Unhedged: Around one fourth of active and passive world-bond funds leave their overseas currency exposures completely unhedged and, as a result, carry the most currency risk among the three subgroups examined here. From a regional standpoint, half the group focuses on non-U.S. debt while the rest have a global purview. More than half of these offerings focus mostly, if not solely, on government debt. A smaller subset focuses on global or non-U.S. corporates, and just a few are dedicated to global inflation-linked bonds. Therefore, funds in this cohort sport varying levels of interest-rate and credit risk. Given the variety of approaches used in this group, many different benchmarks are employed beyond the broad-based Barclays Global Aggregate and the Barclays Global Aggregate ex-U.S. indexes.

Hedged: The smallest subset (17% of world-bond offerings) comprises funds that fully hedge currency exposures back to the U.S. dollar. These funds, which are mostly global, focus on Treasuries or a mix of Treasuries and corporates, and there are no dedicated high-yield or inflation-protection strategies in the group. Here, investors forgo currency risk, with hedged versions of the Barclays Global Aggregate and the Barclays Global Aggregate ex-U.S. serving as common benchmarks.

Currency Hedging
One possible way of making foreign stocks easier to own is to hedge the currency risk with a currency-hedged fund, such as  Deutsche X-trackers MSCI EAFE Hedged Equity DBEF (0.35%). This fund invests in large- and mid-cap stocks in developed markets overseas and uses currency forwards to hedge its currency exposure. Currency hedging has put DBEF’s volatility on par with U.S. stock funds, like VTI, and improves performance when the U.S. dollar strengthens.

It is important to note that currency hedging does not protect investors from expected changes in currency values. If interest rates are higher in the foreign market than in the domestic market, the forward price should be lower than the spot price such that the effective risk-free return should be the same in both markets. This is a condition known as covered interest-rate parity. While interest-rate parity doesn’t always hold in the spot market, arbitrage enforces this condition in the forward market.

For example, if the risk-free interest rates in Australia and the United States are 4% and 1%, respectively, and the current spot price of the Australian dollar is 1.0 AUD/USD, the one-year forward price should be 0.971 [1.0*((1+.01)/(1+.04))]. If the forward rate were higher than this (say 0.99), investors could borrow in the U.S. at 1%, convert U.S. dollars into Aussie dollars at the spot rate, invest at the Australian risk-free rate (4%), and sell forwards to hedge out the exposure. At the end of the year, the investor would convert AUD 1.04 to USD at 0.99 (USD 1.03), return USD 1.01 to the lender, leaving a USD 0.02 risk-free profit, with no upfront cash outlay. While the market is not perfectly efficient, it generally doesn’t present this type of free lunch.

As a result of covered interest-rate parity, higher foreign interest rates generally increase the cost of hedging. Over the trailing 10 years through November 2015, the effective cost of hedging the MSCI EAFE Index (before taking fees and taxes into account) was actually a negative 61 basis points annually. This is measured as the difference in the return on stocks in the MSCI EAFE Index in their local currencies and the return on a hedged version of the index. In contrast, it cost 166 basis points annually to hedge the MSCI Emerging Markets Index. Because interest rates are currently higher on average in emerging markets than in developed markets, it is generally more expensive to hedge currency exposure there.

Hedging can increase costs in other ways, too. In addition to the higher fees that currency-hedged funds charge, currency hedging tends to reduce tax efficiency. That’s because hedged funds must regularly roll their contracts forward to maintain the hedge, which can trigger taxable capital gains. For example, Deutsche X-trackers MSC