If you want to invest successfully in foreign stocks, you've got to do more than pick the right fund, or the right company.
You've got to pick the right currency too.
The impact that a rising or falling U.S. dollar has on the value of international investments has never been as apparent as it has been this year,when the strong dollar has cut into the returns of overseas investments.
For some international investors, like those who have put money into German stocks, the rising dollar has, for the most part, meant that their spectacular returns have been less luminous.
But for others, like the unfortunate folks who put money into Thailand stocks, the collapse of the local currency has led to staggering losses.
Either way, the strong dollar, coupled with the continuing strength in the U.S. stock market, has kept international investments from matching the record-setting returns from domestic stocks and mutual funds.
"You've got a very strong domestic market and you've got a very strong currency, so you've been fighting against a double-whammy," says Michael McDonagh, the head of Japanese equities for the GT Global mutual fund family.
Indeed, while the Standard & Poor's 500 index is up 28 percent so far this year and the average growth mutual fund has risen by almost 27 percent, the typical international mutual fund has gone up by only 15.5 percent, according to Lipper Analytical Services Inc.
A big reason why international funds haven't kept pace is the strong dollar.
Just look at some of the major European stock markets and you'll find that most of them have been outpacing the U.S. market. But when you factor in the rise in the dollar, those gains shrink considerably and, in most cases, end up below the rise in the U.S. market.
The German stock market, for instance, is up 42 percent so far this year, but when you factor in the 12 percent drop in the value of the mark, that gain only amounts to 24.6 percent in dollars.
It's the same story in France, where the market is up 29 percent in francs, but if you convert them into dollars, the gain is only 13.6 percent, or less than half the rise in the U.S. market. All that because the franc has lost 12.1 percent of its value against the dollar this year.
But if you want to see real horror stories, look at some of the once high-flying Far Eastern markets, which have been devastated by a major currency crisis. The region's markets have been in turmoil since July 2, when Thailand's government devalued the baht after spending billions in a futile effort to maintain the currency's link to the U.S. dollar.
In subsequent weeks, the governments of the Philippines, Malaysia and Indonesia abandoned similar dollar ties.
The heavy losses in the currency markets spilled into those countries' stock markets, where the benchmark index in Thailand is down 52 percent, while the market is off 48 percent in Malaysia and 49 percent in the Philippines since the start of this year.
"The (third) quarter was a good one for most fund investors unless you were invested in a Southeast Asian fund," says A. Michael Lipper, the president of Lipper Analytical Services Inc., which tracks mutual fund performance.
"The currency crisis has revealed fundamental weaknesses in these economies," says Kevin McDevitt, an analyst at Morningstar Mutual Funds.
"Many banks and property companies have become overextended, after having borrowed dollars freely in the days when money was pouring in from overseas," he says. "Now that growth has slowed, liquidity has dried up and these companies now must repay their dollar loans at higher rates because of their weak currencies."
One way some funds try to smooth over currency fluctuations is by using a small portion of their assets to hedge against sharp rises and falls in the value of the local currency.
But hedging can be expensive, especially in emerging markets, and it won't protect a fund against a calamitous drop, like the ones that hit Thailand this summer or Mexico in late 1994, McDonagh says.
Only about a third of all U.S.-based international funds hedge part of their currency exposure, although studies have suggested that fund managers, in the long run, tend to hurt their returns more often than help them by hedging.
Yet McDonagh says investors shouldn't be scared away from international markets because of their lackluster returns the last few years. They still offer investors a good way to diversify against a slowdown in the U.S. markets, he says.
What's more, McDonagh says international funds may benefit in the future if the long U.S. bull market and economic expansion begins to peter out. "You should look overseas for diversification," says McDonagh, who prefers broad-based international funds to ones that focus on single countries.
"You're in the seventh year of recovery here, and you're not showing any signs of overheating yet," he says. "In Europe, what you're seeing is growth coming through . . . The economies are in far earlier stages of development."