Currency Hedging Impacts Non-UK ETFs

Next month marks the three-year anniversary of the original Brexit referendum, in which the United Kingdom narrowly voted to leave the European Union.

Ever since, a fog of uncertainty has hung over the U.K.'s financial future, with asset managers and financial institutions shifting their operations away from London even as lawmakers continue to debate the terms of Britain's exit.

How Euro Exposure Varies

No compromise has yet been reached, and recent European parliamentary elections, combined with pro-Brexit Prime Minister Theresa May's departure, suggest the U.K. is no closer to inking a deal.

Unsurprisingly, the U.K.'s stock market has struggled to keep pace with the rest of Europe. Over the past three years, the iShares MSCI United Kingdom ETF (EWU), which covers 85% of the U.K. market by market cap, has risen 4%, while the iShares MSCI Eurozone ETF (EZU), which covers only countries that use the euro, has risen 7%:

Source: StockCharts.com. Data as of May 29, 2019.

Given this uncertainty, investors might be considering reducing their exposure to U.K. stocks, by using eurozone-focused ETFs instead of general European funds.

But some eurozone ETFs are outperforming better than others—for one key reason: currency hedging.

2 Kinds Of Eurozone ETFs

Of the 48 developed Europe ETFs, 11 are purely eurozone funds, with no exposure to the U.K. (or, for that matter, to Switzerland or Sweden, which also do not use the euro).

Vanilla, broad-based EZU is the largest, with $6.7 billion in assets under management. Combined, the 11 eurozone ETFs hold $13.6 billion in assets:

Source: ETF.com. Data as of May 28, 2019.

Notably, five of these ETFs implement a currency hedge to the euro, while the other six do not. Currency hedged ETFs use short forward contracts to hedge out exposure to a foreign currency; in this case, the euro.

Isolating Returns

For U.S.-based investors, this neutralizes the impact the underlying foreign currency has on returns, effectively isolating the returns of the securities in question (read: "Are Currency Hedged ETFs Overlooked?").

As it turns out, that euro hedge has made a world of difference. Over year-to-date, 12-month and three-year time periods (the longest time period for which all ETFs had track records), average returns of currency-hedged eurozone ETFs beat those of noncurrency-hedged versions by at 3%. Over the past year, currency-hedged eurozone ETFs outperformed by over 6%:

Source: ETF.com. Data as of May 28, 2019.

Investors Pull Cash From Outperforming ETFs

Despite their outperformance, however, currency-hedged eurozone ETFs have been bleeding assets. In fact, no fund has lost more money than the best-performing eurozone ETF over all three time periods: the $3.5 billion WisdomTree Europe Hedged Equity Fund (HEDJ).

HEDJ, which implements a euro hedge over dividend-paying eurozone stocks, has returned a whopping 14.7% year to date, even outpacing gains from the U.S. stock market. On a 12-month basis, it lost only 0.75%, whereas other eurozone ETFs lost significantly more; while over the past three years, it has returned 9.7%.

However, HEDJ has also suffered the largest outflows over all three time periods examined. The ETF hasn't had a single positive day of flows over the past 12 months, over which time it lost $2.6 billion:

Meanwhile, over the past three years, HEDJ has lost more than $10.6 billion in net investment assets; the next closest was EZU, which lost a net $4.7 billion.

Over the past three years, investors have pulled $12 billion from currency-hedged eurozone ETFs, compared to $5.4 billion lost by noncurrency-hedged versions.

Waning Faith In Eurozone Stocks

Ultimately, this data probably doesn't indicate that investors have lost faith in currency-hedged eurozone ETFs, specifically, so much as they are removing their money from eurozone ETFs as a whole.

Prior to Brexit, more money was in currency-hedged ETFs than noncurrency-hedged ones, meaning there also was more money to pull out. (For example, on Jan. 1, 2016, HEDJ had $17.1 billion in AUM, while EZU had only $14.6 billion.)

What the data does seem to say is that investors continue to feel gloomy about all of Europe, not just the U.K.; and they remain concerned that the problems currently plaguing the U.K. could spread to the rest of Europe. As much as the U.K. tries to argue the island is a self-sufficient economy distinct and separate from that on the continent, investors remain unconvinced.

Still, it's clear that opportunity abounds in eurozone stock ETFs—although those investors seeking to increase their allocation may want to consider a currency-hedged version instead.

Contact Lara Crigger at [email protected]