Last year, one of the most important investment themes was currency hedging
, particularly for euro-denominated stocks. Many investors believed the euro was going to weaken on the back of quantitative easing
by the European Central Bank (ECB)—and that’s exactly what happened. Versus the U.S. dollar, the euro started 2015 at 1.21 and closed the year at 1.09. With such a big move, many investors are wondering if they missed the boat.
From our perspective, to the contrary. The case to hedge the euro has gotten stronger by one very important measure: how much you are now being paid to hedge.
An important element of currency-hedged strategies involves the use of forward contracts
to neutralize currency exposure. The pricing of these forward contracts is based on relative interest rate
differentials. In some countries like Brazil, short-term interest rates
are very high, so it can cost U.S. investors upward of 14% per year to hedge exposure to currencies like the Brazilian real. That creates an incredibly high hurdle for how much the currency has to decline before an investor breaks even on paying that hedge cost.
But the actions the ECB took in December 2015 make hedging the euro different. The ECB took its deposit rate more negative—cutting rates to -30 basis points (bps)
. The U.S. Federal Reserve (Fed)
hiked interest rates for the first time in nine years and now has a band on its short-term rate of 25–50 bps; the midpoint of the range would be 37.5 bps. This means currency hedging is not only inexpensive—investors are actually getting paid to hedge the euro. And if/when the Fed increases rates in 2016
, that “payment” will increase further.
Historical Cost of Hedging the Euro (1-Month Currency Forward Implied Rates as of 12/31/15)
From a tactical perspective, when we look at what factors can help improve the returns from a purely passive hedging standpoint, interest rate differentials are the most powerful long-run signal. Given that an investor is starting to get paid more than 50 basis points a year from the differential in interest rates, this offers a boost to returns to hedged strategies over unhedged strategies, even if the euro does not move.
Of course, if the euro appreciates, the hedged strategies will not participate in those gains, but they will be hedged against further losses in the euro if those were to occur.
WisdomTree has three exchange-traded fund (ETF) options to target euro-area stocks with a currency hedge:
1) WisdomTree Europe Hedged Equity ETF (HEDJ):
Provides access to the dividend
-paying exporters of Europe, which can be positioned to benefit from a decline in the euro with their goods becoming more competitively priced in the global markets. We believe these companies have not fully benefited from the fall in the euro yet, as many of them also have large amounts of business coming from the emerging markets, which have also been weak in the last year. This is our flagship ETF for euro-area-hedging strategies.
2) WisdomTree Europe Hedged SmallCap Equity ETF (EUSC):
Provides access to small-cap companies of the euro area and offers exposure to a more local side of European stocks. This fund can pair nicely with the large-cap multinationals to diversify size exposure and geographic revenue mixes of the companies.
3) WisdomTree Dynamic Currency Hedged Europe Equity ETF (DDEZ):
Provides access to a broad cross-section of dividend payers from the euro area and implies a dynamic currency hedge
. For investors who do not want to rotate between hedged and unhedged strategies, but want to have some currency exposure when the environment is supportive of it, this fund can adapt and provide that type of tactical hedging solution.