Meanwhile, a 2006 working paper by Harald Hau, finance professor with Center for Economic Studies, London, found that money can flow out of foreign currency assets as quickly as it can flow in. That's because cash flows into foreign equities are positively correlated with foreign currency appreciation.
On the investment company side, mutual fund portfolio managers are bearish on the dollar. Gregg Wolper, analyst at Morningstar Inc., says the vast majority of foreign stock funds are not hedging foreign currency positions. "Most international equity funds are completely unhedged," he says. "The managers typically explain that their shareholders prefer that arrangement, saying that they own the fund not only to diversify into foreign stocks, but into currencies as well."
As a result, mutual fund investors have a large stake in foreign currencies. And those funds could experience large losses if the dollar strengthens substantially due to rising interest rates or an international flight to safety.
Edward Yardeni of Yardeni Research, Great Neck, N.Y., is bearish on the dollar. Nevertheless, he says the dollar could strengthen if there is a financial crisis.
"A renewed financial crisis might be bullish for the dollar," he says. "After all, the dollar rallied from July 2008 through March 2009 when there was a great deal of financial turmoil. Risk aversion seems to benefit the dollar much more than other currencies."
Despite the unhedged positions of numerous foreign mutual funds, Wolper says many funds are not averse to changing directions. For example, in 2007 and early 2008 when the dollar was stronger, a number of funds hedged their currency exposure.
Although investors may benefit today from adding currency positions to their portfolios, either in the form of foreign mutual funds or foreign currency funds, others aren't so sure it is absolutely necessary.
William H. Browne, managing director with Tweedy, Browne Fund Group, says over the long term, hedging a portfolio of stocks doesn't matter. For example, the difference between the annualized returns of the MSCI EAFE Index in U.S. dollars and the MSCI EAFE Index, hedged to the U.S. dollar, was only 2 basis points over the past 16 years, ending in September 2009. The hedged index returned 5.19% annualized and the unhedged index returned 5.21%. Tweedy, Browne Global Value Fund hedges its foreign currency positions.
Nevertheless, in October, the investment company launched the Global Value Fund II, an unhedged foreign stock fund, due to investor demand. "In doing this, we are in no way suggesting that investing on an unhedged basis is preferable," Browne says.
"The empirical evidence and our experience in managing the Global Value Fund continue to suggest that over long measurement periods, exposure to foreign currency is not a meaningful addition to the total return." Over shorter periods, foreign currency fluctuations could create substantial differences in performance between these two funds, he adds.
"We would expect this unhedged fund to have similar returns to our existing Global Value Fund over the long term," Browne says.