Getting The Europe ETF Choice Right

With new action by the ECB, hedging may be back in vogue in Europe too.

Yesterday I wrote about Japan, and how I think things have swung back in favor of hedged equity ETFs—specifically the WisdomTree Japan Hedged Equity Fund (DXJ | B-64).

Today's headlines about the policy shifts in Europe bring the eurozone into stark focus for similar reasons. The news is pretty straightforward and not that unexpected. The ECB will be buying up bank loans and cutting interest rates. The much more important part is that ECB President Mario Draghi indicated they're going to keep the easy money going and take any needed actions to keep the eurozone out of further trouble.

As always around here, the question is what that means for ETF investors, especially with regard to hedging.

The developed-markets Europe segment has seen just a rash of creation activity, making the choice here particularly hard.

The top four picks here have at least been around awhile, but four ETFs focused on Europe have launched just in 2014. And these are just the funds explicitly targeting total market exposure. There are large-cap, small-cap and sector approaches you can play as well.

Europe Vs. Eurozone

But let's focus on the big picture.

There are two main questions here as I see it: Which Europe? Whither the euro? If you're explicitly trying to maneuver around Draghi, well, you have to kiss your tea and skis goodbye.

Our Analyst Pick for broad Europe exposure, the Vanguard FTSE Europe ETF (VGK | A-98), has a third of its portfolio in the U.K. alone, and another healthy 14 percent slug in Switzerland, with a smaller piece focused on Sweden. Those U.K. and Swiss stocks may or may not be fantastic investments, but they're definitely going to follow a different path if you believe the ECB is driving the train right now.

That leads more naturally to the iShares MSCI Eurozone ETF (EZU | A-60). EZU removes all the non-euro countries, leaving you with a portfolio dominated by France and Germany (each at 30 percent), and large allocations to Spain, Italy and the Netherlands. While the sector skews aren't enormous for making that choice (you're still 20-something percent in financials), the currency exposure becomes paramount for U.S. investors.

To Hedge Or Not To Hedge?

This gets us to the hedged products, just like we got to them in Japan. With the ECB lowering rates and the U.S. signaling it's going to start raising rates, all signs point to a lower euro and a stronger dollar.

That makes investing in euro-denominated equities problematic. That's the whole story behind the WisdomTree Europe Hedged Equity Fund (HEDJ | B-51). But in 2013, when the same idea in Japan was on fire with DXJ, it didn't work out so well with Europe:

In fact, the best broad market play, iShares' EZU, not only didn't hedge out the euro, it only invested in euro-denominated stocks. It outperformed HEDJ by almost 7 percentage points.

So far in 2014, that story has completely reversed. Hedging out the euro, which is down almost 6 percent versus the dollar this year, has been a genius move so far.

I added the Deutsche X-Trackers MSCI Europe Hedged Equity ETF (DBEU | B-56) to the list, as it's been around at least long enough to make the chart. Both it and HEDJ get rid of any currency exposure, but the difference between the two products is stark—and the same as the difference between VGK and EZU.

The Deutsche product, DBEU, tracks the MSCI Europe Index at its core—which means full exposure to the U.K., Switzerland and Sweden. The WisdomTree product, HEDJ, while not tracking precisely the same index—WisdomTree generally tracks its own in-house indexes—invests solely in eurozone countries.

And that distinction is the critical driver of any performance divergence going forward.

Like its Japan product, WisdomTree's eurozone product doesn't just buy up all the stocks in a country—it's explicitly targeting companies with big revenues from exporting. The theory is that in a currency-devaluation scenario, those are the companies most poised to profit. I'm slightly skeptical that's going to be the story of Europe for the next year, but I still think hedging out the euro is the right move.

As for the other funds in the space … well, they're all just different ways of skinning the cat, whether it's minimum volatility or dividends, or in the case of the iShares Currency Hedged MSCI EMU ETF (HEZU), just a clean hedged alternative to EZU. HEZU may one day be the go-to product for situations like this, but with less than $4 million in assets, it goes days without trading, making it impossible to recommend for the average investor.

So, between DXJ and HEDJ, I'm predicting a good 2015 for WisdomTree.

At the time of this writing, the author had no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @dnadig.