Foreign-stock funds have been some of this year's biggest winners, but many investors aren't feeling the full benefit.
When buying a foreign-stock fund, investors increasingly have two options: One insulates investors from the swings in returns that can be caused by shifts in the dollar's value against the euro, yen and other currencies. These are funds that "hedge" against currencies, while the other group lets investors feel their full effect.
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Coming into this year, with Republicans fully in charge of Washington, expectations were for the dollar to build on a postelection rally, leading many investors to see hedging as the wiser strategy. That turned out to be wrong. Those who tried to time the market by switching into currency-hedged funds missed out on some of the best gains so far this year.
Consider the WisdomTree Europe Hedged Equity fund, an exchange-traded fund that owns Anheuser-Busch InBev, Telefonica and other European stocks. It also invests in the futures market to neutralize the effects of the euro's movement against the dollar.
The fund jumped 6.6 percent between Election Day and the end of 2016, part of a worldwide rally for stocks. And its returns towered over European stock funds that didn't hedge against the dollar's moves versus the euro.
That's because the dollar was in the midst of a strong rally, following the big electoral win for Donald Trump and the Republicans. The thinking was that Washington would enact policies that would lead to stronger U.S. economic growth and higher interest rates. The dollar jumped more than 10 percent against the Japanese yen within a couple months of Election Day, and close to 6 percent against the euro.
As a result, each euro was worth fewer dollars at the end of the year. So, while European stocks rose strongly in euro terms, they had a more lackluster move for investors counting in dollars. The iShares MSCI Eurozone ETF, for example, does not hedge currencies, and its gain from Election Day to the end of the year was only about a quarter of the WisdomTree Europe Hedged Equity fund's.
The two ETFs track different indexes, so they'll usually have differing returns. But currency-hedged funds will generally give the better returns when the dollar is ascending against other currencies.
But an unexpected thing happened early this year: The dollar reversed course, as some early legislative stumbles dimmed expectations for how much Washington can do for the U.S. economy. Plus, economies in Europe and elsewhere appear to be accelerating, which helped their currencies.
Some analysts had predicted the euro would fall to be worth $1 at some point this year. Instead, one euro is now worth $1.17. Investors in funds that don't hedge against currency swings are both feeling the benefit of rising foreign stock markets, and enjoying an added boost provided by the rising euro and other currencies.
The unhedged iShares MSCI Eurozone ETF is up about 19.5 percent for the year, more than double the 7.6 percent gain for the WisdomTree Europe Hedged Equity fund, for example.
This year's quick shift shows the danger in trying to time any kind of market. Just like it's difficult to predict when stocks will rise or fall, it can be tough to guess where the dollar is heading. Anyone who jumped into currency-hedged foreign stock funds this year, and out of unhedged ones, in expectations of much better returns has been disappointed.
It may be easier to pick one way to invest in foreign stocks: either hedged, unhedged or even a mix of the two, and stick with it. Over the very long term, returns for hedged and unhedged funds often end up looking similar because changes in foreign-currency values tend to wash out, analysts say.
The majority of foreign stock funds still don't hedge against currency moves. And hedging is something that's more common for European or Japanese stock funds. Low interest rates in those countries means it's cheap to hedge against their currencies' movements. But in Brazil, Turkey and other emerging markets, interest rates are much higher and can make hedging so expensive that it's not worth the cost.
"For emerging markets, you could have a strong opinion about the currency, but be completely wrong if it's too costly to hedge," said Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management.
In the end, many experts say the first question for investors choosing a foreign-stock fund should not be whether it hedges currencies. What's more important is that it's well run and has low costs.