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.