One Way to Manage Risk Internationally: Hedge Euro Risk

Germany has been a key driver of European growth and has proven to be a resilient force throughout the crisis. With (i) the eurozone exiting recession in the second quarter of this year, and (ii) developed market growth now charting an upward trajectory, Germany’s export channel looks well positioned. In a previous blog post on the declining correlation between German equities and its currency, the euro, we made the case for investors seeking exposure to Germany to hedge out the currency exposure. Furthermore, even in the absence of a strong negative correlation, we note below how hedging out currency exposure can lead to lower volatility in an investor’s total returns profile, as it has historically. Hedging Out the Euro Can Reduce Overall Volatility When an unhedged investment is made in foreign securities, the investor is not only taking on the equity exposure but also the currency risk. This can potentially increase the overall volatility of the investment. Over the past 10 years, the difference in volatility has been considerable. Consider how much additional risk has come from the euro currency itself over recent years based on the volatility of the MSCI Germany Index¹:     + 4.4% over 1 year     + 6.5% per year over 3 years     + 8.2% per year over 5 years     + 5.7% per year over 10 years These statistics show that over one-quarter of the volatility of German equities for U.S. investors would have come from the euro itself. Is that extra risk compensated with expectations of higher returns for the euro going forward? Despite adding significantly to the volatility picture, historically, the euro’s returns have hardly compensated the investor for the additional volatility. The euro returned²:     + 6.1% over 1 year     - 0.3% per year over 3 years     - 0.8% per year over 5 years     + 1.7% per year over 10 years The decline in return over the five years more than wiped out any equity gains over that period. We make the case for hedging out euro exposure in order to potentially reduce overall volatility and mitigate the risk of hurting the overall return profile through potentially adverse currency movements. Conclusion While we made the case here with respect to Germany, we also could broaden the argument with respect to the Eurozone at large. WisdomTree believes there is an increased need to consider hedging currency risks when it comes to international investing. WisdomTree has thus created a series of hedged equity Indexes that include one for the broader European markets as well as for some of the largest countries in Europe, such as Germany and the United Kingdom. ¹Sources: WisdomTree, MSCI. ²Sources: WisdomTree, MSCI, Bloomberg.