Time to Buy The Hedged European ETF?

Zacks

While the crisis in Europe may be reaching a lull, investors aren’t as optimistic about the currency markets. Recent policy decisions by the ECB and comments by Mario Draghi haven’t exactly been favorable to the euro, and now some are expecting some near term volatility for the common currency.

After all, the ECB recently slashed their benchmark rate by 25 basis points with some expecting more cuts in the future as well. Draghi pretty much confirmed this when he said earlier in the week that ‘we are ready to act again’ and that ‘monetary policy will remain accommodative’.

After this news, the euro slumped a bit against the dollar although it is clinging to the 1.30 mark right now. But if we see more cuts or other more ‘innovative’ measures that add to the balance sheet but attempt to stimulate the economy, we could see the euro fall further against the greenback in the weeks ahead (see 3 ETF Strategies for the Second Quarter).

Equity Angle for Europe

If the euro does slump against the dollar, it presents an interesting situation for investors who want to buy up European securities. While stocks in Europe haven’t been that bad to start 2013, an unfavorable currency impact could dull these returns for American investors.

That is because for euro-denominated investments, a sluggish dollar will curtail any U.S. dollar-based returns. In other words, even a correct call on a particular European ETF could be marred by a poor currency translation, so this aspect definitely needs to be taken into account.

This is especially true given the recent surge in many European ETFs over the past month. Broad funds like VGK and EZU have performed quite well in this time frame, so perception about European equities may be shifting, although the currency isn’t.

How to Avoid

Fortunately, the advent of ETFs has led to some currency hedged ETF options. These funds help investors to strip out the currency exposure so U.S. investors don’t have to worry about the negative impact from a foreign currency. While these are also likely to underperform when the dollar is weakening, they have found a niche among certain types of investors.

We have definitely seen this so far in the case of Japan ETFs, and particularly over the past six months. WisdomTree’s DXJ, which hedges out yen exposure, has performed admirably when compared to its unhedged cousin, EWJ, adding over 50% compared to EWJ’s still respectable 30% gain (meanwhile the yen fell by about 20% over the same time frame).

While most analysts aren’t forecasting such an incredible drop in the euro against the dollar, it does showcase that hedging out currency exposure can make a big difference in a particular market. So for investors who want to apply a similar technique to Europe, it may be time to consider the Europe Hedged Equity Index Fund (HEDJ).

Hedged Equity ETF in Focus

This ETF looks to track a broad benchmark of European equities while stripping out euro exposure. The fund does charge 58 basis points a year so investors do have to pay a bit more for the hedging when compared to ‘regular’ ETFs like VGK or EZU.

The fund is also a bit less liquid than those competitors, as roughly 50,000 shares move hands in a normal day. The product is relatively popular though, as more than a quarter billion is invested in the fund, making it one of the more popular hedged products in the market today (read Currency Hedged ETFs: Top International Picks?).

It is also worth noting that the product will invest in a broad basket of stocks from across the euro region with a focus on German, French, and Dutch companies. Additionally, it will tilt towards exporters so it could be better positioned than most to benefit from a slide in the value of the euro against the dollar.

Bottom Line

While European ETF investing is still dicey, it is clear that the ECB is going to throw everything they can at the problem. This could support asset prices in some parts of the region, but it also might result in a slide against the dollar for the common currency (see Volatility Hits Euro ETF after Draghi Comments).

So if investors are seeking to play the stock story in Europe without worrying about a euro slide, consider HEDJ for exposure. The fund looks to eliminate worries from a euro slump and allow investors to take advantage of a broad boost in sentiment about the region, at least in the short term.

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Read the analyst report on VGK

Read the analyst report on EZU

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