Currency Hedged Europe ETFs Back In Spotlight

The U.S. dollar index was on a downward spiral, dropping more than 5.2% year-to-date in reaction to growing doubts the Federal Reserve would actually raise rates this year. But that was until the Brexit vote succeeded.

This morning, the greenback had erased half its losses, rallying some 2.5% as the British pound slipped to a 30-year low and the euro hit a low of $1.09 against the dollar.

In the ETF market, this apparent reversal in trend could bode well for currency-hedged ETFs, or at least put these once-hot strategies back on the center stage of investor interest.

Consider the recent trajectory of the WisdomTree Europe Hedged Equity Fund (HEDJ | B-47). HEDJ is the second-biggest Europe-focused ETF in the market today, with $11.6 billion in total assets. It’s smaller only to the unhedged veteran, the Vanguard FTSE Europe ETF (VGK | A-97), with $13.2 billion. Both funds offer total-market, developed-Europe exposure, and are at the top of the segment.

Before the Brexit vote, buying into the currency-hedged exposure HEDJ offers—with an expense ratio that is nearly 5 times more than VGK’s—didn’t seem to make a lot of sense from a total-return perspective. Investors are shelling out 0.58% for a total market portfolio that’s underperformed the 0.12%-in-fees VGK by more than 2.5 percentage points: 

However, this morning, it was the unhedged VGK that was leading in losses, losing some 8.5% following the surprising outcome of the Brexit vote, while HEDJ was down 6.3%. Friday’s price move pretty much closed the gap between the two, and alluded to the performance benefit a currency-hedged strategy might have over an unhedged counterpart going forward.

The chart below shows VGK’s and HEDJ’s year-to-date performance following Brexit. They are now toe-to-toe:

More About The Dollar Than Underlying

HEDJ’s portfolio allocates most heavily to France and Germany, which, combined, represent more than 50% of the portfolio. That compares with VGK’s focus on the U.K., which represents about 30% of the overall mix, and is the fund’s biggest country bet. But HEDJ’s recent underperformance is largely linked to the performance of the U.S. dollar.

Currency-hedged ETFs, by design, protect U.S. investors from the negative impact a strong U.S. dollar has on international stock returns. But when the dollar weakens, they can be underperformers.

When you own an international stock fund, your money is converted into, say, the euro, to buy the underlying securities abroad. Your gains depend on the performance of those securities, as well as on the performance of the currencies. If the euro weakens—or the dollar strengthens—you lose money when your returns are converted back to dollars.

Deja Vu 2015

In 2015, we saw funds like HEDJ become household names as the euro tumbled. HEDJ was, in fact, the most popular fund that year, raking in $13.8 billion in assets. But so far in 2016, it has faced $4.47 billion in net redemptions, according to FactSet data.

HEDJ isn’t the only example of an ETF that could be sitting pretty for a resurgence of investor demand—and performance—if the dollar does in fact switch gears and rallies further in the wake of Brexit. Here are a few of the other key players in this segment:

• The Deutsche X-trackers MSCI Europe Hedged Equity ETF (DBEU | B-64) has $3 billion in total assets, and so far in 2016, it has seen some $550 million in net outflows. DBEU holds the U.K. as its single biggest country weighting, at about 30% of the portfolio.
• The two-year-old $1.7 billion iShares Currency Hedged MSCI Eurozone ETF (HEZU | D-39) has now lost $731 million in net redemptions this year. France and Germany are the fund’s biggest country allocations.
• The low-volatility take on the segment, the $313 million PowerShares Europe Currency Hedged Low Volatility Portfolio (FXEU | D-31), picks 80 of the least volatile total-market eurozone stocks, while hedging out the effects of currency fluctuations of the euro to the U.S. dollar. The fund, which is a year old, has been one of the few Europe-focused currency-hedged ETFs to attract assets this year, thanks to its low-volatility approach. Investors have poured about $155 million into the fund in 2016.
• The small-cap WisdomTree Europe Hedged SmallCap Equity Fund (EUSC), with $245 million in assets, is essentially a small-cap version of HEDJ. The fund looks for dividend-paying, eurozone small-cap equities and hedges out currency exposure, and despite its weak performance (chart below), it has seen $8.8 million in net creations year-to-date.

All four of these funds have struggled to find upside in 2016, and could benefit from a rallying dollar. 

Chart courtesy of StockCharts.com

Finally, consider a fund that hedges currency exposure, but only with one foot in the trade: the 50/50 hedged IQ 50 Percent Hedged FTSE Europe ETF (HFXE). This Europe fund tracks an index of developed-Europe-based large- and midcap companies, with approximately half of its foreign currency exposure hedged into the U.S. dollar.

The ETF, which came to market last July, and which has a modest $67 million in assets, offers a unique take on the currency-hedged theme. HFXE has now lost about 2.3% before the Brexit vote, but has managed to attract more than $40 million in net creations so far this year. The U.K. is the fund’s largest country allocation, at 31%, followed by France, at 15%.

What happens next to the dollar will be crucial to the appeal of these currency-hedged ETFs, just as much as what happens next to European equities on the heels of an unexpected U.K. exit from the eurozone.

Contact Cinthia Murphy at [email protected].