Here's a trick question: Are Spanish stocks up or down this year?
For someone sitting in a Barcelona cafe, the answer is obviously up. Spanish stocks have climbed 10.9 percent in euros. But for someone counting in U.S. dollars, each of those euros is worth less than at the start of the year, so the same MSCI Spain index is down 1.7 percent in dollar terms.
Such is the conundrum for U.S. investors looking at markets around the world. The dollar's value has climbed against the Argentine peso, the New Zealand dollar and almost everything in between. It hit its highest level against the euro last month in more than a dozen years. That has eroded returns for U.S. investors with foreign stock mutual funds and exchange-traded funds.
A growing number of funds have been trying to blunt this effect. They're called currency-hedged funds, and they're suddenly some of the industry's most popular investments. Proponents say they allow investors to focus on just the stocks they want to buy — Japanese, European or otherwise — and largely ignore currency movements, which can be unpredictable. That's particularly attractive now as investors make their stock portfolios less U.S.-heavy and take advantage of cheaper stock valuations in other parts of the world.
Consider the WisdomTree Europe Hedged Equity fund. It's an ETF that invests in more than 100 European stocks, but it also invests in futures contracts to limit the effect of shifting currency values. It has returned 21 percent this year, more than double the 8 percent return of the average European stock mutual fund.
Investors plugged $5 billion into the fund last month. Only one other fund attracted more, according to Morningstar. Another currency-hedged fund, the Deutsche X-trackers MSCI EAFE Hedged Equity ETF, which invests in more than 900 stocks from 21 developed economies, also ranked among the most popular funds last month. It raked in $2.6 billion, and its assets have grown to more than $11 billion since its birth less than four years ago.
Before jumping on this trend, investors should keep in mind that currency-hedged funds won't always be on top and aren't for everyone. Here are some issues to consider:
— WHEN HEDGED FUNDS SHINE
The appeal of currency-hedged funds is obvious when looking at returns over the last year. Consider two offerings from iShares that are nearly identical except for one thing. Both track the MSCI Japan index, but one hedges to reduce the effect of the dollar's movements against the yen.
The hedged ETF has returned 41.1 percent over the last year, versus 21.1 percent for the unhedged one. The difference is due to the fact that the yen has dropped against the dollar, due in part to the diverging paths the U.S. and Japanese economies have taken. The U.S. economy has strengthened enough that the Federal Reserve has ended its bond-buying stimulus program. Most economists expect the Fed to raise short-term interest rates later this year.
The Bank of Japan, meanwhile, is pushing stimulus to try to invigorate its economy. The European Central Bank has taken a similar position, which has sent the euro down against the dollar.
Many expect the dollar to continue to rise, which would favor currency-hedged funds. Investors should bear in mind that the dollar tends to move in cycles that can last years. The dollar's big move higher against the euro began only last summer. Against the yen, it started at the end of 2012.
— WHY SOME STICK WITH UNHEDGED FUNDS
Holding unhedged funds can improve diversification for a portfolio, says Fran Kinniry, a principal in Vanguard's investment strategy group.
But he suggests going unhedged only with stock funds. With bonds, the big swings in currencies can overwhelm the relatively small, steady returns of those funds. Stocks, which are volatile on their own and have bigger expected returns than bonds, can more easily absorb currency movements.
In the end, many investors agree that forecasting where currencies are heading is difficult.
Consider a seemingly innocuous Thursday earlier this year. The Swiss National Bank shocked markets on Jan. 15, when it abandoned its minimum exchange rate of 1.20 Swiss francs to the euro. The Swiss franc spiked by about a third against the dollar within minutes, driving home how volatile and unpredictable currency trading can be.
If the dollar starts to weaken against the euro and other currencies, as it did from 2001 until 2008, investors would do better to hold unhedged funds. Now that the euro has already dropped more than 20 percent against the dollar over the last year, how much more can it fall?
"If you want to be hedged, these funds are perfectly fine," says Patricia Oey, a senior analyst at Morningstar. "But if you wanted the big exciting gains, that easy money has passed."
Over the really long term, say 20 years, it may not matter much anyway. Conventional wisdom says that changes in currency values eventually wash out. That means the more important question for long-term investors is likely whether a fund is well-run and low-cost, rather than whether it hedges.