to do so than others. The European Central Bank, for instance, has been hawkish for some time and is expected to raise interest rates in July, which could bolster the euro.

Ed Lugo, manager of Franklin International Small Cap Growth Fund, doesn't hedge at all. His view is that international portfolios have enough "inherent offsets" as it is, because the economy is so global and many foreign companies do business with the U.S. For instance, Franklin International owns London-based Signet Group, which operates various jewelry retailers including Kay Jewelers in the U.S., exposing it to the dollar. "Hedging in general is expensive and difficult to do," Lugo says. "It's an increasingly global economy, so an investor will always want some international exposure. The better question is how much 20%, 15% or 10%."

If being pretty well-hedged is an approach you like, the other major offerings are Longleaf Partners International and the Mutual Series funds of Franklin Templeton, says Morningstar's Wolper. But don't jump ship on your unhedged international fund just because you're bullish on the dollar; you should already have plenty of greenback exposure through your U.S. stock holdings.

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