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Course 306
Choosing an International Fund, Part 2

Introduction

As you learned in Lesson 305: Choosing an International Fund, Part One, examining the countries that an international fund invests in is central to understanding whether the fund is right for you. If sharp market movements make you nervous, investing in a fund that concentrates just on Latin America or Asia's emerging markets probably isn't the best idea for you.

But the countries in which a fund invests constitute only one factor contributing to an international fund's returns and volatility. Two other elements-the manager's investment style and currency-hedging policy-play equally important roles. Thus, you have two additional questions to ask before buying an international fund.

What Is Its Style?

In the early days, style wasn't an issue for foreign-stock funds. Most funds bought reasonably priced stocks of the world's largest companies. After all, international-investing pioneers such as Sir John Templeton and the managers at Scudder had profited for decades by using such strategies. In the 1990s, though, Janus and American Century met with great success when they began applying the growth-focused strategies they used at home to investing abroad. Their styles were still novel among foreign-stock investors.

The issue of investment style doesn't end with the choice between value and growth. It also involves the question of the size-otherwise known as market capitalization-of the stocks in which a fund invests. To determine an international fund's investment style, consult its Morningstar style box, which you can find on the Fund Report.

A fund's investment style will have a direct impact on its risk level. If ups and downs make you queasy, steer clear of funds that emphasize small foreign companies, because they tend to be more volatile than large-cap players. (Just like volatile emerging-markets stocks, though, foreign small-cap stocks generally do a better job of diversifying a U.S. portfolio than foreign large-cap stocks do.) And the easiest way to get exposure to both large-value and large-growth foreign stocks is through a large-blend foreign fund.

What Is Its Currency-Hedging Policy?

When fund managers buy foreign stocks, they're also effectively buying the foreign currency that the stock is denominated in. So a foreign stock's return is really a combination of two things: the performance of the stock itself and the performance of the country's currency versus the U.S. dollar.

Let's take an example. Say you buy a Japanese stock, Sony (SNE). The value of the stock itself rises 10%. But the yen (Japan's currency) falls 15% against the U.S. dollar. As a U.S. investor, you've lost money on that investment, because even though the stock price has risen, the currency's value has fallen. What if the yen rises 10% instead? Then you have a nice tailwind, because you get the 10% rise in the stock's price and the 10% rise in the currency.

Managers can own foreign stocks and, with a little work, eliminate their exposure to foreign currencies. They do that by hedging their foreign currencies-trading in their foreign currencies for U.S. dollars.

Let's go back to our example. You buy Sony, but hedge your currencies by selling Japanese yen and buying U.S. dollars. Sony's stock rises 10% and the yen falls 10% against the dollar. Because you hedged your currency exposure, whether the yen rises or falls doesn't have any effect on your investment.

Most studies indicate that hedging currencies has only a minimal effect on returns over very long time periods. But over shorter spans, hedging can make quite a difference in a fund's performance. Aside from simply hedging exposure, some funds managers will actively place currency bets to capitalize on a particular macroeconomic view.

If you can't quite understand why a foreign fund is behaving the way it is, chances are the fund manager is doing something with currencies. To avoid the unexpected behavior that can accompany mistimed currency plays, you can favor funds with strict hedging policies--those that never hedge or those that always do. Consult a fund's shareholder report to find out whether or not it hedges its currencies. If this information isn't available in the shareholder report, call the fund company and ask.

Quiz 306
There is only one correct answer to each question.

1 International small-cap funds are:
a. Better performers than international large-cap funds.
b. Poorer performers than international large-cap funds.
c. More volatile than international large-cap funds.
2 International funds:
a. Can invest in value or growth stocks.
b. All invest in reasonably priced stocks of large companies.
c. Buy only small-company stocks.
3 For a U.S. investor, the return on a foreign stock is:
a. The return of the stock itself.
b. The return of the currency.
c. The return of the stock itself and the currency in which it's denominated.
4 You buy shares of Britain's Glaxo. The stock falls 5%, but the pound (Britain's currency) gains 10% against the dollar. As an unhedged U.S. investor, you:
a. Lost money.
b. Made money.
c. Broke even.
5 You buy shares of Britain's Glaxo. The stock falls 5%, but the pound gains 10% against the dollar. You've hedged your currency back into U.S. dollars. You have:
a. Lost money.
b. Made money.
c. Broke even.
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